Anglo American and Xstrata - The walking wounded

A business combination of Xstrata and Anglo American would create the world's most indebted mining entity, with an awkward pyramid structure, and a woeful track record on acquisitions.

JOHANNESBURG - 

Early in October 2008, weeks after the cataclysmic demise of Lehman Bros. on Wall Street, a veteran London sales trader nearly dried his tears, and then stated: "Bewildering to think that four short months ago the architect of the most successful large mining company this cycle - Mick Davis - bought 1.28m Xstrata shares at GBP 41.70 per share, 58% above today's price, after dispatching a GPB 45.00 per share approach from Vale". Then the tears streamed out again. 

With just short of a billion shares in issue at the time, Xstrata's market value peaked at just over USD 70bn, before sliding precipitously to a low of USD 4.6bn earlier this year. Something of a recovery has taken place since, and knuckle head talk that Xstrata should somehow take over, merge with, or swallow up Anglo American has resurfaced all over again. A good number of investment analysts who cover diversified miners have commented variously on the topic, no doubt conscious that their bosses are licking the streets for any kind of paid fee work. Wall Street may never be the same again, but loose talk in the investment community is back with a vengeance. 

It seems that little is said about how unfashionable such a business combination would be, what with its pyramid structure (courtesy of Anglo American), woeful track record on acquisitions (courtesy mainly Xstrata), and substantial debt structures. Anglo American's awkward body shape, inherited from the old Oppenheimer-controlled days, has been substantially cleaned up over the years, but is left today with stakes in three listed mining companies, in the form of Anglo Platinum, Kumba Iron Ore, Exxaro, and a number of other listed entities. Anglo American's current market value sits at USD 35bn; strip out the value of its stake in 80% Anglo Platinum, 63%-held Kumba, and 10% held Exxaro, and the residual value calculates at USD 17.9bn. 

Investors have long penalized pyramid structures due to the inherent lock up of value, and the majority of bourses, including that in Johannesburg, where the three stocks are listed, frown on such beasts, and normally order them broken up. However, as events on Wall Street have shown for a year or more, stock market regulators have strange senses of humour. 

Questions arise over the independence of directors and executives: do those at Anglo Platinum report to Anglo American, or to all shareholders in Anglo Platinum? It also requires only basic analysis to illustrate how heavily Anglo American has leaned on Anglo Platinum for cash flow in the form of dividends. In 2007, Anglo Platinum reported ZAR 12.3bn in headline earnings, yet paid cash dividends of ZAR 15.9bn. How can a dividend payment exceed earnings? It does, certainly in this story. 

For 2008, Anglo Platinum reflected ZAR 13.3bn in headline earnings, but paid ZAR 13.8bn in cash dividends, and while Anglo Platinum ended 2008 with ZAR 2.9bn in cash, there was also ZAR 15.8bn in interest-bearing borrowings. For years, Anglo Platinum has distinguished itself by failing to meet targets, or rein in cost controls. In years gone by, erstwhile Anglo Platinum CEO and later chairman Barry Davidson ran into severe criticism for accepting stock options in both Anglo Platinum and Anglo American. He let the latter ones go. 

What's categorically clear today is that the restructuring programme underway at Anglo Platinum is under the stewardship of Anglo American CEO Cynthia Carroll. In May she told the Merrill Lynch Global Metals and Mining Conference, inter alia, about "the fundamental reshaping of the platinum business", including a "major overhaul of the senior management team, significant operational and cultural transformation". The Rustenburg and Amandelbult divisions would be rationalized into five and two mines, respectively, while the workforce would be reduced by 10,000 by year-end. Output is being reduced at high cost mines; operating costs are being reduced in real terms, and capital expenditure has been cut by more than 50%. 

