Seasoned management, access to low-cost capital and scale of operations are as critical to developing a successful mine as a promising reserve. Our Global Investment Strategist Metals and Mining Portfolio focuses on companies with these strengths.

All of these companies have the ability to generate shareholder wealth in 2012 and beyond, even if resource prices don’t make a lot of future headway.

Occasionally, we’ll see a company in the same business as one of our portfolio picks that makes better sense as an investment. That’s the case with Glencore International Plc (LN: GLEN, OTC: GLNCY), which we’re now swapping in place of Xstrata (LN: XTA, OTC: XSRAY).

As reported in a previous GIS article {“Mining on a Major Scale,” February 29), Glencore has long been the owner of 34 percent of Xstrata, as well as a major business partner.

Glencore’s expertise is global commodity trading and metals marketing, while Xstrata’s primary strength is its status as one of the world’s major owners and producers of a range of resources, as well as the world’s fourth-largest seller of copper.

Earlier this year, Glencore offered 2.8 of its own shares for each of the rest of the 66 percent of Xstrata shares it didn’t already own. The result has been a solid 26 percent plus gain in Xstrata shares since the beginning of 2012, far outperforming shares of other copper producers (see chart below).



Source: Bloomberg

Tough Crowd

However, the merger continues to face several challenges. Major shareholders have been a tough crowd to please, in large part because Xstrata shares remain some 26 percent below year ago levels. Several have demanded that Glencore raise its offer to further mitigate those losses, which the latter company has so far refused to do.

That opposition may be melting somewhat, with Qatar’s sovereign wealth fund—owner of roughly 5.5 percent of Xstrata’s shares—allegedly agreeing to back the deal. But to block the deal, opponents need only muster 16.48 percent of voting shares, because Glencore itself is not allowed to vote its shares and at least 75 percent of the remaining ownership must vote to approve.

Regulation could prove an even bigger hurdle. Brazil and China, for example, now exert watchdog powers on a par with the European Union and the US. All of these countries need to bestow approval for this merger to go through.

Back in February, we posited the idea that Glencore could increase its offer for Xstrata to 3.2 of its own shares. That would effectively divide ownership of the new company roughly equally between investors in the two companies. Given Glencore’s recent price (see chart below), it would also give Xstrata shares an effective takeover value of about 13.73 British pounds, or 16.1 percent above Xstrata’s current price.



Source: Bloomberg

Unfortunately, that appears a lot less likely. If there’s no increase in the ratio, the takeover value is only 2 British pounds per share, or a premium of just 1.6 percent to Xstrata’s current price.

There’s still the probable appreciation the combined company would enjoy by pooling assets, as profits improve from synergies and improved marketing of Xstrata’s output. The combined company also would enjoy much greater scale and consequently the ability to launch new mining projects, as well as more acquisitions to expand the product line from already dominant positions in copper, coal and zinc.

Synergies are still expected to be in the USD500 million to USD600 million range in the first year after the deal is done, as expertise in mining, processing, storage, freight, logistics, marketing and sales are combined. Xstrata CEO Mick Davis has a storied history of making major mining deals work, as he proved with the construction of BHP Billiton (NYSE: BHP) more than a decade ago.

All those benefits, however, would also flow to shareholders of Glencore, without the risks that this deal could fail. Were that to happen, shares of Xstrata could be expected to tumble back to a range around 9 British pounds, based on the action in other mining stocks in recent months and its trading range before this deal was announced.

In the final analysis, Glencore has a stake in Xstrata already and is unlikely to give up on ambitions to own the rest. It may not pay more this time around, but it’s unlikely to go away. In the meantime, the company continues to grow earnings, both by expanding existing operations and with acquisitions.

The latest of these is a CAD6.1 billion bid for Canadian grain handling firm Viterra (TSX: VT), which would dramatically expand the company’s presence in the grain industry. Shareholders will vote on the deal on May 29, but approval appears increasingly likely with several major shareholders agreeing to back the deal. With much of the business remaining in Canadian hands—two Canadian companies would acquire the bulk of Canadian assets as part of the deal—regulators aren’t likely to raise serious objections.

Adding Viterra will further fire up earnings at Glencore in the second half of 2012, even if the price of resources such as copper remain a drag on profits at Xstrata. That’s another good reason to make the switch now.

Buy Glencore up to GBP 4.35, or USD14.50 through its American Depositary Receipt, which represents two ordinary shares. Sell Xstrata.

Roger S. Conrad is an associate editor of Global Investment Strategist.