GLENCORE´S MOUNTAIN OF CHALLENGES / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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FEBRUARY 8, 2012

Glencore's Mountain of Challenges

By ANDREW PEAPLE

Mick Davis has a new Everest to climb.


The Xstrata chief executive says a proposed all-share merger with trading company Glencore represents the best possible deal for his shareholders. Yet Xstrata investors—excluding Glencore itself, which has a 34.1% stake—will own only 45% of the new company. And despite Xstrata contributing most of the assets and profits, it gets only a slim 8% premium.

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Bloomberg News

That isn't good enough for some institutional shareholders, two of which—Schroders and Standard Life—have said they will vote against the deal. It requires only 16.5% of shareholders to vote down the deal, code-named Project Everest. The onus is now firmly on Mr. Davis to convince others it is the right time for a deal the two sides have been considering for seven years.



Mr. Davis's biggest challenge may be to explain to Xstrata shareholders what value Glencore's low-margin trading business will bring to the combined company. Xstrata has strong stand-alone growth prospects, with copper production expected to rise 50% by the end of 2014 from 2009.


Glencore's trading business, meanwhile, has performed poorly. Supposedly able to hold up well in volatile markets, its earnings before interest and tax fell 18% in 2011. Trading will contribute just 16% to Glencore-Xstrata's combined EBIT, based on 2011 results.



Xstrata shareholders should also demand greater clarity on how the merged business will be funded. Glencore will bring substantial extra debt. The combined group's net debt will be 1.8 times its 2011 operating profit, compared with Xstrata's 0.7 times. One concern is that new bank-capital rules and European bank deleveraging will push up the cost of trade finance and the revolving-credit facilities Glencore relies on to fund working capital. Trading margins fell last year, raising doubts over Glencore's claim it can pass on higher funding costs to customers.



Investors may also want to question the claimed synergies. The two sides reckon a $500 million annual pretax-earnings boost is feasible, mostly the result of Glencore marketing all of Xstrata's commodities output.


But these are revenue synergies, less certain than cost savings. Taxed and capitalized, they are worth about $4.5 billion, just 5% of the combined company's market value. Meanwhile, Glencore's own mining assets offer strong near-term growth potential but are often in areas mining majors normally avoid, like the Democratic Republic of the Congo and Kazakhstan.



Given the modest immediate benefits, investors must also buy into the long-term strategic benefits of the merger that Mr. Davis is touting, including Glencore-Xstrata's ability to do further large deals. And they must give the Xstrata boss the benefit of the doubt when he says a better deal wasn't feasible, because he couldn't force too much dilution on Glencore's shareholders, mostly its employees. Alternatively, they could just force Mr. Davis to go back to base camp.

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