PORTFOLIO POINT: Merging Xstrata and Glencore into a combined mining and food giant could be too hard to swallow for some investors.
If BHP Billiton and Rio Tinto invested in food production it would shock investors, but a change as dramatic as that could happen as the “mining” world’s most entrepreneurial company takes shape in the planned merger of Xstrata and Glencore.
While the merger is yet to win shareholder approval, and might struggle given an outbreak of institutional opposition to generous proposed executive pay scales at “Glenstrata”, the shape of the business effectively means there’s a new kid on the resources block with a foot in both hard and soft commodities.
So far, the proposed mixing of coal, copper and zinc with wheat, sugar, soy and cotton in what might be called an “all resources” model has not been well received, with the share prices of Glencore and Xstrata falling faster over the past five weeks than the prices of conventional miners.
Since early May, Glencore’s share price on the London stock exchange has fallen by 18% and Xstrata is down by 19.5%. Over the same time, BHP Billiton has fallen by 11% on the ASX and Rio Tinto by 15.6%.
The sharper declines by Glencore and Xstrata could be reflecting uncertainty over the terms of the proposed share-swap merger, unhappiness with a proposed $47 million retention payment to Xstrata chief executive, Mick Davis, doubts over whether hard and soft commodities will mix successfully in the same company, or doubts over whether Glenstrata will become a repository of second-class assets cast aside by the majors.
There is also a poor history of similar business models in other spheres of business, such as the relative under-performance of “all finance” models designed to bring together banking, insurance investment advice and stockbroking.
Fine in theory, the “all” models have invariably stumbled because of different styles of management and an inability of staff to sell a diverse range of products.
A similar situation emerged in diversified industrial companies that had corporate fingers in too many pies. The last of the big Australian diversified industrials is Wesfarmers, and even it is dominated today by a single business – retailing.
Glencore chief executive, Ivan Glasenberg, has no reservations about his ability to create an all-resource business which trades in virtually everything, whether sourced from its own mines (and farms) or acquired from other suppliers.
He told a meeting in London late last week that the key to making Glenstrata work was its entrepreneurial approach to management, and while he didn’t fully explain what that means there was no doubt in the audience that Glasenberg was talking about taking more risks than traditional miners – and not being too fussed about what it sells, or exactly how it makes profits.
Return on equity is the sole driving force behind Glenstrata, Glasenberg said, and that’s when his unique, commodity-trader background could represent a challenge for traditional miners. If he can outperform his rivals, and use a broader spread of commodities to achieve higher returns, then the current sector leaders might have no choice but to follow.
There are no indications, yet, that BHP Billiton or Rio Tinto, are concerned about the multi-commodity nature of the Glenstrata business. It could be argued that BHP Billiton is already building a “food related” division through its emerging potash mining operation in Canada, with all of that material destined for consumption by farmers as fertiliser. BHP Billiton is also different to other miners, thanks to its big oil and gas division.
Glenstrata, however, is developing a totally unique structure which seeks to make profits at all stages of the commodity process, from mining and farming, to shipping, trading, refining, smelting and distributing.
While not listed on the ASX, Glenstrata will become a company worth watching to see whether it can successfully mix commodity trading, which is normally the province of private operators, with mining and agricultural products.
The poor reaction, so far, on stock markets indicates that the jury of investors is sidelined, but that could change if Glasenberg can deliver his promised high rates of return and, in turn, that change could see other miners embrace an “all resources” model.
His timing could also be important because there are signs emerging that China is switching its focus from a building phase of its evolution to a consuming phase, meaning that metal usage could start to decline and food consumption start to rise.
To get a better feel for what Glasenberg is trying to create it’s worth hearing it in the man’s own words, as delivered to an audience of 550 in a marquee at the Nursery End of Lord’s cricket ground in London last Thursday evening.
While most reports about Glasenberg’s talk, a rare event in itself, have focused on his defence of high rates of executive pay (he would say that, wouldn’t he?) the question of entrepreneurial spirit inside a resources business is important for investors, especially if he can carry private risk-taking associated with commodity trading into a public company structure.
He also raised eyebrows with implied criticism of BHP Billiton and Rio Tinto for focusing too closely on “tier one” assets, declining to invest in anything that fell short of being among the best in the world.
“We have not focused on these great tier one, first quartile assets,” Glasenberg said. “I know Chip Goodyear is sitting here, and he’s worked for BHP, and they’ve always focussed on those assets.
“There’s nothing wrong with that, but I’ve always said no. I don’t care what kind of assets we have. What we’re focused on is return on equity, that’s what business is about long term.
“We don’t need these great big tier one assets. I’m very happy getting tier two, tier three assets, putting them together ... creating assets which we bought cheaply from other people, put them together, used the synergies which create a great asset, which give us a great return on equity. That has been the strength of Glencore.”
Glasenberg went further in explaining his philosophy of shopping around for cheap assets, an approach which more conservative investors might find uncomfortable, particularly in a period of falling commodity prices when older, tier two mines, can struggle with their higher cost structure.
“I was on a road show the other day and someone said that Marius Kloppers (chief executive of BHP Billiton) had remarked that Glencore had never built an asset,” Glasenberg said.
“That’s great. Who the hell wants to build an asset if I can buy them cheaper than I can build them.
“We do have an experience of building one asset, Minara Resources (formerly Anaconda Nickel), which was designed to produce 40,000 tonnes of nickel. We’re still struggling to get to 30,000 tonnes.”
According to Glasenberg investors are tired of the green fields model of building new projects because of their record of delivering poor returns.
“If we do something, it has to have a good return. It doesn’t have to be tier one. It doesn’t have to be the best asset in the world. It doesn’t have to be a 40-year asset. It just has to give a good return,” he said.
In support of his investment approach, Glasenberg said that over the past 10 years Glencore had delivered an annual average return of 38% on equity, a payback he said was much better than any of its rivals.
Achieving that high return was the result of sponsoring an entrepreneurial culture, he said.
“We like the people who work for us to be entrepreneurs. We like people who work for us to look at ideas, to chase ideas, and to not be the caretakers of an asset,” he said.
That comment led Glasenberg into his most controversial topic, and the one which attracted most interest in London – the need to richly reward management, and a justification for paying Davis his big retention bonus.
For many Australian investors, Glencore and Xstrata are businesses listed on a foreign stock exchange, which detracts from their appeal, and pursuing a new type of “all resources” strategy could be too risky for their portfolios.
However, if Glasenberg succeeds in transferring the private company, total focus on equity return to the merged Glenstrata, it will affect how investors see the model, and how other major miners behave, especially with Asian demand for commodities expanding to include higher spending on food.
“We will struggle to feed China,” is how Glasenberg describes the challenge and the opportunity of supplying wheat, soy and sugar to a country which is approaching its peak metal-consuming phase.
But whether it makes business sense to combine metals and food will be one of the more interesting business experiments of the past 50 years.
If it works, Glasenberg will be praised for his foresight. If it fails he will be condemned for biting off more than he could chew, and also for believing that second-class assets can match the performance, over time, of first-class assets.