The Curious Question of Glencore's Debt

MAY 11, 2011   THE WALL STREET JOURNAL

By ANDREW PEAPLE And SIMON NIXON

Glencore International's bankers say investors are flocking to the commodities company's initial public offering after it cut its target price range last week.

It is now seeking a valuation of $48 billion to $58 billion before new money, compared with up to $70 billion previously touted by its bankers. But does the new price range really represent such a bargain? That depends partly on whether one agrees with Glencore's decision to allocate the bulk of its $30.6 billion debt to its mining, rather than trading, operations.

Bloomberg News

Is Glencore a bargain? Above, Prodeco Group's Calenturitas coal mine, owned by Glencore.

Some $12.8 billion of Glencore's debt is short-term asset-backed borrowing, with an average interest rate of 2.86% used to fund the trading business. Glencore then allocates the remainder of the $17.8 billion of debt, held by the holding company and carrying an average interest rate of 6.51%, to the mining division. This includes $2.3 billion secured against its 34.5% stake in Xstrata.

This seems odd. It implies Glencore's mining business has debt equivalent to 50% of fixed assets, high relative to the sector. On this measure, Glencore's four major U.K.-listed mining peers had average financial leverage of 20% at the end of 2010.

Meanwhile, Glencore's trading operations resemble an investment bank because they are primarily exposed to liquidity and counterparty risks; market-price risks can largely be hedged. Logically, one would have expected it to opt for a similar capital structure, piling on debt to maximize the return on equity.

This matters because Glencore's bankers are encouraging investors to value the group on the basis that the trading division should command a much higher price/earnings multiple. By allocating all the expensive debt to the mining division, Glencore can maximize its earnings from trading, generating a higher group valuation.

Liberum Capital reckons the mining business will generate net income of $4.87 billion in 2011, which it values on a multiple of 7.6 times; it expects the trading business to deliver net income of $2.29 billion, valued at 11.9 times. But if one reallocates the debt to bring mining-division financial leverage in line with peers, then mining net income rises to $5.29 billion while trading net income falls to $1.65 billion, based on a Heard on the Street analysis. Glencore's value falls by $4.5 billion, to $59.8 billion.

But Liberum Capital's forecast is based on a bullish assumption that the mining division can increase operating income by 123% this year. Investors also may question whether the trading business should really be valued at a higher multiple than Goldman Sachs Group, which trades at 10 times forecast earnings, according to Factset. Applying Goldman's multiple to the trading business and assuming a 90% increase in 2011 mining operating income reduces Glencore's value to $50.3 billion, close to the bottom of its IPO range.

Maybe not such a bargain after all.

Write to Andrew Peaple at andrew.peaple@dowjones.com and Simon Nixon atsimon.nixon@wsj.com