Winning Rio

Ivan Glasenberg's Glencore beats Rio on most metrics. A touted combination of the two companies could be very successful.

Summary: It’s worth taking seriously recent speculation of a Glencore takeover bid for Rio Tinto. Diversified commodities giant Glencore has a far stronger corporate culture and is more focused on shareholder returns. The Swiss giant has a greater mix of assets and could be interested in adding Rio’s prize low-cost iron ore operations. A combined Glencore-Rio, possibly executed with a share-swap and cash top up takeover bid, would be the biggest mining company in the world.

Key take-out: Glencore could succeed in a bid for Rio Tinto. The merged resources giant would be a “must-own” for investors seeking mining exposure.

Key beneficiaries: General investors. Category: Shares.

Rio Tinto is bigger than arch-rival Glencore, but not that much bigger, which is the first reason to take seriously speculation that a takeover bid by Swiss-based Glencore for Australia’s second biggest mining company might be brewing.

An even more important fact is that Glencore has outperformed Rio Tinto as an investment over the past few years, greatly impressing the people who really matter when it comes to deciding whether to back a bid, the institutional fund managers of London.

For Australian investors it might come as a shock to discover that Rio Tinto, a business which has a place in most investment portfolios, is regarded in London as a company in need of a radical overhaul, a more balanced basket of assets, and better management.

What’s happened over the past few years is that Rio Tinto’s accident-prone past has caught up with it, while Glencore’s dynamic growth and greater focus on shareholder returns has made it a business with what looks to be a brighter future, a point seized on by analysts at US stockbroking firm Bernstein.

But, before examining the strengths and weaknesses of the $90 billion Glencore and the $122 billion Rio Tinto, it’s worth considering an imprecise but important element; the far stronger corporate culture of Glencore compared with that of Rio Tinto.

At Glencore the chief executive is an “owner driver” and 8% shareholder, Ivan Glasenberg, a man able to make quick decisions without time wasted on committee structures.

Glasenberg is a man with absolute faith in his ability to make the right decision, which he generally does.

Rio Tinto lacks the drive and ruthless ambition that can be found in Glencore’s Glasenberg. While it’s not often that a smaller company acquires a bigger rival, it can happen and when it does it is the company with the stronger corporate culture that emerges the winner.

BHP’s takeover of Billiton in 2001 is a case study. It was seen as a big mining company acquiring a smaller business, but the Billiton culture rose quickly to the top inside BHP with many of its former managers appointed to leadership roles in the merged entity.

The rise of ex-Billiton executives annoyed lifetime employees of BHP, leading to a spectacular clash between chief executive Brian Gilbertson (a South African-born Billiton man) and the Australian chairman of the merged entity, Don Argus.

Gilbertson lost in that showdown with the formidable Argus, but he extracted a multi-million dollar settlement.

Easy as it might be to dismiss personalities in a corporate takeover they are critical to how investors see a business. This leads to the first of several key points to consider when assessing whether Glencore could succeed in a bid for Rio Tinto.

Chief executives:

Glencore boss Ivan Glasenberg has a lower profile in Australia than Rio Tinto chief executive, Sam Walsh, but he is eight years younger and because I have met and interviewed both I can say that he is a more impressive man than Walsh.

Walsh, who turns 65 in December, has performed well in rescuing Rio Tinto from its most recent series of disasters, including heavy asset value writedowns over coal and aluminium assets.

But his reputation is built on the good fortune of being the man in charge of the company’s iron ore division at a time of record high prices for the material, an advantage which is fading with the iron ore price.

Glasenberg, who is 58 next January, is the architect of Glencore, growing it from a low-profile commodity trader into a world-class business with a new approach to resource investment that is totally focussed on shareholder returns. This fact is easy to understand given his 8% stake in Glencore is valued at more than $7 billion.

Asset mix:

Rio Tinto’s assortment of assets has become dangerously unbalanced with 90% of its profits coming from a single division, iron ore. The recent collapse in the iron ore price will be reflected in Rio Tinto’s future profits, but does not yet appear to be reflected in the share price.


Graph for Winning Rio

Glencore has a greater mix of assets and is pursuing a unique strategy which might be called “all commodities and all fees”. It has “soft” operations in products such as wheat and soy as well as “hard” operations in metals. It is also a ferocious trader, able to peel fees off every stage of the production, transport and distribution process.

