When a company’s share price more than halves in the space of four months, it naturally attracts the attention of The Value Perspective. As Glencore’s shares came under increasing pressure over the course of the summer, therefore, we put the commodities trading and mining multinational under our microscope but, ultimately, passed on taking any sort of position. This is why.
As a general rule, we prefer to steer clear of businesses that have high levels of both operational leverage (variable profits in combination with significant fixed costs) and financial leverage (lots of debt). The big exception to this rule is if the business is already priced for financial distress – and a look at Glencore’s recent share history would suggest it is heading into that sort of territory.
If you are looking for great recovery-type investments – as of course, here on The Value Perspective, we are – then if you identify a business that, regardless of its current low valuation, you are confident is resilient enough sooner or later to emerge from its bad patch, you can potentially make a lot of money. Debt can severely reduce that resilience, however – and debt is something of which Glencore has a lot.
That, at least, is our view so why has this apparently been overlooked for so long by the wider market? There are a number of reasons but predominantly, we would suggest, it is because of how Glencore characterises its ‘net debt’ – a figure that is supposed to offer a clearer picture of a business’s outstanding debt levels by subtracting all the cash on its balance sheet from its total debt.
The thing about Glencore is a significant part of its business involves trading commodities – buying and selling zinc, copper and so on for its clients. Naturally this means the company will at any time have on its books a large amount of commodities inventory and it has always maintained the value of these ‘readily marketable investments’, as it calls them, should also be deducted from its total debt.
As Glencore is one of the largest commodities traders in the world and also very successful, we are talking a huge number here – some $20bn (£13.2bn). In the context of the $3bn or so cash the company has on its balance sheet and total debt of around $50bn, this greatly enhances the respectability of its debt ratios. This inventory is also very liquid so why shouldn’t Glencore lump it all in with its cash?
Well, for starters, can you name any comparable business that does so? One consideration is that, while those ‘readily marketable investments’ may be fairly easily turned into cash, there is a reason for that. Glencore needs liquidity to run its commodities-trading business and, if it sells what is effectively its float, there is no business. That is a problem as trading accounts for some 30% of Glencore’s profits.
A further consideration is that, when you have actual cash on your balance sheet, it does not bounce around in value. In contrast, if you have an inventory of, say, copper and copper suddenly falls 20% in value, then you have 20% less on your balance sheet than you did the day before. At the end of the day, copper is a commodity; cash, however, is cash.
For these reasons – and just as we would not do so for any other business – we choose not to adjust Glencore’s net debt for those ‘readily marketable investments’. Were you to choose not to do so either, you would see the company moves from having a just about acceptable amount of debt to having a deeply concerning level.
On Glencore’s own metrics, the business has a ratio of net debt to earnings, interest, taxes, depreciation and amortisation (‘EBITDA)’ for short and an indication of cashflow) of about 2.5x, which is all right, if towards the upper end of our comfort zone. On our metrics, however, the ratio is nearer 4x, which is the sort of gearing level that, frankly, you need to be a utility company to even try and make work.
That is because the profits utilities companies make tend to be as stable as anything you find in investment while Glencore is the polar opposite – a cyclical business. Ironically enough, due to the limited degree of commodity risk involved, the trading arm is the least cyclical part of its operations but profits from the rest of the business – what used to be Xstrata – are under immense pressure.
That has implications of its own for Glencore’s EBITDA and, in turn, for its net debt to EBITDA ratio – regardless of how the net debt part may be calculated. Here on The Value Perspective, we struggle to see how the company can make significant inroads into such a level of indebtedness – even if it resorts to a rights issue, as has been mooted in the press – but we will continue to maintain a watching brief.