Why Rio won't be tempted by a Glencore merger

Why would a prominent UK investment banker who says he has no client in the deal call together 20 hedge funds and institutions to canvass the prospect of a renewed tilt by Glencore at Rio Tinto?

The obvious conclusion is that, despite the rejection of its original overtures, Glencore's ambitions remain alive and former JPMorgan banker Ian Hannam is trying to help destabilise the Rio register -- with or without Glencore's encouragement.

Bloomberg reported that Hannam, who now runs a boutique advisory firm, brought together the hedge funds earlier this month to "share his views" on a renewed bid by Glencore for Rio, saying that if it didn't happen now it would in the near future. He estimated cost savings of about $US1.8 billion from a merger, primarily from leveraging Glencore's trading expertise.

Last month, in response to speculation, Rio acknowledged it had been approached by Glencore in August but said its board had concluded unanimously that a combination of Rio and Glencore wasn't in the best interests of Rio's shareholders. After conveying that view to Glencore, there had been no further contact.

It would, however, be out of character for Glencore's Ivan Glasenberg to simply shelve his ambition, particularly when the combination would create the world's largest resource group, pushing BHP Billiton out of the top spot. It would also give Glencore control of the world's best iron ore business, both in terms of quality and cost, as well as a very strong position in copper and coal.

It is, however, easy to see why Rio dismissed the concept.

Rio is meaningfully larger than Glencore, with a market capitalisation of just over $100bn against Glencore's $80bn. Its asset base, while overly reliant on iron ore, is of significantly better quality that Glencore's suite of mainly second-tier assets.

It would be acutely aware that the dive in the iron ore price to around $US70 a tonne does create some vulnerability, given that its iron business generates about 90 per cent of its earnings.

It would, however, be equally conscious that the extent of the decline and the increased low-cost production it and BHP are pushing into the market will accelerate the price cycle by forcing out higher-cost production.This would therefore bring forward the point at which the market will shift closer to a balance between supply and demand. It also knows it has a strong and strengthening presence in copper, the metal where the market structure is probably most favourable in the medium term.

One can understand Glasenberg's interest in Rio. Commodities do move in cycles and his best (perhaps only) chance of pulling off a merger with Rio is at the low point of the cycle.

He would also believe that his trading network and the focus of his management on capital discipline would create extra value, although Sam Walsh and his team have re-established the credibility of Rio's management and are driving significant improvements in Rio's underlying performance.

The big problem for Glencore is that while Glasenberg has his admirers, the numbers required to make a merger work are difficult given that Rio is about 20 per cent bigger than Glencore and that he would have to pay a 25 per cent to 30 per cent premium to convince Rio shareholders to take an offer seriously.

He'd also have to include a relatively large proportion of cash in any bid. With Glencore already carrying about $US38bn of net debt and Rio about $US15bn, a meaningful cash component would leave a combined group quite highly leveraged in a difficult part of the cycle. One suspects Rio shareholders, having experienced leverage during the financial crisis, wouldn't be keen on reprising that experience.

Then, of course, there are the regulatory obstacles. The European, UK, Australian and Chinese anti-trust authorities would take a very keen interest in any merger proposal.

BHP's bid for Rio just ahead of the crisis faced significant obstacles from the European authorities. Its secondary proposal, a joint venturing of the two groups' Pilbara operations, was going to fail to get regulatory clearances when it was abandoned.

While Glencore has no meaningful iron ore interests, the sheer size of a combination would create sensitivities. In Glencore's own merger with Xstrata, it was forced by China to offload the Las Bambas copper project in Peru, one of the world's largest copper mines. The price of approval, if approval could be gained for a combination of Glencore's coal and copper interests with Rio's, would be much higher.

If Glencore is going to have another crack at Rio, Hannam is right. It will have to be soon because Walsh is driving cost reductions and volume gains through his business, offloading non-core assets and creating a platform that will be leveraged to any improvement in commodity prices, or even their stabilisation. Given time Rio will be beyond Glencore's reach, if it isn't already.

Rio itself isn't going to embrace the notion of getting into bed with Glencore just to be able to claim the 'world's biggest' mantle.

Rio's culture and values, apart from that brief departure just ahead of the financial crisis when it was spooked into the disastrous bid for Alcan because it knew BHP was stalking it, have always been about owning tier one assets. It has them. Glencore doesn't.