Meeting of mines still in balance


Under normal circumstances, a 42 per cent dive in an FTSE 100 company profits – as demonstrated by Xstrata as it kicked off the miners' earnings season yesterday – would be the talk of the City.

But the vice-like downer that rising costs and tumbling commodity prices are exerting on the miners' bottom lines has been well flagged and, as it happens, Xstrata's $2.45bn (£1.57bn) first-half operating profit was actually better than expected, thanks mainly to making cuts and delaying investment.

Of far greater interest to the City and mining communities alike was what yesterday's results meant for Xstrata's proposed £57bn mega-merger with Glencore, the world's largest commodities trader. To recap, the pair announced plans in February to create a global one-stop mining and commodity trading shop through a merger of equals deal that involved Glencore giving Xstrata investors 2.8 of its shares for each of theirs.

With commodity prices again riding reasonably high after taking a tumble in the second half of 2011, the masters of the resources universe were so confident that the deal would get done that they made it contingent on their top 73 executives getting paid £170m just to stay on for between two and three years after the deal went through – irrespective of its performance. Xstrata chief executive Mick Davis stood to gain £29m all by himself.

The next few weeks proved something of a shock for Mr Davis and Ivan Glasenberg – his opposite number at Glencore – as they hit a wall of opposition with a series of heavyweight investors such as Standard Life and Fidelity speaking out against the deal.

The rebel shareholders complained that the performance-unrelated retention bonuses made it look like senior management was more concerned with lining its pockets than creating value for investors. And they pooh-poohed the claim it was a merger of equals, arguing, in turn, that the 7 per cent premium implied by Glencore's offer was simply not enough.

At first, the two companies held their ground. But when the Qatari sovereign wealth fund – Xstrata's second-biggest shareholder with an 11 per cent stake – added its voice of opposition to a deal that can be voted down by just 16.4 per cent of investors, they finally took note. The companies switched the retention bonuses from cash to shares and introduced a performance element, at the same time as postponing the shareholder vote from July 11 to September 7 to give the changes more time to sink in.

With the vote now looming, much of the City's thinking has seemed to be paralysed on the subject of whether the deal should go through – and on what terms. Against this backdrop, all eyes were on Xstrata's results yesterday as investors sought clues about the chances of the deal being revised – and how.

So what did we learn?

"It's still just incredibly difficult to call," concluded Charles Stanley analyst Tom Gidley-Kitchin. "We really need to wait for the Glencore results [on August 21] to see how its business model stacks up."

Alison Turner at Panmure Gordon added: "I wouldn't think that these results would do anything to change the view of Glencore or indeed the Qataris, except to reinforce the Xstrata proposition as it stands."

So what is the deal's proposition?

Essentially, it is about cutting costs. When they originally announced the deal, Xstrata and Glencore said it would enable them to cut $450m out of their annual costs by combining their sales and marketing operations. They will also seek to find another $300m of cost savings in the two years after the merger by consolidating areas such as transport, distribution and catering, which they should manage because it's what their retention bonuses will be based on.

While Xstrata investors have no beef about the cost-cutting rationale, they are unhappy with the price and a deal looks unlikely to go through at the original price. As Schroders head of equities Richard Buxton put it in February: "Xstrata has higher-quality assets with better growth prospects over the next five to 10 years than Glencore." And that is the view of many.

However, Glencore does potentially have an ace up its sleeve. Because most of its profits come from trading, Glencore can still make handsome profits when commodities are falling – as long as it bets the right way.

While Xstrata is struggling with falling coal, nickel, copper and iron ore prices – and the rising labour and equipment costs that lag a commodity price boom by 12 to 18 months – Glencore could be riding high, giving it the potential to prop up a combined entity during future tough times.

Which is why, as Mr Gidley-Kitchin says, we need to wait until Glencore reports later this month. If it has weathered the commodities storm noticeably better than Xstrata, its investors may become a bit more relaxed about the price. If not, they'll probably remain tense.

While trading profits are notoriously difficult to predict, investors are hopeful that Glencore could announce some decent results later this month. If they do, hostile Xstrata shareholders such as Qatar may reduce their demand that Glencore pays 3.25 shares for each Xstrata one. But it is likely they will still want to see the price increased from 2.8 to, say, 3.0 times.

Glencore appears extremely reluctant to pay any more than it already has – even without the relative outperformance of Xstrata that looks to be needed to soften Xstrata's demands. So the chances of the two sides meeting in the middle looks slim. Just ask the City. Even after yesterday's 13.9p, or 1.6 per cent, rise to 869.9p, Xstrata's shares were still only trading at 2.68 times the value of Glencore's.

Far from implying a deal at an increased price, this suggests no deal at all. But only just, and there will no doubt be a couple more twists and turns yet.

The merger by numbers

Glencore The commodities trading giant is run by Ivan Glasenberg, headquartered in Baar, Switzerland, with a market capitalisation of about £30bn. In 2011, it sold 92.2m tonnes of thermal coal and 20.9m tonnes of grains.

Xstrata The mining giant is run by Mick Davis, heaquartered in Zug, Switzerland, with a market capitalisation of £27bn. In 2011, it produced 83.5m tonnes of coal, 105,925 tonnes of nickel, 517,000 ounces of gold and 92,411 ounces of platinum.

Glenstrata The combined entity would be the world's fourth biggest mining group after BHP Billiton, Rio Tinto and Brazil's Vale. Glencore is already the world's biggest commodities trader. It will be headed by Davis, with Glasenberg acting as deputy.

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