Growth:

Rio Tinto has promised to stop investing in new projects other than its high-margin iron ore business as it works to retire an excessive debt load. Rio is also trying to resolve ongoing problems in the giant Oyu Tolgoi copper project in Mongolia and the Simandou iron ore project in West Africa.

Glencore is not putting on the brakes and has a mandate from institutional investors to keep growing at a rapid pace in a number of areas, including soft commodities and a newly formed oil division.

Shareholder rewards:

Rio Tinto has been lifting its annual dividend payment and has promised some form of capital management such as a share buyback or capital return.

Glencore is doing more than promise. It outperformed both Rio Tinto and BHP Billiton this year by delivering a $1 billion share buyback, a move which greatly impressed London institutional fund managers.

As for timing, it will be difficult for Glasenberg to decide if Rio Tinto will ever be cheaper than it is now.

As Adam Carr suggests today (China slows down ... as planned), Rio Tinto and BHP Billiton have been range trading in recent times, indicating the wider market is unsure whether the much-vaunted "China slowdown" is a genuine concern or not.

Domicile and tax base:

Rio Tinto suffers from a split personality with its dual-listed (Australia and London) structure which can be confusing to investors.

Glencore has a London head office but for tax purposes it is essentially a Swiss company with all the advantages that come from working in an ultra-low tax environment.

Blunders:

Glencore is a lot younger than Rio Tinto which means it has had fewer opportunities to destroy shareholder wealth with ill-conceived project developments or ill-timed acquisitions.

Rio Tinto on the other hand almost destroyed itself in 2008 with the $US40 billion acquisition of the Alcan aluminium business just before the price of the lightweight metal collapsed.

It doubled down on the dud Alcan investment by acquiring a coal business in Mozambique just before the coal-priced collapsed and without properly assessing the project, which lacks an effective transport route from the proposed inland mine to coastal ports.

Compatibility:

Coal in NSW is an obvious starting point for a merged Glencore and Rio Tinto to generate synergy benefits. But any gains there are small beer compared to the big prize Glencore might be seeking: Rio Tinto’s iron ore division.

Because Rio Tinto’s iron ore mines in the Pilbara are the world’s low-cost leaders they would make a brilliant acquisition for any suitor, but Glencore has an advantage in that it only has a small iron ore mine under development in Africa and an iron ore trading business which is acting as an incubator for something bigger.

Government anti-monopoly regulators, particularly those in China, are unlikely to object to a change of ownership of the Pilbara iron ore mines, though they would object to the integration of other mining assets, particularly copper.

Outlook:

Rio Tinto, despite a steady recovery in the aluminium operations, is grossly over-exposed to iron ore. While most analysis of the company remains favourable, its profits from iron ore will be falling and its ability to deliver promised capital management and debt retirement at the same time is being questioned.

Glencore is a far more diversified business. While its major assets are not regarded as being of the same quality as Rio Tinto it has a better balance and a highly profitable (and high risk) commodity trading division, which is missing in both Rio Tinto and BHP Billiton.

In effect, Glencore has developed an “all resources” model that revolves around its central commodity trading business with new commodity assets easily bolted on – iron ore, for example, would be a natural fit with its metallurgical coal business because both serve the same steel mill customers.

The possible deal:

Size does matter in business, but so too does imagination and an ability to structure a deal.

In the case of Glencore it is possible to see a share-swap (plus cash top up) deal kicking a bid for Rio Tinto into play with Glasenberg happy to play a long game, as he did with Xstrata. This would allow institutional fund managers to decide who is the better manager of the funds they control.

Monopoly concerns could be easily fixed by selling Rio Tinto assets that worry government regulators, so long as Glencore can retain what is the world’s best iron ore business.

A possible sideline player in any sell-off of surplus assets could be Glasenberg’s former close associate, Mick Davis, once head of Xstrata but now leading the X2 private equity fund which has $US10 billion to spend but is yet to land a deal.

Rio Tinto leftovers would be a very handy start for X2.

A research paper by Wall Street brokerage firm Bernstein Research triggered the current bout of Rio Tinto takeover speculation. While it is an unsourced document it is easy to imagine the broker having spent some time talking to Glasenberg and his lieutenants.

“A Rio Tinto-Glencore combination would create market-leading positions in iron ore, copper, nickel, zinc and coal as well as significant optionality around a number of lesser metals and minerals,” Bernstein wrote.

“Moreover, it would create the biggest and most diversified mining company on the planet. It would be a Glencore-Rio combination that would quickly become the “must own” stock for anyone looking for mining exposure.”