8 May, 2015


What new disclosure?

Gillem Tulloch

We’ve actually managed to write about something other than Noble Group, Asia’s largest commodity trader whose accounting is under the spotlight. Rob has published on some other companies we suspect have window-dressed their financial statements. In this report, we focus on companies outside of Asia following on from an earlier report focused on the same problem in Asia. Given that there is still a lot of interest in Noble due to their 1Q results, we thought to comment on these in this month’s newsletter.

Noble's disclosure has not improved

If you’d read the press headlines, you might believe that Noble had lived up to its promises and delivered on greater disclosure this past quarter. That’s just nonsense. Noble failed to provide clarity on areas of concern and gave away a small amount of irrelevant information in order to justify their statements that disclosure would be improved. For the most part, this consisted of information that was previously only available at the year-end that has now been made available on a quarterly basis. However, given that the information at year-end was already inadequate, this is hardly an improvement. Geographic and commodity breakdowns are of limited interest and represent more of a PR exercise than anything substantive. Some of the issues we wanted clarity on were as follows:

  • the contribution to profits from capitalised long-term supply contracts
  • a breakdown of net fair value gains between inventory hedges and long term contracts
  • major counter parties for long-term fair value gains
  • percentage of net fair value gains derived from counter-parties who have yet to commence operation
  • major counter-parties that comprise payables

Noble's obfuscation serves a purpose

In our opinion, proper clarity would have helped uncover operating losses of US$1.5-2.5bn between 2010 and 2014 which have been masked by US$4-5bn in net fair value gains and asset revaluations. If that was understood, then the very people who are currently in charge of giving greater disclosure might not be there anymore. It’s a game of cat and mouse between management and investors.

Financing inventories

Still, there were a couple of nuggets contained in 1Q results, especially with regards to working capital management. We know that Noble factors its receivables and finances its inventories, we’ve just not been able to quantify by how much up until now. For the first time, Noble disclosed that it had inventory in transit of US$800m. This seems way too low relative to sales of US$16.6bn in 1Q15, implying a transit time of just four days (are they putting inventory in speedboats?). If we assume that the average transit time is closer to 2 to 3 weeks, inventory in transit should be somewhere between US$2.5bn to US$3.9bn. The quarter end number of US$800m was either seasonally low or inventory has been financed off-balance sheet. Normalising inventory levels would require US$1.7-3.1bn of extra capital.

Factoring receivables

Also of interest is that Noble mentioned payables of US$5.2bn were now at more normal levels, close to 30 days payment terms. If we assume that Noble extends similar payment terms to its clients, receivables would logically be close to US$5bn by end-1Q15, compared to the US$3.6bn actually reported. This suggests that the Group generated US$1.4bn of cash by factoring receivables.

Helps explain high interest expenses

Taking factored receivables and financed inventory together and we suspect the Group has managed to reduce net debt by around US$3.1bn, as we show in the table below. This might help explain why Noble’s 7% effective interest rate (interest expenses / average total debt) has been so high relative to its 3.3% implied cost of debt (taken from credit lines revealed within the annual report). As such, debt to capitalisation would rise from 44% to 57%, as shown below....

Noble’s Adjusted Net Debt: 1Q15

Reported net debt 1Q15: US$4.0bn
Add: Normalised receivables: US$1.4bn, i.e. add back factorisation
Add: Normalised inventory: US$1.7bn, i.e. assume 2 week transit time

Adjusted net debt: US$7.1bn
Debt to capitalisation: 57% vs 44% reported
Source: GMT Research

Debt under-stated through working capital management

So why does this matter? Factored receivables and financed inventory are just another form of debt which needs to be taken into consideration when painting a picture of a company’s overall financial position. In addition to structuring its working capital, we also suspect that Noble is window dressing its balance sheet through credit revolvers. We think this because interest costs are unusually high relative to the stated cost of debt but also because debt churn is unusually high. For example, Noble drew-down on US$4.4bn of debt and repaid US$3.5bn in the first quarter compared to total debt outstanding of US$4.9bn. It all seems to support our view that gearing is likely twice as high between reporting dates than at reporting dates.

Profitability historically suspect

We’ve always been very suspect about Noble’s profits given management’s refusal to disclose the contribution from fair value gains, specifically capitalised future profits. Indeed, we argue that large deferred tax assets of US$445m (recognised and de-recognised end-2014) hint at large operating losses which have been covered up by fair value gains. Still, net fair value gains fell in the first quarter suggesting that management held off on this dubious profit line…and, unsurprisingly, profits fell 30% YoY. Noble revealed that most profits were generated by short-term trading in the energy segment. We don’t know if this is from the oil contango trade or proprietary trading positions. Either way it suggests that the margin improvement may be short lived and profits may not be recurring.

Noble will never give meaningful disclosure

To conclude, Noble management continues to avoid addressing the real issues, hoping that bluster and a focus on semantics will convince investors that all is well. To end our conjecture and market uncertainty, management could simply answer our questions. But that will never happen as then investors might begin to understand management's financial alchemy. AVOID.