It is not that the metals and mining industry needed any more bad news. But when analysts raised questions about the credit worthiness of global mining and commodity trading major Glencore Plc, it precipitated a new meltdown on Monday. The stock lost a third of its value on Monday as equity investors worried if there is any residual value left for shareholders after paying off debt.

 

This sent share prices of global mining companies down on Monday. Shares of BHP Billiton touched a seven-year low in the Australian exchange. The BSE Metal Index touched a new two-year low of 6,680 and hovers over the August 2013 five-year low of about 6500.

 

The Glencore stock has since pared its losses, and moved up over 10 per cent yesterday after the management assured investors of the company’s financial stability and debt reduction plans. This episode, however, shines light on the risks faced by investors who buy shares of mining companies. Are they standing on a land mine?

 

Falling earnings

The mining sector is reeling under the downward spiral in commodity prices. As realisations are hitting new lows, mining is becoming uneconomical. Add to this the debt obligations due for the inflated prices paid to acquire mining resources in the boom period. Mining majors globally are facing losses and concerns over bankruptcy.

 

Take the case of Glencore. It has a net debt of about $30 billion. The company has exposure to metals such as copper and nickel, energy such as coal and oil, as well as agri-commodities. It had enjoyed a higher valuation than peers such as BHP Biliton and Rio Tinto, in spite of the peers having lower debt. This was thanks to its sizable trading desk, which generates 80 per cent of the revenue. The segment, however, has a low margin and accounted for 40 per cent of its operating profit last year. And in the first half of 2015, this division’s adjusted earnings fell 29 per cent year-on-year to $1.1 billion, casting doubts over its ability to buttress overall earnings.

 

Worthless assets

With earnings falling, the company has been selling its assets to pay down debt, but most of the mines are worth much less than the cost of acquisition. For instance, Glencore sold an Australian nickel mine in June 2015 for $19 million. The mine was bought for $2.4 billion in 2007, when nickel prices were about $32,000 per tonne. Metal prices have dropped about $11,000 currently.

 

Glencore is not alone. Rio Tinto, another global mining major, made a fire sale of its coal assets in Africa – the mine was bought for $3.7 billion 2011 and was sold for $50 million in 2014. Vale, listed in Brazil, sold a coal mine it owned with Japan’s Sumitomo Corp for $1 in July 2015. The mine was bought for $630 million in 2012. South African coal trades at $54 per tonne currently, down from the peak of over $160 in July 2008.

 

Investor lessons

Why would assets lose soo much value in a short time? For one, the assets are valued based on the present value of extractable resources over the life of the mine. With high commodity prices and expectations of increasing price, the assets were over-priced.  

 

Also, the companies relied on debt to fund their expansions. With low interest rate and benign commodity prices, leverage did not seem like a big issue. But with risk of higher interest rate and falling profits, debt poses immediate risk of default.

 

So investors must be wary of companies that may be overpaying for mining assets, especially with debt funding.  Closer to home, while public sector mining majors such as Coal India and NMDC are sitting on a cash pile, many private players such as Vedanta and Hindalco are saddled with similar issues – high debt and falling metal prices hurting revenue and profits. 

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