Trading using borrowed money is always risky. When the going is good, you can make abnormally high profits, but when the market moves against you, profits can rapidly disappear.
This is one of the main reasons that commodity giant Glencore (LSE: GLEN) has been the worst performer in the FTSE 100 this year, falling by 40%.
In the past, Glencore has always sung the praises of its trading division, which founder Ivan Glasenberg believes can deliver more consistent profits than mining operations. However, the trading division operates on very thin profit margins.
In 2014, Glencores reported an operating profit margin of just 1.6% on trading turnover of $178bn. Much of this trading activity is funded using borrowed money, and Glencores net debt was $30bn at the end of 2014.
This year things may get worse. During the commodity boom, Glencore was always able to use its scale to control large volumes of certain commodities, forcing buyers to pay a premium to secure a reliable supply.
However, the main reason the price of iron ore, coal, copper, oil and other commodities has slumped this year is that there is too much supply, and not enough demand. In this situation, Glencores trading profit margins could come under pressure.
The latest consensus forecasts suggest that operating profit from Glencores trading division will be around $2.6bn in 2015. However, profits from Glencores mining operations are expected to fall sharply, as the prices of key commodities such as coal and copper have fallen hard this year.
According to a Morgan Stanley forecast recently quoted in the Financial Times, Glencores falling profits mean that it is at risk of losing its investment grade credit rating.If this were to happen, Glencore would face a sharp rise in borrowing costs, which would eat into trading profits.
The consequences of this could be severe and I dont think Glencores founder, Ivan Glasenberg, will allow this to happen. But Mr Glasenberg may need to find some cash from somewhere, and one possibility is that he will decide to cut Glencores dividend payout.
The current consensus forecast is for a payout of $0.19 per share in 2015. This equates to a total payout of almost $2.5bn. In my view a dividend cut is increasingly likely.
After all, at 180p, Glencore shares now have a prospective yield of 6.8%. A yield of more than 6% is generally seen as a warning of potential problems. A cut could make sense and help restore investor confidence.
Is Glencore a buy?
Share investors need to be very careful when investing in heavily-indebted firms which are experiencing poor trading. Debt always has priority over equity, and shareholders can be left with nothing.
However, I believe Glencore is probably large and profitable enough to avoid getting into serious difficulties. The firms management is also strongly incentivised to protect the value of Glencore shares, as Mr Glasenberg remains the second-largest shareholder, with an 8.4% stake in the firm.
Despite this, I wouldnt buy shares in Glencore today. The firm is due to publish its interim results on 19 August, and plan to wait until then before deciding whether to invest.
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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.