Glencore faces balance sheet 'Armageddon'
Glencore was trading at £1.31 then. Now it's down to £0.70, a 46% decline in just a few days.
If you look back as far as 2011, when the commodity giant first listed shares in London, it was over £5.00.
Armageddon hasn't yet arrived at Glencore, but it might be around the corner.
How can it be that a company that booked $221 billion in revenues last year, and was profitable, is now trading like a penny stock?
There are two basic reasons. Two Horsemen of the Glencore Apocalypse, if you will: Copper and debt.
Here's a basic guide to Glencore's finances, culled from its own statements, which explain the trouble the company is in.
It is not profitable
Very broadly, the mining and commodities trading colossus faces a huge task: It is not profitable, it is highly indebted, it holds little cash, and its fortunes are heavily dependent on the price of copper, which is going down.
More specifically, it has on paper roughly $100 billion in liabilities on its balance sheet and only $3 billion in cash.
The key phrase there is "on paper." In reality, the company has more going for it than that. But traditional accounting principles are not kind to the company, and they make its numbers look worse than they are.
The company is complicated. It doesn't just own a bunch of mines, it also trades commodities in its marketing division, and those trades are also hedged with other trades, so that the company isn't exposed to unexpected moves in prices.
As a whole, Glencore believes it has the kind of scale and assets that will allow it to thrive in the long term. Unfortunately, the stock market appears to betting that Glencore can't make it.
But first, here are some of the key metrics from its financial statements at the end of the first half of 2015:
- Revenues: $85.7 billion
- Cost of goods sold: $83.6 billion
This implies that the company's gross profit - the simple deduction of its manufacturing costs from its sales revenues - is only 2% of its revenues. That is a razor-thin margin. The company is basically spending $84 billion to make $86 billion, every six months. (For comparison, a competing mining company, Anglo American, had a gross profit margin of 16% of revenues in 2014, and was profitable.) That margin would improve if the price of copper went back up. Right now, copper trades at around $5,000 per metric tonne. Back in 2011 it was twice the price.
Unsurprisingly, once you account for Glencore's other costs, it loses money:
- Expenses (highlights):
- Admin/sales: $636 million
- Interest expenses: $786 million
- Net income: -$817 million
The company had hardly any cash on its balance sheet, just $3 billion at the end of June 2015. (That sounds like a lot, but to only keep $3 billion after you've done $86 billion in sales seems a bit thin.)
It has a lot of debt
The problem is that Glencore is heavily indebted and spends a huge amount of cash servicing its debts and loans. Here are the liabilities on its balance sheet:
Add the current and non-current liabilities together and, technically, you have a company that owes $100 billion even though it only has $3 billion in cash on hand.
Now, not all liabilities are equal, and not all are due immediately. Like a mortgage on a house, debt isn't necessarily bad if it is properly managed and apportioned over time. To make this more clear, Glencore prefers investors look at its "net debt," which is only $30 billion:
"Net debt" is defined as the debt left over if the company were to sell all its "readily marketable inventories," which are assets it believes can be liquidated so quickly they essentially function like cash.
As a measure of its underlying profitability, the company also prefers analysts to look at EBITDA, or earnings before interest, taxes, depreciation and amortisation, rather than net income on the bottom line. It defines EBITDA as revenue less cost of goods sold, selling/administrative expenses, plus share of income from joint ventures, dividend income, plus depreciation and amortisation.
On that basis, Glencore generated $4.6 billion in EBITDA:
In sum, on Glencore's preferred metrics, the company makes $4.6 billion in profits, holds $3 billion in cash, and only has $30 billion in debt - a picture that looks a lot more manageable.
Cashflow is weak
But cashflow is also a problem for Glencore. Cash leaks out of the business at high speed and that means the $3 billion cash pile it's sitting on is more likely to decrease rather than increase in size.
Glencore's operations are actually cashflow positive, but they are eclipsed by all the company's financing and investing costs:
- Operating activities: $7.5 billion
- Investing activities: -$3.1 billion
- Financing activities: -$4.1 billion
- Net cash increase in the period: $238 million
In there, "repayment of borrowings" is a single line accounting for $2.7 billion in negative cashflow alone. That's one reason why a company whose basic operations throw off $7.5 billion in cash every six months still only keeps $238 million of that (3%) in the bank at the end of the period.
Earlier this month, the company launched a plan to work its way out of trouble. It sold 1.3 billion new shares, raising $2.5 billion in cash. It also cancelled a dividend payment and sold down some assets. It wants to get its net debt down to the low $20 billions.
But investors today believe that plan has two headwinds: Glencore simply has a lot of debt and doesn't generate a lot of cash, so it needs to pray that its borrowing costs don't go up. Those costs might go up either because central banks raise rates, or if its credit ratings slip. Glencore has pinned a huge bet on maintaining an investment grade rating of BBB. If that slips, then expect the stock to plunge further.
At the same time, the low price of copper (and all other commodities generally) is depriving Glencore of the healthy margins it happily took back in 2011. Then, when copper was high, Glencore booked $2.6 billion in net income on the bottom line for the equivalent period this year.
If copper doesn't go up, GLEN.LN won't either.
That's what Armageddon looks like at Glencore: Low copper and high debt service costs. Right now, at least one of those factors - low copper - is already killing Glencore's stock.
We won't know until Glencore reports its next set of results whether the other factor, debt costs, is in play too.