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‘Core belief' – Why we are still passing on Glencore despite its continuing share price falls

06/10/2015

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

In the month since The Value Perspective last wrote about Glencore, the share price of the beleaguered commodities trading and mining multinational has continued to sink. In Sudden debt, we declared ourselves unconvinced by the innovative way the business characterises its net debt – and downright uncomfortable about its high levels of indebtedness. This time, then, let’s try to be more constructive. 

A company whose share price has dropped the way Glencore’s has of late will always catch the eye of investors who specialise, as we do, in recovery-type situations. Nor do we invariably shy away from debt on principle – we just like to make sure that, if we take it on, we are doing so when we think the market has overreacted and there is an opportunity to make a lot of money for our clients. 

Now, there are undeniably some attractive elements within Glencore – most notably its trading arm, where it has built up a strong position as a global middleman, bringing together buyers and sellers of various commodities for a small percentage and with a limited degree of commodity risk. It is, of course, a cyclical business but there will always be people who want to buy and to sell commodities. 

Standing in sharp contrast is the other, larger part of the company – what used to be Xstrata – which actually mines commodities and which, in common with all the other players in this sector, has seen its profits come under immense pressure this year. Some good, some bad, then – but all of it dwarfed, as we said in our previous article, by the amount of debt on Glencore’s balance sheet.                                                                                                                                     

Share price upside 

We were looking to be more constructive, however, so let’s now set about working out what it would take for the company to have an amount of debt with which we felt comfortable and then see if there is any share price upside there. What follows will involve some very crude assumptions – about one step up from the back of a cigarette packet – but nothing that should prove too contentious. 

As in Sudden debt, we will focus on Glencore’s ratio of net debt to earnings, interest, taxes, depreciation and amortisation (EBITDA’ for short and an indication of a business’s cashflow). All else being equal, we would not want that ratio to exceed 2.5x – and, to be clear, we are using our view of what constitutes net debt rather than Glencore’s. 

Let’s assume then that this peak level of indebtedness of 2.5x net debt coincides with the trough in Glencore’s business, which would make sense because, as things improve, the company would be able to pay down its debt. In order to come up with the amount of debt we think the company should have at that low point, we then need to work out the actual EBITDA ( the business will generate.)

That, of course, is fraught with difficulty but taking a view rather than sitting on the fence is what we are paid to do. So let’s make another assumption – that this year will be the trough. That is not all that conservative but it is a serviceable starting point and, anyway, to see a market environment where everything collapsed simultaneously and then quickly rebounded, we only need look back to 2009. 

Reasonable assumptions 

Glencore’s first-half results tell us the company made roughly $4.5bn (£3bn) of profits, with $1bn of that coming from the trading arm and the balance from its mining operations. We could reasonably assume the trading arm also goes on to make $1bn in the second half of the year – that would put it a bit down on recent years, but not too much – but the mining operations are much more problematic. 

Glencore has been used to seeing around $10bn a year from this part of its business. A bad first half saw profits of just $3.5bn but things are a whole lot worse now. So let’s assume profits fall even further and the mining operations only make $1bn in the second half – that works out as $4.5bn in total and a collapse of more than half on recent years. 

Given copper and coal have respectively dropped 15% and 20% since the first half of the year, these numbers are less arbitrary than they might at first appear. The sales impact of these falls in a business with so much fixed mining cost could have an enormous impact on profits. It may be harsh to assume the full impact would be felt in the second half of this year – after all, 2015 only has three months left to run – but we would rather err on the side of caution on this point. 

As it happens, some of Glencore’s competitors have seen worse falls than that but we have to pick a number and $4.5bn for the full year it is. Add in the $2bn from the trading arm and we arrive at $6.5bn of EBITDA for the year in total. All we need to do now is multiply that by 2.5 to reach $16.25bn – the amount of debt that, here on The Value Perspective, we would suggest the business can sustain. 

That may seem a huge amount but it in fact equates to just one-third of the roughly $50bn of debt that, on our numbers, Glencore has on its balance sheet. Now Glencore would of course take issue with our numbers, arguing – as we discussed in Sudden debt – its trading arm’s $20bn or so commodities inventory, its so-called ‘readily marketable investments’, should also be deducted from its debt. 

Shrinking minority 

Well, if you do deduct $20bn from $16.25bn, you are saying Glencore is a net-cash business – and, if you are saying that, you are in a steadily shrinking minority. After all, one of the principal reasons Glencore’s share price has been collapsing is that the market has now realised making a deduction for those ‘readily marketable investments’ is not the right way to approach this situation. 

Having made our case in more detail in our last article, we will confine ourselves to just one point here – even if we were to make a deduction for Glencore’s inventory, what number should we pick? Every day commodity prices shrink, that inventory’s value shrinks also. As we put it in Sudden debt: “Copper is not cash.” So we are going to stick to our guns and to our $16.25bn number. 

To reach it, Glencore would have to find some $34bn in a year and, if it attempted to do so through a rights issue, it would be asking investors to stump up almost twice as much as its current $18bn market capitalisation. Here on The Value Perspective, we do not believe that is possible and so Glencore fails one of our golden rules – that a company has to be able to fix its balance sheet with one rights issue. 

We do not believe we have been overly conservative with our assumptions. We have assumed that the market improves next year, that the business bounces back almost instantly from its current travails and that none of its mines are losing money – even though that is what is happening at some of its competitors – and yet Glencore still cannot fix its balance sheet without a full recapitalisation. 

None of which is to deny the possibility that, tomorrow, commodity prices rebound, Glencore’s share price shoots back up and it turns out we have missed a great buying opportunity. Still, our analysis reveals no value angle to Glencore and suggests we would leave ourselves and our clients hugely exposed if we bought in today. What is certain is we cannot lose any money on a stock we do not own.

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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