Reflecting mainly the huge fall in dollar platinum group metal (PGMs), pricing patterns among global mining stocks show up platinum miners as the most troubled subsector, second only to the far smaller diamond subsector. Xstrata has a growing interest in platinum; on 6 August 2008, it announced intention of a hostile GBP 33.00 a share cash bid for Lonmin, effectively valuing Lonmin, global No 3 in PGMs, at around USD 10bn. Xstrata later dropped the bid, but not before it ended up with 25% of Lonmin, at a cost of USD 1.9bn. The Lonmin stock price would subsequently fall to GBP 5.37, but has since recovered to around GBP 12.44 a share. 

In 2007, Xstrata spent USD 1.1bn buying South Africa's Eland Platinum, in what is widely regarded as one of the most expensive platinum transactions ever. Xstrata has had more than one incident of questions being asked over price paid vs. value purchased. Analysts and other experts who tout an Xstrata combination with Anglo American seldom mention the possibility that shareholder value has been eroded in the wake of Xstrata's trail of acquisitions. The diversified Anglo Swiss miner raised USD 3bn upon its London IPO in 2002, and has openly prided itself on an acquisitions strategy.  

In its earlier days, the company reported that "from the formation of Xstrata plc in 2002, Xstrata has grown rapidly through a series of transforming and bolt-on acquisitions to diversify its portfolio by geography and by commodity. As a result, the group's portfolio is evenly spread between bulk, traded commodities such as coal and alloys, and metals traded according to London Metals Exchange (LME) terminal prices, such as copper, lead and zinc". 

To date, Xstrata has spent USD 36.5bn on acquisitions, the vast majority paid for in the form of hard cash, including, of course, the USD 18.8bn shelled out for Falconbridge in 2006. For all that, Xstrata's market value would fall, as mentioned, to below USD 5bn earlier this year, less than a third of what had been paid for Falconbridge, alone, and something of a fraction of the USD 36.5bn spent on acquisitions since 2001. 

In emphasising that investing is more of a game than anything else, Xstrata in January this year announced a massively dilutive two-for-one rights issue, and raised the equivalent of USD 6.7bn. Investors coughed up, naturally, with fees and commissions in the millions flying in all directions. Given the underlying general rise in mining, and other, stock prices, and an extra 2bn issued shares, Xstrata's market value is currently around USD 33bn. 

Anglo American CEO Cynthia Carroll has also been criticised for possibly paying too much for acquisitions, not least the USD 5.5bn spent in 2008 on controlling stakes in Brazil's Minas-Rio and Amapa iron ore projects. While there have been delays in developing the projects, seaborne iron ore, 70%-controlled by Vale, BHP Billiton, and Rio Tinto, currently ranks as the world's most lucrative mining franchise. 

Certain contract iron ore prices have been cut back of late, but new prices will still be above those that prevailed in 2007, locking in billions of dollars of forward profits for the Big Three. During the first quarter of 2009, Vale reduced its iron ore production by 27% to 49.8m tonnes, compared to the first quarter of 2008; pellet production was slashed down 73% to 2.9m tonnes. Even so, Vale's adjusted EBITDA (earnings before interest, depreciation and amortisation) from ferrous minerals, mainly iron ore, was reported as USD 2.2bn for the first quarter of 2009, compared to USD 2.0bn for the first quarter of 2008. 

While both Anglo American and Xstrata may yet show up with answers on justifying the quantum of cash paid for acquisitions, relative to the value acquired, there is no question that both groups continue to rank as serious debtors. Xstrata ended 2008 as one of the world's top five most indebted miners, with USD 16.50bn in net debt, but has subsequently eaten into that after its huge rights issue. Anglo American was also in the top five, with USD 11.00bn in net debt, but has since eroded that somewhat with proceeds from a number of asset sales. It has also issued corporate bonds, and convertibles, and suspended dividend payments, but has so far avoided an equity issue. 

At this stage, however, a pro forma merged Anglo American-Xstrata would carry combined net debt of USD 21bn, excluding internal company cash flows so far during 2009. The pro forma merged entity would rank as the world's single most indebted mining entity, pipping Rio Tinto, currently busy with a USD 15.2bn rights issue, and likely also to receive a USD 5.8bn iron ore joint venture equalisation payment from BHP Billiton. 

