Is Glencore in a precarious position?

The story of Glencore, the Swiss-based commodity producer and trader, is a fascinating one. Originally founded in 1974 by Marc Rich, as Marc Rich & Co, the company was bought out by management (including current CEO and major shareholder, Ivan Glasenberg) in 1994 following an internal dispute. Wishing to rid itself of an association to Rich, the company changed its name to Glencore – a portmanteau of the words: global, energy, commodity and resources.

Glencore’s primary business was always in commodity trading. Profiting from arbitrages in pricing spreads, physical premiums, quality differentials and the like, the business could, in theory, profit under all market conditions.

Commodity traders are notoriously secretive – ask yourself: how much do you know about businesses like LouisDreyfus, Gunvor, Trafigura, Vitol or Cargill? A commodity trader’s edge comes from privileged information that it never wants to share with competitors. As one trader put it: “If I was a Catholic, I would say commodity traders fear publicity like the devil fears holy water.”[1]

So it was a surprise, therefore, to see Glencore list on the London Stock Exchange in May 2011. How would the company fare under this new public scrutiny? And while it made instant millionaires, and in some cases billionaires, of many of its staff, would this result in a massive brain-drain as the “28-year old traders worth $100 million” opted for retirement over creating value for their new public shareholders?

If nothing else, it allowed analysts and investors to peak under the hood of the business (your author included). A detailed analysis of the financial accounts at the time would reveal very poor cash flow, poor returns on capital and a large array of one-time gains and impairment reversals that served to inflate headline earnings but were essentially non-recurring into the future. The company’s disclosures at the time also revealed the poor quality of the mining assets owned by the company. For example, many mines had a remaining life of less than five years – and this was in 2011.

So it was perhaps not surprising that Glencore subsequently acquired Xstrata in 2013. After all, if its own mining assets were running out, it needed to replace them with a larger set of reserves. In simple terms, Xstrata was primarily a coal and copper producer. So in 2013, Ivan Glasenberg essentially paid a significant premium to acquire a large base of coal and copper assets – those of Xstrata’s.

This was a big bet. The merged company in 2013 was the fourth largest mining company in the world. It had the unique combination of a trading business with a mining business and claimed one of the shrewdest CEOs in the space in Ivan Glasenberg. Furthermore, Glasenberg was an 8.4% shareholder – much more than can be said for other executives in the mining space – so incentives were aligned.

All was well, or so it seemed, until the prices of Glencore’s two primary commodities, coal and copper, began to fall. The drivers of the price declines relate to both the Chinese economy and the behaviour of other commodity suppliers. Essentially, Chinese demand for these inputs began to slow without a commensurate slowing in supply growth. The price declines were the natural consequence.

Commodity producers deal with price declines all the time – this is the nature of the business. But Glencore is not your typical mining company: Glencore has over US$50 billion of debt on its balance sheet. This is a dangerous combination. When asset values fall, debt liabilities remain the same, so shareholder’s equity becomes squeezed at an accelerated rate. And this has been the case at Glencore.

In the most recent 1H15 company results filing, Glencore reported a halving of income attributable to shareholders. Earnings related to the mining side of the business were down (84%) year-on-year; and even the earnings related to the trading side of the business declined (27%) year-on-year. So much for being able to make money under all market conditions.

Assets have started to become impaired and the company’s credit metrics are rapidly deteriorating. While the company still pays a dividend, this may well be short-lived. On the conference call with analysts and investors, CEO Ivan Glasenberg summed up the problem quite honestly: “All depends on demand from China and that’s the one we’re struggling to read…”

Glencore now remains in a precarious position. Earnings are declining while financial leverage is high. Much of the easy fruit has already been picked with regard to cost-cutting following the merger with Xstrata in 2013. So the fate of the company’s equity is now in the hands of Chinese copper and coal demand growth forecasts – and all indications thus far are that they will likely get worse before they get better.

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Montaka has been short the shares of Glencore since its inception.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

[1] The King of Oil: The Secret Lives of Marc Rich, Ammann, 2009

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