Behind Gloucester's friendly face

At face value it would appear straightforward. A merger proposal with a big headline offer price that is enthusiastically supported by a 64.5 per cent shareholder ought to be smooth sailing. There is a subtext, however, to Gloucester Coal's response to the overtures from China's Yanzhou Coal that suggests Gloucester's independent directors may not be quite as unconditionally enthusiastic about the deal as their majority shareholder.

Gloucester announced today that it had entered into a "merger proposal deed" (rather than a scheme implementation agreement) with Yanzhou Coal and its Australian subsidiary, Yancoal Australia, under which Gloucester's assets would be combined with most of Yancoal's Australian assets.

Under the deal, if it is consummated, the enlarged entity would be 77 per cent owned by Yanzhou and 23 per cent by Gloucester shareholders. Through a combination of a special dividend and a capital return, Gloucester shareholders would get about $3.20 a share in cash and have shares in the enlarged group that the proposal envisages as being worth at least $6.96 each, suggesting a deal worth about $10.16 a share for Gloucester shareholders against the pre-announcement share price of just over $7.

The proposal isn't yet locked in, despite the support of Hong Kong-based Noble Group and its 64.5 per cent shareholding.

It is conditional on Gloucester conducting a due diligence investigation of the Yancoal assets, a favourable recommendation by an independent expert and ultimately, the approval of 75 per cent of Gloucester shares voted and 50 per cent of shareholders who vote at the scheme meeting – which means that it will also almost certainly need the support of the independent directors.

That's where the transaction may not necessarily be as straightforward as it might appear. Most of the assets that would be vended into Gloucester by Yanzhou were acquired by the Chinese state-owned enterprise in 2009 when it bid for Felix Resources.

The Felix assets were valued, on a discounted cash flow basis, by the independent expert Deloitte at between $2.5 billion and $2.7 billion. The portfolio of coal mines also includes Yancoal's Austar mine, which was acquired for an inconsequential amount in 2004. Yancoal has subsequently invested several hundred million dollars in the mine.

Deloitte, perhaps not coincidentally, has been appointed by the independent directors to produce the independent expert's report.

Trying to deduce the value being attributed to the Yancoal assets isn't a simple exercise, but it would appear that, with the enlarged group carrying something close to $3.8 billion of debt, its implied enterprise value would be between about $7.5 billion and something approaching $8 billion, which would suggest those assets have appreciated substantially since 2009. Given its role in assessing the value of Felix, Deloitte is perfectly placed to stress test that appreciation.

The valuation issue obviously concerns the independents more than it does Noble, which has not only signalled its intention to support the proposal in the absence of a superior alternative, but has agreed to underwrite a $20 million break fee that Gloucester would incur if the deal doesn't proceed, as well as Gloucester's costs.

That question mark over the value of the Yancoal assets is reflected in an unusual aspect of the proposed deal structure, with Gloucester shareholders being offered a "contingent value right" share which would give them up to $3 a share of protection, underwritten by Yanzhou, if shares in the merged entity trade below $6.96 within 18 months of the scheme being implemented.

That would appear to be another reflection of the independent directors' caution – it builds in a $600 million valuation buffer. Their due diligence, the independent expert's report and the significance of their ultimate view of the transaction to the way the non-Noble shareholders vote provides some layers of protection for the minorities' interests.

Interestingly, Noble has flagged that it won't elect to receive the CVRs, which either says something about its confidence in the value of the merged group or Yanzhou's reluctance to take on a $600 million contingent liability. With Noble not participating, its maximum exposure would be capped at just over $210 million.

In concept the merger does make sense – and the independents appear attracted by the logic – provided the valuation of the Yancoal assets, currently unlisted, is reasonable and the market isn't unnerved by the relatively high debt levels and the US dollar exposure the Yancoal borrowings would create. It will create a much larger listed coal entity, bring together adjacent projects in NSW's Hunter Valley and bring Gloucester's excess port capacity to bear on Yancoal assets whose expansion is constrained by its limited port capacity.

It would also go a long way towards satisfying Yanzhou's commitment to the Australian government, made when it acquired Felix, to float 30 per cent of Yancoal by the end of next year.