M&A set to rise after Xstrata approaches Anglo

Anglo American yesterday confirmed that Xstrata has approached the platinum producer with a preliminary proposal of a ‘merger of equals,’ valued according to the weekend press in the region of $35 billion.

Unsurprisingly, Anglo’s shares rallied in Monday trade and at midday were 5.5% higher at 1,712p. Xstrata’s shares, however, fell back 4.2% to 652.2p and, with other mining companies following suit, the FTSE 100 index shed 51.2 points or 1.2% to 4,294.8.

Whatever the outcome for Xstrata and Anglo, it seems safe to say that M&A activity is set to continue in the metals and mining sector as companies strive to increase scale and market share. As Citigroup noted this morning, “This trend could put pressure on the Anglo board to consider a merger.”

Furthermore, mergers of equals are going to increase in popularity, notwithstanding anti-trust concerns, as companies focus on cost savings and synergies amid rising pressure from customers to reduce pricing, Robin Johnson, corporate partner at international law firm Eversheds, commented earlier today.

Johnson's Eversheds colleague, head of mining & natural resources Chris Halliday, added: "Consolidation in the mining sector will be one way for these businesses to remain competitive in the current marketplace. With falling commodity prices and limited external finance available, the ability to make cost savings will be key to their success."

Xstrata said on Sunday that it believes a merger of the two companies would create a premier portfolio of operations diversified across multiple commodities and geographies, with enhanced scale and financial flexibility to fund future growth.

Industry analysts appear to agree in principal, although many have highlighted considerable hurdles to achieving such a deal.

Citigroup analysts on Monday told clients that a clash of cultures between the two firms, in addition to complicated deal structuring, limited balance sheet flexibility, and marketing rights negotiations could make striking a deal tricky. “Anglo’s reluctance to do a deal and the stark difference in corporate cultures are the main blocks,” the broker said, adding that marketing rights could also be a key issue in negotiations as they were between Vale and Xstrata last year. Vale's $90 billion takeover approach to Xstrata collapsed in early 2008 after discussions between the two hit a stalemate.

“Xstrata operates a devolved style business model based around aggressive LBO-style growth compared to Anglo’s more traditional and conservative style, operating off a much larger corporate base,” Citigroup wrote in a note this morning.

The broker estimates that a combination of the two could create synergies of $750 million per year (net present value of $7.3 billion or 10% of the combined market cap), but believes a merger of equals would be unlikely to extract the same level of head office and tax savings, bringing synergies of less than $500 million p.a.

Assessing the likelihood of a white knight entering the fray, Citigroup noted that both Anglo and Xstrata are Brazilian firm Vale’s only two options of making a “one-deal jump into the big time to compete against global peers across a broad range of commodities” but that while there are minimal synergies between Anglo and Vale, Vale management has repeatedly noted a preference for copper and coking coal, two commodities

Xstrata has significant exposure to. However, the broker said: “Near term we believe a deal is unlikely as debt financing would be a stretch for Vale,” adding that “Equity financing is complicated by Vale's dual shareholding structure.”

Citigroup has a Buy recommendation on Xstrata and a Hold on Anglo.

Analysts at Banc of America-Merrill Lynch said today that they believe a combination of Anglo and Xstrata is “logical,” would create value for shareholders and is part of the inevitable ongoing consolidation in the metals and mining sector.

The broker also highlighted obstacles, however, namely Anglo management’s reluctance to ‘engage’ and South African government concerns on potential job losses and other potential negative economic impacts. Still, should the two companies agree a merger deal, Banc of America-Merrill Lynch estimates 8% earnings accretion in 2010 and 30% in 2011, assuming a nil premium merger.

The broker’s stance on Xstrata stock remains Neutral, while Anglo is rated Underperform.

Analysts at both Evolution Securities and FinnCap suggested Anglo could be worth more than the market is currently valuing it at.

“We think that, unlike Xstrata, Anglo’s current market value underplays the value of its assets,” FinnCap told investors this morning. While Evolution said that although Xstrata appears to have garnered shareholder support for its approach it is still early days and the broker believes a re-evaluation of Anglo’s true worth may push it out of Xstrata’s ball-park.

Evolution rates Xstrata Reduce, while FinnCap recommended investors adopt a ‘wait and see’ approach to both stocks.