Glencore’s huge cash call announced this week both shocked and pleased the market. On one hand, by announcing the debt reduction plan Glencore has been able to allay shareholder concerns about the company’s weak balance sheet.
However, by moving to raise cash now, Glencore has piled the pressure on peers BHP Billiton (LSE: BLT) and Rio Tinto (LSE: RIO) to do the same and bolster their balance sheets.
Heavy debt loads
Both BHP and Rio have been actively trying to reduce their debt piles during the past year or so. But with commodity prices trading at 13-year lows, these two companies are under more pressure than ever before to reduce balance sheet leverage.
According to City analysts, based on historic figures, Rio’s net debt to earnings before interest, tax, amortization and depreciation (EBITDA ) ratio is less than one. BHP’s net debt to EBITDA ratio is slightly over one. At present, these numbers aren’t cause for concern. It’s generally considered that a company is financially sound if its net debt to EBITDA ratio is less than two.
Nevertheless, what’s really worrying analysts is the fact that Glencore’s sudden decision to issue equity, after months of rebuffing calls to reduce its debt level, could imply that the trading house believes commodity prices are heading lower.
Clearly, if commodity prices fell even further, it would be a disaster for the whole industry.
Further declines
Some of the City’s most pessimistic analysts have suggested that commodity prices could fall another 30% from present levels. And while it’s unlikely that these dismal forecasts will be realised, it is always wise to prepare for the worst.
The analysts’ “doom & gloom” scenario is projecting that BHP’s shares could fall to as low as 446p if commodity prices fell a further 30%. This dismal forecast is based on the fact that the company’s oil operations are still burning through cash at an alarming rate, and BHP is paying out the majority of its profits as dividends to investors.
The “doom & gloom” scenario for Rio suggests that the company’s shares could fall a further 56% to 1,037p.
Plenty of unknowns
The “doom & gloom” forecasts above may seem overly pessimistic, but it’s worth remembering how wrong even the most dismal City forecasts were this time last year.
For example, during May last year, even the most pessimistic City forecast was calling for the price of iron ore to drop only as low as $86 per ton. Most analysts believed that the price or iron ore would settle at around $90 per ton. But the price of iron ore dropped to a low of $44 per ton during July.
And as commodity prices plunge to new lows, BHP and Rio’s earnings estimates have been consistently downgraded. Specifically, this time last year analysts were expecting BHP to report earnings per share of $2.81 for 2016 and $3.16 for 2017.
Current forecasts are significantly lower than those published 12 months ago. City analysts now expect BHP to report earnings per share of $0.95 for 2016 and $1.32 for 2017, 66% and 59% lower the initial predictions.
Similarly, the City has reduced its full-year 2015/2016 earnings estimates for Rio by 55% and 58% respectively.
The point here is that the future is extremely uncertain for miners. As a result, it is almost impossible to produce an accurate valuation for the companies.
