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Why Glencore’s assets will fail to realize its true value
Prologue
The company made headlines on Monday (28/09/15) when its shares fell by 30%.
Management made assurances to investors they are raising cash and selling assets to reduce its gross debt of $50bn, which is more than the company’s market capitalisation.
More: If you want to read my analysis on Glencore, the company, click on the link HERE. But today, we will be discussing Glencore biggest acquisition: Xstrata.
Before we begin, here is some background on Glencore.
Who is Glencore?
A business that trade hard and soft commodities, it also mined natural resources and in 2013 merged with Xstrata at a cost of $30bn for the 66% stake Glencore doesn’t own.
So on a 100% equity basis, Glencore values Xstrata’s stake at $44.6bn.
Today, the market value of Glencore and Xstrata is valued at $26bn.
Why have investors diluted the value of Glencore?
At the time of acquisition, Ivan Glasenberg says operational cost-saving would be $2bn.
But Glencore impaired $7.5bn of its assets and made a loss of $7.4bn in 2013. Also, the company paid out an extra $600m in interest costs from the previous year.
Gross debt in 2013 jumped to $55bn from $35bn.
It means that Glencore’s debt to equity is exceeding 100%, which adds financial risk if company’s profits can’t cover their capex, dividends and debt repayments.
Glencore’s Xstrata problem
However, Glencore’s management is no better than (previous) management at BHP Billiton and Rio Tinto. Both of which did acquisitions and share buyback at the wrong business cycle.
For example, Rio bought Alcan for $38.1bn in 2008 but was forced to write off $25bn of its Alcan’s assets!
At the time of the purchase, Alcan had revenue of $30bn in revenue and $2bn of earnings.
BHP Billiton made the same mistake in 2011 when it bought Petrohawk (a gas company) for $12bn (debt + cash offer). In the end, they had to write-off $5.8bn of Petrohawk’s assets. At the time, BHP was paying 18 times Petrohawk’s EBITDA.
Both Rio and BHP has written down between 66% and 48% of its investments respectively. Meanwhile, Glencore has written off 17% of Xstrata’s assets.
But, will there be further writedowns from Xstrata?
Xstrata – the business
Xstrata’s four main commodities: Coal, copper, nickel and zinc accounts for 75% of its revenue.
Let see the performance of these commodities.
2006 2007 2008 2009 2010 2011 20120
2,000
4,000
6,000
8,000
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12,000
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16,000
Xstrata's revenue breakdown
CoalCopperNickelZinc
($m
)
Source: Xstrata annual report
Coal has played a major role in contributing to Xstrata’s revenue while nickel and zinc stayed on the back foot. Copper stays on as the biggest contributor.
By analysing Xstrata’s commodities EBIT margin vs. the commodity market price, we get the sense of direction of where the EBIT margin is heading.
2006 2007 2008 2009 2010 2011 2012 2013 2014 20150
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Xstrata's copper EBIT margin
Copper (%)Copper ($/tonne)
(%)
($/T
ON
NE)
Source: Xstrata annual report
Copper’s margins were falling even though the average selling price is high, meaning fixed operational costs have increased substantially since 2006. From 2012 onwards, the copper price has dropped by 27.3%.
20062007
20082009
20102011
20122013
20142015
0.0
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Xstrata's coal EBIT margin
Coal (%)S.A. thermal coal price ($/ton)Australian thermal coal price ($/ton)(%
)
($/T
ON
)
Source: Xstrata annual report
The EBIT margin for coal is even worse when prices touched their all-time high!
This kind of situation happens because capacity utilisation has not reached its optimal level, especially when the company is adding to capacity.
Meaning that coal’s EBIT margin has to compensate for the spare ‘unused’ capacity. Now, that coal prices have dropped on average by 40%, the EBIT margin will be significantly reduced.
