When theres a mad dash out of a sector, you often find that bargains begin appearing in places where valuations of affiliated but ultimately unaffected businesses get unfairly punished by association. So it is in the case ofGlencore (LSE: GLEN), a commodities trading firm and mining company that has fallen out of favour recently due to the plunge in the price of oil specifically and commodities more broadly.
To gain a proper understanding of how this company operates a little differently from traditional drillers and miners such asRio Tinto(LSE: RIO) (NYSE: RIO.US),Royal Dutch Shell (LSE: RSDB)andBP (LSE: BP), its helpful to dig a bit deeper into the companys previous interim earnings statement. At the end of H114, Glencore reported adjusted EBITDA of $6.5 billion, which was up 8.5% on the same year-ago period. Of that, it reported that a chunky $4.9 billion was comprised of operating cash flow.
Compare this to Rio Tintos results, where cash flows from operations were just $2.7 billion on the back of similar profit before taxof$6.09 billion.Its clear that there is a fairly wide berth between what Rio Tinto is doing and what Glencore is up to. Butwhat is the magic ingredient that accounts for nearlydouble the amount of operating cashflow in the case of Glencore?
Unlike major mining companies, Glencore makes sizeable earnings from marketing activities today, sales and trading related to a wide range of commodities.
Thus, while commodities prices didnt fare the best over the first half of last year, strong volumes among copper and thermal coal trading meant that the firm was able to show some stellar earnings results on the back of, in large part, income derived from activities related to brokering these commodities.
Glecores comparatively high operating cashflow has meant the company was inthe perfect position to enhance earnings in creative ways, which it did by announcing abuy-back of $1 billion of its own stock. That move may prove fortuitous, for it comes just as profitability is on therise and the companys shareprice has begun to lookconsiderably cheaper(Glencorehas fallen 17% over the last half-year period). This is a wonderful scenario as far as shareholders are concerned, since they can now expect to participate in earnings increases derived purely from the companys dividend payouts, compounding upside.
Glencore works a little differently to traditional mining companies in that its really a sort of hybrid broker-minerto the commodities market. (It is from this legacy from which the firm hails from, after all, as the Mark Rich commodities trading company). So in addition to benefiting from multi-directional markets where volumes are high, Glencoresmanagement team is always focused on making smart, low cost acquisitions of mining and commodities firms where synergies are high for Glencore to roll out its giant distribution model across the global commodities trading floor. Savvyacquisitions such as those of Xstrata in the past few years have thus meant that the company is still getting bettervalue on mining activities than competitors despite a weak market price.
But thats not all.The company is the most diversified natural resources company around. Compare that scenario to Shell, which is pure-play oil and gas, or Rio Tinto, which is essentially a one-way directional bet on metals prices and it quickly becomes clear how much hidden value lies beneath the surface than can be gleaned fromGlencores day-to-day market environment.
Distinctions such as these are easy to forget in the midst of the deafening crushing of commodities prices, but they are critical: 42%of Glencores earnings come from marketing activities; of combined marketing and mining activities, 14% of earnings are from agricultural products and 16% are from energy products, with the remainder derived from metals.
In other words,its going to take much more to impact this broad, far-reaching giant negatively. Given the traditionally higher multiples commodities firms can command, the shares, at 17 x earnings, look like temporary bargain here.
Staying well diversified is one of the major ways in which investors can realise long-term gains from the market, but the strategyneeds to be combined with insightful and detailed analysis of how a company’s earnings are being calculated and what the real return-drivers are in a stock.
Too many investors assume that just because a companyoperates in a particularly favourable (or out-of-favour) sector, it’s probably worth buying (or not worth looking at) without taking the necessary precautions to drill-down into how relevant such comparisons are at any one time.
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