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Take the hindmost

21 June 2012 By Kevin Allison

Xstrata’s share price could fall sharply if its $90 billion mega-merger with commodity trader Glencore falls apart. But that would have more to do with short-term market dynamics than permanent damage to Xstrata’s underlying business. What’s more, even if the merger completes, shares in the combined group could be vulnerable for different reasons.

Some risk of deal failure already looks priced in. On June 21, a single Xstrata share was worth just over 2.6 times one Glencore share – a 7 percent discount to the exchange ratio of 2.8 set when the deal was unveiled in February. In January, an Xstrata share was worth about 2.5 Glencore shares.

The possibility of a transaction is still supporting the shares. After the recent commodity rout, the miner still trades on 8.1 times consensus 2012 earnings, according to Reuters data – a 10 percent premium to the average for London-listed peers BHP Billiton and Rio Tinto. During last year’s euro zone flare-up, Xstrata traded at a 10 percent discount to the sector.

A vote against the merger or the retention bonuses on which it depends would cause some short-term disruption, not least because it would probably entail a boardroom shakeup. But the main effects would be technical: the 10 percent stake built up by Qatar’s sovereign wealth fund since the merger announcement would become a stock overhang – even though it’s unlikely Qatar would suddenly exit.

But if the peg to Glencore shares is inflating Xstrata’s valuation right now, that may also be for technical factors. Glencore’s forward multiple of 7.7 times consensus 2012 earnings is perhaps flattered by a lack of analyst attention, as much of the sell-side is restricted because so many firms are working on the deal. Glencore’s earnings estimates have barely budged since early spring. Perhaps that explains why the combined company trades at 15 percent premium to diversified mining peers on 2013 earnings multiples, according to Macquarie research.

Long-term Xstrata shareholders shouldn’t mind sitting out short-term volatility. They should prepare for it.


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