Glencore Debt Seen Punished Without Xstrata

Glencore Debt Seen Punished Without Xstrata
Glencore International Plc faces an expensive dilemma: increase its $27 billion merger offer for Xstrata Plc, or let it fail and risk a credit-rating downgrade and higher borrowing costs. Photographer: Gianluca Colla/Bloomberg

Glencore International Plc faces an expensive dilemma: increase its $27 billion merger offer for Xstrata Plc, or let it fail and risk a credit-rating downgrade and higher borrowing costs.

The world’s largest commodity trader must raise its all-stock offer to appease Xstrata shareholders or potentially be cut to the cusp of junk by rating companies. The combined business would have a net debt-to-equity ratio of 42 percent at year-end, compared with 96 percent for Glencore if it abandons the deal, BMO Capital Markets estimates, a level unsustainable for the current Baa2 rating.

Glencore, which has been adding debt after it bought Viterra Inc. and is seeking $1.5 billion of loans to back the proposed merger, wants to reduce its leverage by combining with Xstrata, whose net debt-to-equity ratio was 18 percent at the end of 2011. Its cashless bid for the mining company was jeopardized when Xstrata’s second-largest shareholder, Qatar Holding LLC, asked the Swiss firm to raise its offer last month.

Moody’s Investors Service “have said Glencore may be downgraded if the deal falls through,” said Barbora Matouskova, a credit strategist at Societe Generale SA in London. “If they’re downgraded they will have to pay up. They will pay more on their existing bonds with step-up language as well as for new bond issues, as they will be a riskier company.”

Sweetened Terms

Glencore had to sweeten terms on about $2.47 billion of debt securities sold this year to entice investors that were losing confidence the deal would succeed. The company agreed to pay an extra half percentage point on the coupon if the deal doesn’t go ahead before the first payment, according to data compiled by Bloomberg. It now faces $83 million in extra interest on those bonds over the next decade.

Charles Watenphul, a spokesman for Baar, Switzerland-based Glencore, and Alison Flynn, a spokeswoman for Xstrata in London, declined to comment.

Glencore is seeking to gain control of Xstrata’s copper, coal and zinc operations to establish the fourth-biggest mining company behind BHP Billiton Ltd., Vale SA and Rio Tinto Plc, reducing its own debt burden in the process.

Qatar’s sovereign wealth fund, which has a stake of about 11 percent in Xstrata, asked the company on June 26 to raise its bid to 3.25 of its shares for each one in Xstrata from 2.8 in February. Shareholders Knight Vinke Asset Management LLC, Standard Life Plc and Schroders Plc have also called for sweetened terms, and the date shareholders will vote on the proposed merger has been pushed back to Sept. 7 from this month.

Xstrata fell 7 pence to 835 pence at 1:47 p.m. in London, below the value of the existing bid of 881 pence. Glencore traded 0.7 percent down at 314.8 pence, extending its year-to-date decline to 20 percent.

Blocking Vote

Only 16.48 percent of shareholders’ votes are required to block the so-called “merger of equals” as U.K. takeover rules prevent Glencore from voting its 34 percent stake in its target.

Glencore has a market value of $34 billion, Bloomberg data show. It had negative free cash flow in 2011 of $2.6 billion. Free cash is money that can be used to reward shareholders with dividends and buybacks, pay down debt, and reinvest in the company.

The company trades commodities such as coal and oil and owns mines, factories and warehouses. Glencore, which changed its name after management bought out former U.S. fugitive Marc Rich in 1994, undertook a $10 billion initial public offering in May 2011. Rich, who fled to Switzerland after being indicted on 65 counts including fraud, racketeering and tax evasion, was pardoned by President Bill Clinton in January 2001, hours before he left office.

Debt Ratings

Moody’s said in March it may cut Glencore’s credit rating by one step to Baa3 if the transaction fails. Moody’s cited Glencore’s leverage as a reason for cutting its credit outlook following its C$6.1 billion ($6 billion) acquisition of Viterra Inc. in March. Standard & Poor’s estimated the same month that this transaction would increase Glencore’s net debt by a “significant” $4.3 billion. S&P rates the company BBB, equivalent to the Moody’s rating.

High-yield, high-risk, or junk, bonds are rated below Baa3 at Moody’s and BBB- by S&P.

Glencore is also spending $2.2 billion in cash to increase its stake in Ust-Kamenogorsk, Kazakhstan-based metals producer TOO Kazzinc to 93 percent from 50.7 percent, it said last year, as part of a three-year $5 billion capital spending program.

