This is an excerpt from the Morningstar Research report on Xstrata. Premium subscribers can read the full report, including fair value estimate and financial health assessment. Not a Premium member? Get instant access when you take a free 14-day trial.
In a surprise move yesterday, the Qatar Investment Authority (QIA) now holder of nearly 11% of Xstrata (XTA) shares, announced it was "seeking improved merger terms" for the proposed Glencore-Xstrata tie-up. The sovereign wealth fund noted that an exchange ratio of 3.25 Glencore International (GLEN) shares for each Xstrata share would "provide a more appropriate distribution of the benefits of the merger" than the original 2.8 exchange ratio agreed upon by the boards of Glencore and Xstrata.
The announcement comes as somewhat of a bombshell, as most investors had assumed QIA, which has been gradually building its stake in Xstrata since the deal's announcement, would back the deal under the originally proposed terms. The steadily growing stake was taken as a sign that the deal's probability of success was growing, too. But taking QIA's statement as an implicit threat that they would not vote in favour of the deal at a 2.8 exchange ratio, it would appear that investors arrayed against the original terms may now own at least 16.5% of total Xstrata shares, the magic number needed to scuttle the deal.
For our part, we think Qatar's claim has merit. Based on a stand-alone valuation of each entity, we think an exchange ratio of 3.5 would most fairly capture the value both sides bring to the table. Interestingly, as we write, a single Xstrata share would buy 2.67 Glencore shares, which suggests the market ascribes a meaningful probability of failure to the deal. Our published fair value estimates (Xstrata at 1,000 GBX, Glencore at 360 GBX) continue to reflect an expectation that the deal will proceed as planned. Pending new information concerning QIA's specific intentions, we may need to revise our expectation accordingly.
Separately, Xstrata announced revisions to the much-discussed "retention package" that has raised the ire of many investors upset that CEO Mick Davis and key management personnel would reap a financial windfall (GBP 173 million across 73 senior employees) with no strings attached (other than showing up for work each day). Under the new plan, retention awards would be paid entirely in shares of the combined entity rather than cash. Retention awards for Xstrata's senior management other than three executive directors and six other members of the executive committee will be paid in equal tranches one year and two years after the deal's closing. These payments will not be subject to any performance targets. Retention awards for the executive directors and executive committee members will be tied to performance targets pertaining to cost synergies. Specifically, retention awards will vest if the company achieves cost savings in excess of the $50 million in cost savings already identified in the previously articulated $500 million per annum synergy estimate. Maximum vesting would occur if incremental cost savings exceed $300 million within two years of the deal's close.
At face value, this might seem like a major concession to investors upset with the lack of performance hurdles (even if non-executive personnel still wouldn't be subject to any performance targets). Yet given the difficult to measure and unverifiable quality of "cost savings," we don't think the new performance hurdle has teeth. Xstrata's press release defined "merger-related cost savings" as those "realised from initiatives including reorganising the Combined Group's assets, the reduction of any duplicated costs not already identified in our synergy estimate, financial synergies and other cost savings." That is an extremely broad definition.
Judging by its history of measuring cost savings from its own operations, the Xstrata management team should have no trouble "finding" the level of savings necessary to justify a payout. Over the past five years, the company claims it has achieved an astounding $1.87 billion in cumulative cost savings ($374 million per year). With this kind of track record, one would think another $350 million over two years shouldn't be hard. The problem is that the claimed savings are unavoidably unverifiable--by outsiders or even by Xstrata itself. Capitalizing the cumulative claimed savings offers some perspective on the matter. Assuming a multiple of 6.5 times would suggest $12.2 billion in value creation in only five years. This is equal to roughly one third of the company's market capitalization, making the savings claim rather hard to take seriously.
This is an excerpt from the Morningstar Research report on Xstrata. Premium subscribers can read the full report, including fair value estimate and financial health assessment. Not a Premium member? Get instant access when you take a free 14-day trial.
