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Clouds gather over Glencore

What happens when a company's strategy relies on one of the most politically-fraught nations on earth?
June 7, 2018

Should Glencore (GLEN) have ever gone public? Its 2011 flotation may have made billions for its executives and traders, but those investors who bought into the group’s mine-to-market proposition still nurse a 13 per cent loss, including reinvested dividends. Of course, neither IPO buyers nor Glencore traders anticipated the market collapse, which made the first five years so painful, or the takeover of Xstrata, which was financially precarious. Since 2016, remedial measures and tighter markets have helped the shares rebound along with the sector. Yet Glencore's trump cards – a black-box-like marketing division, contrarian strategic nous and an appetite for political risk – now look like weaknesses. With skies darkening, we expect Glencore’s mixed history of return on capital to persist, and for the shares to continue to underperform peers.

IC TIP: Sell at 384.8p
Tip style
Sell
Risk rating
High
Timescale
Short Term
Bull points

Fat dividend yield

Growing copper focus

Bear points

Growing political risk

Possible SFO probe

Coal assets overhyped

Black-box marketing division

Recent months have brought a deluge of political headaches. US sanctions have complicated trading with Russia's Rusal and a deal to acquire shares in EN+, another Russian miner while a new buyer had to be found for the sale of a stake in Rosneft. But the biggest issues are in the Democratic Republic of Congo (DRC), where Glencore owns and operates the Mutanda and Katanga copper-cobalt mines. Both are central to the miner’s views for long-term metal demand, particularly from electric vehicles. DRC's president, Joseph Kabila, appears to be of the same view, and in March waved through new laws that raise mining taxes and royalties, add a windfall charge on “strategic” minerals such as cobalt, and remove a provision granting miners time to adapt.

Dialogue has floundered, and Glencore and other miners are now invoking the courts. That could usher in an even worse scenario than the potential hit to earnings and $633m (£475m) of tax credits. Compounding matters, DRC's state-controlled miner, Gécamines, has launched its own legal action, alleging Glencore has failed to meet a capital shortfall for the Katanga mine. Meanwhile, Dan Gertler, who helped broker Glencore’s DRC holdings, has initiated claims for $3bn in damages from unpaid royalty payments.

In its defence, Glencore has been unable to deal with Mr Gertler since he came under the US sanctions regime in December. But the feud between the two is unlikely to fade from view soon, following reports that the UK's Serious Fraud Office (SFO) is weighing up a probe into the miner’s relationship with the Israeli businessman. That news wiped $3.6bn off Glencore’s market value.

Putting a price on the SFO news is highly speculative. Modelling against the agency’s deferred prosecution agreement with Rolls-Royce, and given Katanga’s lossmaking history, investment bank JPMorgan notes the recent fall could “exceed any potential liability”. Equally speculative, though more worrying, is the possibility that Katanga and Mutanda will be nationalised. City broker Liberum estimates that Glencore’s African copper assets represent “virtually all” of the group’s organic growth, and would otherwise contribute 13 per cent of 2019 cash profits at spot prices if Katanga ramps up as planned. That looks threatened, and could place greater reliance on dealmaking, particularly in copper, just as sector valuations hit multi-year highs.

Speaking of which, we question Glencore’s bullishness on coal, evidenced in its recent $1.7bn purchase of Rio Tinto’s Hail Creek mine (at four times’ trailing cash profits), following another pricey deal for Rio’s Coal & Allied division at the second bite. Coal assets contributed $3.5bn in cash profits to Glencore’s industrial division in 2017, but with supply rebounding thermal coal prices are expected to soften this year. Longer-term demand is questionable.

We think investors should also query the oft-touted virtues of the marketing division, which despite its low capital expenditure has not beaten management's profit guidance since 2008. The division's long-term adjusted operating profit guidance of $2.2bn-$3.2bn may offer a backstop to the dividend, which generates a fat yield (see table), but earnings generally underperformed in the downturn, when they were supposed to offer a hedge to a battered industrial division.  

GLENCORE (GLEN)   
ORD PRICE:384.8pMARKET VALUE:£55.5bn
TOUCH:384.8-384.9p12-MONTH HIGH:409pLOW: 267p
FORWARD DIVIDEND YIELD:6.3%FORWARD PE RATIO:7
NET ASSET VALUE:257pNET DEBT:22%
Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)Earnings per share (¢)Dividend per share (¢)
20151730.62-58.26
20161771.789.74
20172216.9240.514
2018*25411.158.925
2019*24713.068.232
% change-3+17+16+28
Normal market size:3,000   
Matched bargain trading    
Beta:1.4   
*JPMorgan forecasts (adjusted PTP and EPS figures). £1=$1.33