Rio Tinto plc Rejects Glencore PLC On This Occasion… But Will It A Second Time?

The mining sector just got what it needed to receive a fillip. Guess what? A big takeover story. 

Rio Tinto (LSE: RIO) confirmed on Tuesday that it had rejected a merger proposal from Glencore (LSE: GLEN) earlier this summer. “The Rio Tinto board confirms that no discussions are taking place with Glencore,” Rio Tinto added.  

Analysts suggest that a deal may take place by mid-2015, however. As M&A talk comes back with a vengeance, which miner is the best buy right now? Well, the answer may well be Anglo American (LSE: AAL)! 

A Glencore/Rio Tinto “Merger”

The deal would be structured as a merger, but it would essentially be a takeover of Rio by Glencore. It would hold strategic merits, as the assets base of Rio appeals to Glencore. 

Glencore stock trades at 8x and 7x adjusted operating cash flow for 2014 and 2015, respectively. Rio stock trades on forward trading multiples of about 5x into 2015, which means that Rio management will unlikely be able to negotiate a terrific deal for its shareholders. 

The high valuation of Glencore means that Rio shareholders would be offered a very small cash component if the deal takes place. In fact, between 60% and 80% of the takeover price would be financed by Glencore’s equity. The deal would likely value Rio in the region of £65bn, excluding net debt.

For Glencore, such a large takeover would make lots of sense. Meaningful cost and revenue synergies are up for grabs at a time diversified miners need to shed assets to become more efficient and preserve cash flows. 

Divestments: The Tricky Bit? 

Royal Bank of Canada told its clients on Tuesday that if a deal occurs, Glencore would “have the potential to nearly double its free cash flow generation potential from 2015 onwards,” adding that Glencore “could further enhance cash flow generation from currently underperforming businesses via cost synergies (Hunter Valley thermal coal assets), restructuring (copper business) and potential spin-offs or divestments (aluminum)”.

The broker also pointed out that Glencore “should be able to overcome any anti-trust issues”, given that Glencore could undertake divestments just as it did in the past when it merged with Xstrata. This may be the tricky bit: the mining sector is in trouble and needs consolidation, which means that plenty of assets are on the market and sellers do not dictate prices.

Economically, a Glencore/Rio tie-up has its own attraction. Analysts at Exane BNP Paribas suggest that a deal done at a 20% premium to Rio’s current valuation would yield a 12% accretion in earnings per share. Earnings accretion could be about 20% if the combined entity hits its high-end annual synergies target, according to my calculation, but that also depends on the loss of earnings from possible disposals. 

So, what’s next? It’s a tough market for miners. The performance of Rio stock is still under pressure for the year in spite of a 6% surge on Tuesday. Anglo American stock, meanwhile, is flat year to date. 

Of course, a takeover of Anglo would cost less than half that of Rio. Anglo’s relative valuation is line with Rio’s, although Anglo offer less value in terms of cost and revenue synergies than its largest rival. It could also be argued that BHP Billiton may show interest for certain assets once its corporate restructuring is done and dusted. In order to know how the competitive landscape will change, though, we’ll likely have to wait until next year…