‘Negative Pressure’

“Moody’s cautions that under a scenario where the merger with Xstrata does not progress, while the Viterra acquisition moves forward as announced, Glencore’s ratings would be subject to negative pressure,” the company said on March 21. “In such a scenario, therefore, Moody’s would consider a downgrade, likely be limited to one notch.”

The company is offering to pay an initial interest of 150 basis points more than the London interbank offered rate on the loan to finance the Viterra purchase, people with knowledge of the matter said in May. It is expected to close this month.

Glencore said July 16 that approval from China’s Ministry of Commerce for the Viterra acquisition was no longer expected by the end of this month. It plans to provide an update on the expected completion date “in due course,” it said.

Glencore also said it signed a $3.1 billion loan backing the proposed merger with Xstrata, scaling back from the $6 billion originally sought, according to data compiled by Bloomberg. It received commitments for about $11 billion in syndication from 31 banks, the company said.

Xstrata’s Appeal

Glencore has a “unique pipeline of production growth from low-risk, low-cost and high-grade brownfield operations,” Chief Executive Officer Ivan Glasenberg said in a May presentation on the company’s website. A total of 80 percent of its expansion spending is due to take place before 2014, the company said in a separate presentation last month.

“More important than the credit rating may be that without Xstrata the growth profile may have to slow,” Tony Robson, co-head of metals and mining research at Toronto, Canada-based BMO, said in a telephone interview. “Commodity prices are low and not helping Glencore’s need to fund capex. Glencore needs Xstrata more than Xstrata needs Glencore, mainly for the strength of Xstrata’s balance sheet,” he said.

Xstrata had long-term debt of $8.8 billion at the end of 2011, down from $16.7 billion in 2008, and a market capitalization of $39 billion, Bloomberg data show. The Zug, Switzerland-based miner had free cash flow of about $6.96 billion last year, a 7 percent increase from full-year 2010, it said in its annual results.

Note Sale

One project Glencore would struggle to finance if the deal collapses is a $1.5 billion expansion at its majority-owned Mopani Copper Mines in Zambia, BMO’s Robson said. Glencore is planning an upgrade to the smelter at Mopani and a new shaft allowing it to access 115 million metric tons of copper ore.

Glencore most recently sold 450 million Swiss francs ($461 million) of 2.625 percent notes due 2018. Terms of the bonds, issued on June 19, require the interest rate to be increased 50 basis points if the Xstrata deal is not completed before December 2013, and by a further 125 basis points if the rating firms strip the company of its investment-grade ranking, Bloomberg data show. A basis point is 0.01 percentage point.

The bonds rose to 102.15 centimes on the franc from an issue price of 100.56 centimes, Bloomberg Bond Trader prices show.

Headline Risk

“There’s a headline risk associated with the credit downgrade, but in terms of the day-to-day business I could see where potentially financing costs might go up modestly, but it won’t be too detrimental to the business,” Jeff Largey, a mining analyst at Macquarie Group Ltd. in London, said in a telephone interview.

The 50 basis-point step-up also applies to Glencore’s 1.25 billion euros of 4.125 percent bonds due 2018 and 300 million pounds of 5.5 percent notes due 2022, the data show.

The merger will be “very materially accruing to Glencore, mainly through the deleveraging of its balance sheet and the control of Xstrata’s cash-flows once its ownership goes beyond 50 percent,” Exane BNP Paribas analysts led by Sylvain Brunet wrote in a July 13 report. If the deal collapses “we see some downside risk in Glencore shares if no deleveraging happens and a debt downgrade takes place.”

Spreads on Glencore’s bonds widened nine basis points to 238 basis points since Feb. 6, compared with a 24 basis-point decline for all bonds in the Bank of America Merrill Lynch Euro Basic Industry index, which ended July 17 at 149.

Swaps Converge

Credit-default swaps insuring Glencore’s debt trade at levels implying a junk rating of Ba1, two steps below its current ranking, according to Moody’s Analytics. The swaps have fallen 89 basis points to 324 basis points since June 14 and are converging with contracts on Xstrata, signaling that investors remain confident the merger will be concluded. Xstrata swaps have declined 35 basis points to 217 basis points, Bloomberg prices show.

The swaps contracts typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals 1,000 euros annually on a contract protecting 10 million euros of debt.

Analysts at Exane BNP Paribas and BMO Capital Markets also predict a one-step rating downgrade if Glencore abandons its bid, echoing Moody’s concerns.

“One of the appeals of the deal is that Glencore will benefit from absorbing Xstrata’s balance sheet,” Macquarie’s Largey said. “Glencore has more to gain if they get this deal done, than what they’d gain from pulling it.”

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