This follows the 5 June announcement that Rio Tinto was abandoning a near-USD 20bn deal with smaller rival Chinalco, opting instead for a rights issue, and agreeing a USD 116bn joint venture with BHP Billiton over the two companies' West Australian iron ore assets. In 2007 Rio Tinto famously paid USD 38bn, in cash, for Alcan. Rio Tinto's market value, as a whole, would fall to USD 20bn, earlier this year. 

When the roast is dripping, listed companies are not unknown to develop sloppy drools, but hurling cash around to get the best cuts can be dangerous. In March 2007, Freeport-McMoRan completed the USD 26bn acquisition of Phelps Dodge, creating the world's largest publicly traded copper company, the world's largest producer of molybdenum, and a significant, effectively global Tier I, gold producer. 

To complete the transaction Freeport borrowed USD 16bn, and immediately raised USD 5.8bn in fresh equity. Mixing equity proceeds and cash flows from operations, Freeport reduced its acquisition debt by more than USD 10bn by the end of 2007, achieving, according to Freeport, its debt reduction objectives "two to three years sooner than initially targeted". By the end of 2008, net debt was down to less than USD 7bn. 

BHP Billiton and Vale have managed to completely escape even visits to the balance sheet casualty ward, and rank as the world's biggest miners, by value. As for acquisitive companies, there can be, and are, successes; last month's announcement by India-founded London-listed Vedanta launching a USD 1bn convertible bond, and news that its Indian iron ore subsidiary Sesa Goa would acquire Dempo Group's Goa mining assets, for the equivalent of USD 368m, appears to confirm Vedanta as the world's most acquisitive mining company so far in 2009, with a strong thirst to remain on an expansionary path. Vedanta subsidiary Sterlite was listed on the NYSE during 2008, raising fresh equity of USD 2bn, ranking as the highest IPO ever by any Indian company in US markets. The IPO saw Vedanta's stake in Sterlite fall from 75.9% to 59.9%. 

Some years ago, Xstrata reported that "in the 11 months of its existence, the group has thus invested USD 230m on incremental acquisitions to its existing businesses, all of which are earnings accretive and all of which are expected to deliver returns comfortably in excess of our cost of capital". Those were the days, all right. As for all the Xstrata shares that Mick Davis bought for GBP 41.70 a piece in 2008, those could have been had for GBP 2.90 each a few months ago, playing pure havoc with any notion of "cost of capital". 

Disclaimer

MINEWEB is an interactive publication, with rolling deadlines through each day, commencing in the Sydney morning,  and concluding, 24 hours later,  in the Vancouver evening.  If you believe your side of an issue deserves inclusion, but has failed to meet one of our deadlines, you are invited to notify the Editor in Chief in Johannesburg, and we will include you in our editing and expanding on our stories. Email him at alechogg@gmail.com

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responses to this article

Say what you will but ..... When the O's ran the shop with JOT they bought during the downturns (i.e now) and sold in the upswing. Poor little Cynthia does not have a clue of how it all fits together by Senhor on June 19 2009, 11:22 Find this comment inappropriate? Report it

Cynthia's judgement Cynthia okayed the share buy back scheme when the sahre price was in never never land. Everyone with a modicum of business savvy knows that you stash the cash in good times and buy back after the crash. After the party there is always a crash. This . .more is as true as night following day. Cynth should do the honorable Anglo thing and fall on her sword. . .less by Lord Max mater of infinity on June 20 2009, 00:17 Find this comment inappropriate? Report it

MInas Rio I am still puzzled why Cynthia has not consulted Kumba on this acquisition? Did she? Any Rio de Janeiro taxi driver would know it was a bad deal! by Elpidio Reis on June 22 2009, 06:33 Find this comment inappropriate? Report it

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