8 April, 2015


Mongolian Maze

Gillem Tulloch

Apologies, our March newsletter is out in early April. Our tardiness stems from immersion in Noble Group’s (NOBL SP) financial statements these past months and the publication of a series of reports on the back of this. You can check out some of our videos at gmtresearch.com/gmtv/. The reason Noble Group fascinates is that it's a modern day alchemist - the mythical science of turning common metals into gold - metaphorically speaking. The simplified reality is that it ships base metals and coal around Asia.

Lord Percy explains alchemy to Blackadder

So why do we think Noble a modern day alchemist? Let’s start by looking at the Enkhtunkh Orchlon (EO) transaction in Mongolia where it appears to have turned coal into gold despite the misfortune suffered by everyone else in that country. It’s been difficult to make money in Mongolia these past few years, especially in the mining sector where a lack of secure property rights and confusion over government mining concessions has undermined confidence. Problems have been compounded by recent declines in commodity prices. As a result, the main Mongolian stock exchange index is down 74% in US dollars, since peaking in February 2011, as the chart shows.

Figure 1: The Mongolian Stock Exchange Top 20 Index (US$): -74%

MongoliaSource: GMT Research, Bloomberg

Noble Group has seemingly managed to buck this trend. At face value, the Group appears to have made 12.6x its money in just ten months through the sale and purchase of EO. Noble bought EO which has mining assets in Mongolia in February 2014 for US$3.7m, hardly a material amount for a Group which had shareholders’ equity of US$5.1bn by end-2014. However, it seems to have sold this asset just ten months later for US$46.7m. That's an amazing return in difficult times.

Curiously, Noble's financial statements (page 108, Noble Group 2014 Annual Report) reveal an US$11.2m loss on the disposal. So how can the Group buy an asset for US$3.7m and then sell it for US$46.7m a few months later booking a loss of US$11.2m? Surely it should have booked a gain on disposal, not a loss? Clearly, something material must have happened in the intervening reporting periods.

An immediate US$64m asset revaluation of EO assets

A clue is revealed in a filing made by Noble (read the SGX release, as shown in Figure 2) upon the acquisition of EO. As at 27th of February 2014, EO had negative book value of US$6.4m. And yet just ten months later, by 31st December, this had risen to US$57.8m, according to Noble's annual report (see Figure 3). Normally, book value rises by either retained profits or increased capital but in this instance we think it represents a US$64m asset revaluation.

Historically, Noble has immediately revalued assets upon acquisition. If revalued equity exceeds the acquisition price, the difference has been recognised as negative goodwill through the income statement. For example, in 2014 it booked a US$178m profit from the revaluation of recent acquisitions, General Alumina Jamaica and San Juan Fuels. Without this, the Group would have been loss-making in 2014. Given that there is considerable subjectivity in deriving fair value, we consider these timely revaluations to be a very aggressive accounting treatment. Curiously, there appears no evidence that Noble has booked EO's revaluation as a profit although it will still have boosted equity. It is not the first instance we have come across inconsistent accounting treatment by Noble.

Figure 2: Noble Group: SGX Release on EO Purchase (27 Feb 2014)

NobleSource: Singapore Exchange, Noble Group

The structure of consideration to be received by Noble is also curious. Payment of US$46.6m is “to be received in cash and royalties”. Note our emphasis on the “to be received” and “royalties”. In other words, the cash has yet to arrive.

Figure 3: Noble Group: Note on EO Sale (31 Dec 2014)

NobleNoteSource: Noble Group 2014 Annual Report

A US$41m gain on future royalties from EO

It transpires that EO has been sold to Guildford Coal (GUF AU) for US$6m (Guildford Coal Prospectus, 27/1/2015) which implies that Noble expects to receive US$41m in future royalties. Had Noble not booked the present value of these royalties as part of the consideration, it would have recorded a US$52m loss on the sale of EO which makes a mockery of its initial revaluation of EO's assets. This is the first time we have encountered future royalties being included as part of the consideration price. Once again, we consider this to be aggressive accounting.

A possible off-take agreement with EO

If Noble has recognised royalties from future EO production, we suspect that it has also booked a fair value gain through a long-term off-take agreement. After all, Noble's business model appears to have become increasingly reliant on the recognition of profit from long-term off-take agreements which have yet to commence. This off-take agreement might have been very material to Noble's bottom-line in order to justify such a hefty asset revaluation at EO. Perhaps the reason Noble did not also recognise EO's asset revaluation as a profit is that it would have been double accounting, meriting more disclosure and attracting greater scrutiny. We suspect fair value gains booked from this off-take agreement might be in excess of US$50m, but this is pure guesswork owing to limited disclosure.

Guildford Coal in financial distress

Given the correction in commodity prices and legal problems with mining in Mongolia, there must be valid concerns over the ability of some assets to make it to market. Those without strong financial support and a compelling business model are likely to be shelved. It transpires that Guildford Coal (to which Noble has sold EO and from which it is generating substantial profits) has been given a going concern qualification by its auditors for its 2014 financials and is in technical default with its major creditors, OCP Asia and Noble Group. Indeed, Guildford's 2014 financial statements revealed that it owed US$42m to Noble. In fact, without Noble's support it is likely that Guildford Coal would be liquidated making a mockery of the transaction.

EO is not even a hole in the ground

It also transpires that EO's main mining asset (lease EL12600X) is more of a concept than a plan (hence the below clip from the film Guardian of the Galaxies). In Guildford Coal's technical specialist report contained within its Lodgement of Target's Statement (24 December 2014), Xenith Consulting reveals that "...as no mine plan currently exists for these areas they have not been included in the DCF".

Put simply, we estimate that Noble Group has recognised somewhere between US$105-155m in gains (US$64m asset revaluation, US$41m fair value gain from royalties and a possible US$50m off-take agreement) from a patch of barren land in the middle of Mongolia from a counter-party in financial distress.

Marvel's Guardians of the Galaxy clip - 12 percent of a plan

Unfortunately, this dubious gain is not a one-off occurrence; Noble’s financial statements are peppered with billions of dollars of asset revaluations and fair value gains as we have detailed in our reports. Another favourite is the purchase of Alhasanie for US$0.3m in 2011 which was revalued upwards allowing Noble to book a US$46.5m gain through the income statement. And let's not forget the deals with Gloucester Coal, Noble Americas Energy Solutions, Bioenergia, Territory Recourses, and so on. And last but not least, Asset management would be far easier if fund managers could follow Noble's example by immediately revaluing their share purchases to what they considered to be fair value and then paying themselves based on this mark-to-model approach.

Sadly, alchemy, whether financial or otherwise, does not work. You can’t turn lead into gold. It’s still a lump of rock. Worse still, it could be a lump of rock buried deep in Mongolia.