Xstrata Triggers Consolidation Talk With Anglo American Offer

Consolidation is the key word again in the base metals sector after Xstrata (XSRAF-O, XTA-L) tabled an informal offer for London-based Anglo American (AAL-L, AAUK-Q) on June 21.

And while Xstrata branded the proposal a merger of two equals, Anglo’s board wasted little time in rejecting the offer.

“The strategic case for the combination is unattractive for Anglo American shareholders. Irrespective of this lack of strategic merit, the terms proposed by Xstrata were totally unacceptable,” Anglo said in a statement issued on June 22.

Anglo’s labelling the strategic case for a merger as unattractive picks up on investor perception that its assets are superior to Xstrata’s.

“Anglo makes a good point that some of the things it is exposed to — mainly platinum and diamonds — are more in demand than the zinc and nickel that Xstrata is strong in,” says Tom Gidley- Kitchin, an analyst with Charles Stanley based in London.

Anglo has also touted the size of its reserves, the long lives of its projects and their position on the cost curve as some of the best in the industry — although some analysts question such a claim.

“It’s debatable,” Tony Robson, an analyst with BMO Capital Markets in Toronto, says of the view that Anglo would be diluting its portfolio by merging with Xstrata. “Anglo has longer mine lives with some products like platinum, but in terms of global cost curves and margins the two companies are similar. Both have some good assets, as well as mediocre. The difference is less than is made out by some.”

As for Anglo’s disdain for the terms of the proposal, observers reasoned that it meant the offer was made without a premium, although since the terms of the offer were not disclosed, that cannot be confirmed.

Anglo American holds a 77% stake in Anglo Platinum, the world’s biggest producer of platinum. It also owns a 45% of De Beers, the largest diamond company. Beyond those two interests, the company also produces copper, coal, zinc and iron ore in 45 countries.

The company was once South Africa’s largest as the apartheid years — and the sanctions that went with it — forced it to expand within the country.

As for Xstrata, the company was founded only in 2002. And it has been on a merger and acquisition streak ever since — the most significant of which was its purchase of nickel producer Falconbridge for $18.1 billion in 2006.

Such an acquisition tear, however, burned through cash and led the company to make a dilutive $5.9-billion rights issue in January to pay down debt.

The value of a combined company, without a premium, would be about US$68 billion.

And while Xstrata touted increased scale and cost synergies as key benefits of the merger, it was likely also counting on a high level of Anglo shareholder discontentment to see it through.

Such discontent is believed to have been simmering under the leadership of Anglo’s chief executive Cynthia Carroll. Some investors have chuffed that Carroll has not reduced costs as much as expected since coming on board in 2007. Such perturbation was agitated by the cancellation of the company’s longstanding dividend payment in February of this year.

In that context, Xstrata’s offer may well be read as a vote of confidence on Anglo’s management, meaning Anglo management’s rejection of the offer may not be enough if Xstrata takes its case to the company’s shareholders.

In such a scenario, Xstrata will likely argue that its management team is the right one to guide Anglo’s assets in the future.

“More than just focusing on cost synergies, the attraction for Xstrata is whether it can bring production discipline to Anglo Platinum to drive its value higher,” says Paul Cliff, an analyst with Nomura in London.

He says Xstrata has a good track record of bringing such efficiencies into projects it has purchased and that acquiring Anglo Platinum is likely a key driver to Xstrata’s pitch for Anglo American.

Estimates of the cost savings that could be realized by a combined company range between US$700 million and US$875 million a year.

But mitigating against such strong fundamentals is a South African government that has already said it is cool on a merger. The government fears a takeover would translate into a loss of mining jobs in the country, which is already suffering from high unemployment.

Already, lower base metal prices led Anglo to shed some 19,000 jobs back in February — at the same time it announced the end to its dividend.

Analysts are betting, however, that such obstacles won’t deter Xstrata.

“It is quite likely that Xstrata will increase its offer,” Gidley-Kitchin says. “Whether or not it is completed will depend on regulators in South Africa and the European Commission, but I don’t think Xstrata would just get to this stage without having thought through where it was going to end up on this.”

And while a combination of the two companies would create a new base metal company to be reckoned with, its new market cap of US$68 billion would still pale in comparison to BHP Billiton’s (BLT-L, BHP-N, BHP-A) US$144-billion market value, and it would only rank fourth amongst base metal producers in terms of market capitalization.

Brazilian miner Vale (VALE-N) is worth US$93 billion, while Rio Tinto (RIO-L, RTP-N) has a market cap of US$74 billion.

What is clear is that the two large base metal producers are now in play, with rumours of renewed interest from Vale swirling overhead. A proposed Vale takeover of Xstrata broke down last April.

Chinese state-owned Aluminum Corp. of China (ACH-N) or Chinalco — which was thwarted in its attempt at a US$19.5-billion tie-up with Rio Tinto, which then went on to set up an iron ore joint venture with BHP — is also rumoured as a possible suitor of Anglo American.

One significant factor that could moderate Chinalco’s interest is the fact that Anglo is not a major iron ore producer. The company produced 37.4 million tonnes of iron ore in 2008 — just a fraction of the 293.4 million tonnes Vale produced in the same period.

“The Chinese are unlikely to get involved,” Gidley-Kitchin says. “I’m also ruling out Russian companies coming in, so I think Vale is the only credible third party that might become involved.”

But even that, Cliff says, is a ways off.

“Anything like a Vale or Chinalco offer is further down the line,” he says. “It is still the very early stages and I don’t think there is any upside in coming in this early.”

Not to be forgotten as a key part of the mix is privately held, Swiss metal trader Glencore — which holds a 35% stake in Xstrata. Glencore has been rumoured to be considering a reverse takeover of Xstrata. But Cliff sees Glencore going in the opposite direction.

“The long-term strategy for Glencore is to dilute its stake through a large Xstrata acquisition with Glencore taking the marketing rights of the merged company and then doing its own IPO,” he says.

Cliff says such a move would allow Glencore to get back to fo cusing on what it does best — trading metals and other commodities.