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-5
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Xstrata's nickel EBIT margin
Nickel (%)Nickel ($/ton)
(%)
($/T
ON
NE)
Source: Xstrata annual report
2006 2007 2008 2009 2010 2011 2012 2013 2014 20150
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Xstrata's zinc EBIT
Zinc (%)Zinc ($/ton)
(%)
($/T
ON
)
Source: Xstrata annual report
Both Nickel and Zinc plays a supporting role; nickel margin is likely to fall further, after the Glencore’s acquisition. But the margin on zinc is likely to be maintained, given its price resilience.
Investors need to remember that heavily capital intensive industry needs to make a decent margin if they are going to rely on internal funds to repay debt and pay a ‘sustainable’ level of dividends.
More importantly, to maintain production level, these types of businesses need to reinvest their ‘surplus’ capital. To know how much capital is required, one should look at their depreciation and amortisation (D + A) expenses per year.
If the company invest the equivalent of its (D + A), then they have maintained its production levels.
For Xstrata, if we ignore net interest costs and corporate taxes, the amount of EBIT (earnings before tax and interest) it makes each year barely cover their Capital expenditure (see below):
2006 2007 2008 2009 2010 2011 2012
-2000
-1000
0
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Xstatra's EBIT minus CAPEX breakdown
CoalCopperNickelZinc
($m
)
Source: Xstrata annual report
People would bash me for not including depreciation and amortisation charges. However, the above illustration should make retail investors that a highly capitalised business needs to make a decent margin to cover their CAPEX!
Secondly, investors should be careful if businesses (especially highly capitalized ones) talk about expansion.
2006 2007 2008 2009 2010 2011 20120
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Revenue vs. net profit vs. cash profit
Revenue Operating cash flowNet profit
($bn
)
Source: Xstrata annual report
In the case of Xstrata, it manages to double revenue in the last six years; however operating cash flow and net profit did not double!
Lesson: If businesses rely on market prices for their fortune, it doesn’t possess any competitive advantages, apart from being labelled the ‘lowest costs producers’.
Therefore, when management decides to expand the size of its operations, make sure that cash profit grows at the same pace as revenue.
If we look at the free cash flow of Xstrata and compare this alongside its net operating cash flow and total debt we get this:
2006 2007 2008 2009 2010 2011 2012
-20,000
-15,000
-10,000
-5,000
0
5,000
10,000
15,000
0
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Xstrata's FCF vs. OCF
Free cash flow ($m)Net operating cash flow ($m)Total debt ($m, RHS)
($m
)
($m
)
Source: Xstrata annual report
The chart tells us two things about Xstrata:
1. ‘Net operating cash flow’ from 2006 to 2012 ranges from $4bn-$9bn per annum equivalent to 20% to 35% of its revenue.
And free cash flow after capex, acquisitions and disposal is negative!
2. Total debt increases when free cash flow is negative, except for 2008/09 because they raised $5.7bn from shareholders. Otherwise, total debt would be $22bn, instead of $17bn.
Will there be a further write down in Xstrata’s assets?
Furthermore, Glencore will need to write down it’s Xstrata stake because margins would have deteriorated further as commodities prices dropped a further 30-40% (except zinc), since 2012.
Glencore values its Xstrata stake at 13 times net earnings (Xstrata’s average net earnings is $3.53bn from 2006-2012), or 32 times 2012’s earnings.
Giving the prolonged and persistent weakness in commodities prices, a write down of 50% of Xstrata's assets is appropriate.
Because Glencore is desperate to raise cash from selling its assets to reduce its ‘mammoth’ $50bn of debt.
Also, with weak persistent commodities prices, assets held by miners will be less valuable.
My conclusion on Glencore’s Xstrata stake would be a further write down of between $7bn and $15bn.
However, the company has indicated they will be selling assets to raise cash, and it will be interesting how much they will get for their asset vs. how much they have valued it in their books!!
Disclosure: I do not own any Glencore shares, but this could change if certain events occurred!
