Digging Into Glencore's Sales Pitch

APRIL 27, 2011   THE WALL STREET JOURNAL

By ANDREW PEAPLE

If Glencore International is selling, commodity prices must be peaking, or so the theory goes.

The Swiss company plans an $11 billion flotation next month. That has plenty of people speculating its partners want to cash out before the commodity cycle turns. Glencore counters by saying its earnings hold up well even when prices fall, thanks to the way its marketing arm operates. That's the theory investors should be scrutinizing.

The marketing business contributes about 40% of Glencore's earnings before interest, tax, depreciation and amortization, or Ebitda. Commodity-price bets are mostly not its game: Glencore hedges 98% of its inventory, limiting its daily estimated maximum loss from unhedged positions to $100 million. Instead, Glencore looks for price arbitrage opportunities. It uses its global network of offices, ships and warehouses to move commodities quickly to where demand is high; to blend products to meet specific customer needs; or to take advantage of price differentials caused by timing.

Glencore says its steady marketing profits cushion earnings fluctuations from its commodity-producing assets, making overall profits less volatile than those of pure mining companies. So analysts attach a higher valuation to the marketing business. It's valued at between eight and nine times expected 2011 Ebitda, compared with 5.6 to seven times for Glencore's industrial assets, Liberum Capital says.

But Glencore must do more to prove how resilient its marketing arm really is. Detailed earnings data on the company pre-2008 aren't available yet, but recent figures aren't encouraging.

The marketing arm's earnings before interest and tax fell 50% year on year in 2009, when commodity prices slumped, while Glencore's mining earnings fell 43%. A 10% fall from current commodity-price levels would reduce Glencore's overall 2011 earnings 22%, compared with a 17% fall for pure miner BHP Billiton, Liberum Capital estimates.

Marketing growth may get harder, too. Glencore already has dominant market positions in the trading of zinc, copper and lead. There's more room to expand market share in iron ore, oil and agricultural-product trading, but competition from other trading firms, oil majors and even investment banks is fierce. Meanwhile, Glencore may find the scrutiny that comes with being a public company makes it harder for it to do profitable marketing deals.

Glencore's marketing earnings before interest and tax were $3.2 billion in 2008, but may only reach that level again in 2015, Citi forecasts. Faster growth will only come if Glencore expands its industrial operations more quickly, providing more product for the marketing arm to trade with.

Similar logic underlies Glencore's scarcely concealed desire to merge with pure miner Xstrata. Expanding production, whether organically or through acquisition, will require more capital from the equity markets. That is why Glencore's partners are selling out now.

Write to Andrew Peaple at andrew.peaple@dowjones.com