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Glencore - debt demons

The dark days of 2015 may well be over, but Glencore still has a lot of work to do

Few companies in the extractive industries have attracted as much attention as Glencore and its towering debt. The Switzerland-based group's revenues from oil, coal and other commodities tumbled in the global market downturn. Investors even feared their shares would be wiped out if the company skipped its obligations on more than $30bn in borrowings of various kinds, much of it incurred in the merger with mining giant Xstrata. Even more dire, there were concerns that a failure might precipitate another global financial crisis.

But their worst fears appear to be behind them, for now, after chief executive Ivan Glasenberg embarked on a programme of debt reduction. By October, Glencore had slashed borrowings, mainly through asset sales, and looked certain to meet its target by year-end. In an increasingly uncertain world for commodities, in part down to China's slowing economy, the chief executive has clearly started to take its debt problem seriously.

The 2013 "hybrid merger" with Xstrata is still, though, seen as a step or three too far. Glencore's market value has collapsed from its peak of $75bn in July 2014 to about $36bn in mid-November. Debt aside, the merger was supposed to help cushion Glencore from market swings. It has demonstrably failed to do so. At around £253 ($315) on the London stock market in mid-November, Glencore's share price has slumped from more than £330 around the time of the merger. The rationale for the merger was that the mining and trading divisions would support each other through thick and thin, but the collapse in prices in the industrial division has forced Glencore to rely increasingly on trading profits to keep its head above water. At the time of the merger, trading accounted for $1.2bn of adjusted earnings before interest and tax, while mining accounted for $2.8bn. That balance has progressively reversed: in the second half of 2015 nearly all group earnings came from trading.

Glasenberg's change of heart was partly motivated by the need to maintain Glencore's investment-grade credit rating. Now rated Baa3 (stable) by Moody's and BBB- (stable) by Standard & Poor's, an investment-grade score is particularly important because of the company's heroic debt. Although the chief executive said last year that a single-notch fall would not inflict "a high cost to the company", chief financial officer Steve Kalmin seemed to disagree. Glasenberg also believed Glencore could maintain dividend payments, then at $0.06 a share, but his CFO went on record to say he would not rule out cutting them to save the credit rating. Not long afterwards the dividend was axed.

A poor 2015 would have helped change the chief executive's mind. During the commodities rout a string of investment houses feared the worst, and analysts at Bank of America, Goldman Sachs and Morgan Stanley painted bleak pictures. The last estimated Glencore's shares would collapse to £0.17 in a stubbornly depressed commodities market. At one point, Investec, another bank, implied the entire company could be wiped out if markets didn't stabilise quickly. Over the full year Glencore's share price fell by 70%.

Probably under pressure from investors, management scrapped the dividend, sold $2.5bn of new shares and embarked on an urgent divestment project. The chief executive promised to slash debt to $28bn from $31bn by the end of 2016.

But some think the debt is actually higher than that. Late last year Bank of America analysts estimated the lenders' exposure to Glencore at over $100bn, most of it unsecured. In a note to investors they analysed the company's debt as $35bn in bonds, $9bn in bank debt, $8bn in available drawings and $1bn in secured borrowing. The analysts also believed they had identified around $50bn in "committed lines against which [Glencore] can draw letters of credit with which to finance its trading inventories".

Massive though the debt is, it has been carefully composed. According to Kalmin, there are few covenants attached to it, and the near-term maturities are manageable. The group also benefits from plenty of liquidity and free cashflow from its operations.

Confidence abounds

The banks seem happy to keep supporting Glencore. In May, the group signed a new one-year revolving credit facility of $7.7bn and a $6.8bn five-year revolving credit facility with options to extend it for two twelve-month periods. As of 30 June, the group could draw on credit and cash totalling $14.9bn, more than enough to see it through at least the next 12 months.

One of the few bright spots so far this year has come in oil trading, despite low prices. As Glasenberg told investors and analysts, Glencore has been extracting arbitrage opportunities as it exploits variations in refining margins.

An improvement in the coal market has helped too. A dearth of capex has caught up with seaborne thermal coal and buyers have jumped into the market as prices have dropped. Glencore is operating on the basis that thermal coal will play a key role in the global energy mix for a long time to come because of its low cost.

Although lower coal prices hit the group hard, mainly accounting for the 50% fall in adjusted EBITDA to $0.571bn compared to the same quarter in 2015, management points out that coal is finally on the rise, citing improving indices from their lows earlier in the year. Languishing at around $55 a tonne in mid-2016, the Newcastle index had risen in October to just over $99/t.

Similarly, in January prices of $28 a barrel for Brent also contributed to the savaging of Glencore's energy division. But here too the group believes crude has hit the bottom of the trough.

The divestment programme has gone better than many analysts expected. In June, Glencore sold 9.99% of its agricultural products division, Glencore Agri, to British Columbia Investment Management Corporation for $0.6249bn in cash. The transaction followed the sale of a 40% stake in Glencore Agri to Canada Pension Plan Investment Board for $2.5bn in April, leaving Glencore with what remained. The partial sale provided an insight into Glencore's leverage.

At the time of the sale to British Columbia Investment, Glencore Agri held $3.6bn in debt, most of it funded by the parent company. Following the transaction, Glencore Agri took over the funding. Only $0.6bn of the debt is long-term with the other $3bn short-term.

So that debt is now off the parent group's debts. And counting the earlier sale of gold field Komarovskoe in Kazakhstan for $100m, the Glencore Agri transaction allowed Glencore to pump $3.14bn in cash into its debt mountain. That left another $1.2bn to find before the end of 2016. In October, the group agreed the $0.87bn sale of GRail, its coal haulage business in the Hunter Valley, to help plug the gap.

Like other commodity companies in a roiled market, Glencore dramatically cut capex to preserve its liquidity. In the first half of 2016, spending on the mining business was slashed by more than half to $1.5bn, and over the full year total capex will be $3.5bn. Some operations were mothballed and management is waiting on the markets to pick up before it invests more in production. In Glencore management-parlance, "post-2016 capex remains dependant on price and associated incentive to reactivate certain latent capacities". If the markets stay flat, the company estimates it can sustain a group capex of $2.7bn at current production levels.

In short, Glencore is battening down the hatches until the storm passes. "We are pleased to say that during this tough commodity environment we have worked very hard on reducing our operational costs around the world," said Glasenberg recently.

But without a big price upturn, Glencore will have to sell off more assets next year. As financial analyst Quinn Foley of Madison Investment Research says: "Glencore will rely more than it expects on divestitures. The company is too optimistic about the outlook of commodity prices." Pointing out that underlying earnings, which adjust for unusual and infrequent items, fell by 66% year on year to $300m, Foley adds: "Rising commodity prices since the beginning of the year and major cost cuts were not enough to quell the tide. We don't think investors should expect things to improve anytime soon."

Glasenberg, though, insists things are looking up. Commodities broke out of their "five-year period of price underperformance" during the first half of 2016, he believes. And he notes that producers of many commodities can hardly keep up with demand, particularly in base metals and coal.

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