Next M&A deal could be an Anglo American takeover by either Vale or Xstrata, Citigroup says

Just months after Vale (RIO-N) declared that the deal to buy Swiss-based rival Xstrata (XTA-L, XSRAF-O) was dead, the Brazilian mining giant unveiled plans to raise about US$14-15 billion in equity to finance, among other things, “organic growth” and “strategic acquisitions.”

But a week after the financing announcement was made earlier this month, Vale denied rumors in the Brazilian press that an acquisition was in the cards and issued a statement maintaining that it was “not negotiating an acquisition of any company.”

Analysts at Citigroup Global Markets aren’t ruling out an acquisition, however, and assert in a new research report that Vale’s first target could very well be Anglo American (AAUK-Q, AAL-L), followed by Xstrata at a later date.

A merger with Anglo American, one of the most diversified of the large-cap miners in terms of commodities, would diversify Vale from iron ore and nickel to world class coal, diamonds and platinum assets.

Perhaps equally importantly it would diversify Vale geographically, the investment bank argues. Currently Vale’s business is predominantly in North and South America. Anglo offers exposure to Australia and South Africa. Geographical diversification could mitigate political risk, currency risk and provide exploration growth potential in new parts of the world.

In the nickel space, Citigroup estimates annual cost savings of the tie-up would be in the region of US$100-$200 million.

“Although a deal would lack major upfront synergy gains it could enable Vale to revisit Xstrata at a later date and extract any benefits which existed from the asset overlap between Vale-Xstrata-Anglo American,” Citigroup argues in its June 26 research report.

Of course Anglo American would also make a nice fit with Xstrata, Citigroup concedesand most likely a more sensible one. A tie-up with Anglo American would make the combined company the world’s second-largest copper producer with an 11% market share after state-owned Codelco, the number one zinc producer (16% market share) and the number four nickel producer (8% market share). The group would also be the world’s leading platinum group metals and diamond producer.

Xstrata needs exposure to more commodities, with about 79% of its estimated 2008 EBITDA (earnings before interest, taxes, depreciation and amortization) derived from base metals.

In addition, a merger would marry Xstrata’s take-no-prisoners management style with Anglo American’s “rather flabby cost structure.” Anglo American’s assets have “generally lagged in volume growth, cost control, and health and safety issues,” the bank adds, and would benefit from Xstrata’s “aggressive management.”

Xstrata has already demonstrated that it can generate costs savings through mergers. It has generated annual cost savings of roughly US$600 million following its acquisition of Falconbridge, the investment bank points out.

Citigroup forecasts that if Xstrata were to take over Anglo American, it could generate annual cost savings of between US$160 and US$230 million for copper and between US$320 million and US$450 million in coal.

Xstrata and Anglo are already joint-venture partners at the Collahuasi mine in Chile and a good number of their coal projects are adjacent to one another.

Nonetheless, Citigroup still believes that a long-term tie-up between Vale and Xstrata would be the “most logical and most interesting exit plan for Xstrata and its management.”

If the two teamed up, the combined entity would be the number one iron ore producer, number one nickel producer (24% market share) and a top five copper producer (8% market share).

“The largest and the only real synergies in a Vale and Xstrata tie-up would be in the nickel assets,” it says. “The synergies would be primarily focused on the Sudbury Basin, but some greater nickel division savings, certainly around the Koniambo and Goro developments, would be a possibility.”

Goro is a nickel operation in New Caledonia in the South Pacific that is slated to go into production this year and reach full capacity next year. Koniambo is also a nickel project in New Caledonia, that is expected to produce its first ore in 2011.

The investment bank estimates annual cost savings could reach US$100 million to US$200 million about 2% of the total cost base of the two combined companies.