Why Xstrata Is a Hot Commodity

Rising mineral prices have helped the sector escape the recent economic gloom. The Anglo-Swiss outfit's diversified portfolio makes it an M&A target

As warnings of a financial downturn spread through the world economy, it seems somebody has forgotten to tell mining companies about the doom and gloom. On Mar. 3, Anglo-Swiss giant Xstrata (XTA.L) became the latest company to announce bumper 2007 profits on the back of continued strong global demand for commodities from emerging economies (BusinessWeek.com, 2/13/08)

Xstrata—the fifth-biggest company in the sector, based on market capitalization—posted annual net earnings of $5.5 billion, up 13% from 2006, on pretax profits of $8.8 billion. Yearly revenue grew 12%, to $28.5 billion, predominantly on rising commodity prices, including a 54% surge in the price of nickel in 2007. Xstrata shares closed up 1% in London trading on Mar. 3, and are up 65% in the past 12 months.

The strong figures come as Xstrata remains at the center of a potential takeover bid (BusinessWeek, 2/21/08) by larger Brazilian rival Vale (RIO), which is expected to put forward as much as $90 billion for the London-listed company. Xstrata Chief Executive Mick Davis declined to give specifics on the deal, although he reiterated that "discussions with Vale are ongoing and may or may not lead to an offer for Xstrata."

"Out of Nowhere"

Despite the takeover uncertainty, Xstrata's strong 2007 performance illustrates the rise of a mining upstart that only went public in 2002. The key to its success has been its strength in copper and nickel production, which represent three-quarters of its total operating profit. That income was augmented in August, 2006, after Xstrata forked out $18 billion for Canadian mining company Falconbridge. Since then, the company has spent an extra $6 billion to ramp up production and has a further $12 billion earmarked for expansion over the next three years.

"Xstrata really has come out of nowhere," says Tom Gidley-Kitchin, mining analyst at brokerage Charles Stanley (CAY.L) in London. "It's now big enough to make sizable acquisitions of around $1 billion, but smaller than the other diversified mining companies, so the acquisitions have a bigger impact."

What has turned this onetime private company into a mining heavy hitter? Three words: rising commodity prices (BusinessWeek.com, 9/28/07). According to Credit Suisse (CS), the average price for copper—Xstrata's main source of revenue—has increased by more than 50% since January, 2006, to over $7,000 per metric ton. Similarly, nickel prices have jumped roughly 140% over the same period, to approximately $30,000 per ton, after hitting record highs of over $50,000 per ton at the beginning of 2007.

Riding the Wave of Growing Demand

Xstrata is also the world largest producer of zinc, but its position there could come under more pressure after Australian miner Oxiana (OXR.AX) announced a $5.6 billion merger on Mar. 3 with local counterpart Zinifex (ZFX.AX) that will create the world's second largest zinc producer

By making strategic acquisitions just as the market began to take off, analysts say Xstrata has been able to ride the wave of growing demand for commodities. "The mining sector as a whole has been very bullish about short- and long-term prices. Xstrata's decentralized management structure has allowed the firm to move on acquisitions deals very quickly," says Charles Stanley's Gidley-Kitchin.

To be sure, Xstrata's growth—pretax profits have risen tenfold since its 2002 IPO—could come under pressure from rising infrastructure costs and the weakening dollar. According to Xstrata CEO Davis, expenses associated with backlogs in exporting coal from Australia, for example, more than doubled annually to $110 million during 2007, while fluctuations in exchange rates cost the company $457 million over the same period.

Deal Highlights Bullish Outlook

Such expenditures, though, shouldn't cause too much worry for a company that expects to invest $30 billion in new projects in the medium term and has increased shareholder dividends by 400% since 2002, to the current 50¢ per share. Indeed, Xstrata's strong growth potential due to its diversified commodity portfolio is the principal reason Vale is expected to up its takeover offer to $91 a share to acquire the company.

Analysts say the deal is now dependent on an agreement between Xstrata's largest shareholder, Swiss firm Glencore International, and Vale over future trading concessions within the newly merged company. These should be ironed out over the coming months. No matter how long the negotiations take, Xstrata's strong 2007 performance highlights the bullish outlook for the mining industry despite continued uncertainty surrounding the global economy.

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