Glencore, Xstrata merger faces investor scrutiny

A deal that would be a defining  transaction in the natural resource sector is facing pointed criticism from a group of activist investors. Prominent shareholders of mega-miner Xstrata (XTA-L) are questioning the inherent value in a US$39-billion takeover offer from Swiss-based trading house Glencore International (GLEN-L).

Announced in February, the proposed merger came as no great surprise, considering Glencore held 34% of Xstrata and had taken itself public through a US$10-billion ­initial offering in May 2011, which allowed for Glencore’s long-speculated value to finally be pegged at US$59 billion.

The proposal — which would create a mining powerhouse by having Glencore exchange 2.8 of its own shares for every share of Xstrata — met with investor discord early on as Xstrata institutional shareholders Standard Life Investments and Schroders  said they ­intended to dissent during voting, in an attempt to achieve more favourable conditions.

“Although we see some merit in the merger of Xstrata and Glencore, the proposed exchange ratio clearly undervalues Xstrata’s assets and future earnings contribution,” David Cumming, Standard Life’s Head of Equities, told Reuters in early February. “It is our intention to vote against the deal unless the merger terms for Xstrata shareholders are materially improved.”

Standard Life and Schroders held 3.5% of Xstrata’s outstanding shares when the deal was first announced, and under British securities law they would need to rally 16.48% in investor support to block the transaction.

Glencore’s offer was almost universally viewed as discounted by analysts. BMO Capital Markets calculated that the 2.8-share ratio bid was 15% share destructive to Xstrata investors, but 20% accretive to Glencore shareholders. BMO analysts estimated an appropriate offer would entail Glencore upping its bid to a share ratio between 3.5 and 3.75, based on 2011 profits and net present values.

“For Xstrata shareholders the bid ratio is dilutive, further highlighting the unlikelihood that a deal will be reached at its current proposal,” BMO analyst Tony Robson wrote in February. “A higher bid ratio is still accretive for Glencore, which allows the company to further sweeten the deal if necessary.”

It seemed unlikely that minority shareholders like Standard Life and Schroder could rally the support needed to block the merger, until a wildcard in the form of Qatar Holding joined the fray in late June. The direct investing vehicle for the Gulf state of Qatar had amassed an 11% interest in Xstrata, which at first glance appeared to be simply a move to acquire a stake in the merged company under the original bid terms.

Qatar Holding is guided by Ahmad al-Sayed, a U.S.- and European-educated Qatari lawyer who previously acted as general counsel for the Qatar Investment Authority. Qatar Holding controls an investment fund valued at around US$100 billion, and is known for acquiring stakes in high-profile assets like Harrods department store in London, and the Porsche-Volkswagen automotive conglomerate in Germany.

Qatar Holding issued a press release on June 26 saying it would oppose the merger on grounds that the premium being paid was a poor return for Xstrata shareholders. Qatar Holding stated that “a share ratio of 3.25 would be a more appropriate premium.”

The number is in-line with industry speculation, as Bloomberg statistics show that the current offer values Xstrata at 6.2 times its earnings before deducting interest, tax and amortization expenses, which represents the fourth-lowest multiple in a mining takeover valued at over US$5 billion.

“Qatar’s push for an increase in the Xstrata bid ratio puts Glencore in a difficult position,” Robson notes in a June 29 research update. “Increasing the bid is dilutive relative to current market expectations, while to walk away leaves Glencore’s balance sheet exposed to credit rating downgrades.”

BMO Capital Markets labels the challenge a “lose-lose” for Glencore, which must decide between increased dilution from a larger bid for Xstrata versus balance-sheet issues, capital expenditure challenges and a potential US$470-million “break-up fee” if the deal collapses.

Qatar’s actions have emboldened other Xstrata investors to threaten to holdout for a better deal. New York-based asset manager Knight Vinke, a top-20 shareholder, joined the battle on July 3, publicly supporting demands for Glencore to increase its bid.

Knight Vinke reportedly holds 0.7% in Xstrata, and says the current offer represents “no premium to shareholders for a transaction that appears to represent a change of control.”

Xstrata is revisiting an executive bonus plan valued at US$270 million after investors began to protest in early June, and escalating shareholder activism forced both Xstrata and Glencore to delay to Sept. 7 meetings that were originally to be held in July to vote on the merger.

Glencore has until two weeks before the meetings to alter the terms of its offer.