Glencore (OTCPK:GLCNF) shares have underperformed this year, despite offering investors a diverse commodity mix, exposure to base metals and bulks, along with FCF yield of c. 11%. However, there is a catch to the Glencore story, as regulatory overhang continues, with ongoing investigations by the US Department of Justice (DoJ) and the UK Serious Fraud Office (SFO). Additionally, operating challenges at key growth assets are a concern, while the elevated debt load does leave the company vulnerable to macro risks. As such, I remain cautious on shares heading into the December update.

Copper and Zinc Lead FQ3 Production Strength

Glencore reported strong FQ3 copper production numbers at 347kt (+18% Q/Q), with zinc production also solid at 310kt (+22% Q/Q). Cobalt production of 7.3kt and attributable oil production of 748kbbls were also positive highlights from the production report. Notably, the company’s copper business benefited from the ongoing ramp-up of Katanga and strong milling performance at Collahuasi. For zinc, improved throughput at Mt. Isa and higher zinc grades at Antamina contributed to the strong operational performance.

By contrast, lead, nickel, ferrochrome, and coal production for the quarter lagged. However, much of the drag is attributable to factors beyond the company’s control – coal, for example, was impacted by the ongoing labor strike at Cerrejon, which negatively impacted production. Ferrochrome was also impacted by the enforcement of strict lockdown measures in South Africa. Nonetheless, Glencore still expects to meet its operational targets for the year (except in coal), which I think is commendable.

Source: Glencore FQ3 ’20 Production Report

Katanga Copper Ramp Up to Support Earnings

I think Glencore’s African copper production, which benefited from a stronger ramp up in FQ3, is worth keeping an eye on. To recap, copper production in FQ3 was up c. 9% to 81kt, highlighting the fact that the major Katanga copper/cobalt mine continues to perform well. Encouragingly, the mine is on track to achieve design capacity by the end of this year (produced at c. 270 ktpa in FQ3 vs. a target of c. 290 ktpa). A successful ramp-up of Katanga will be key to driving earnings going forward.

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Source: Glencore FQ3 ’20 Production Report

Largely Unchanged Guidance Leaves Room for an Upside Surprise

Notably, Glencore also maintained its full-year production guidance for 2020, even tightening its target ranges for most commodities. The exception was coal production guidance, which was cut by c. 4% to 109mt as continued industrial action at the Cerrejon mine in Colombia is now expected to last through FQ4 as well. At this point, I think strategic actions such as returning free cash flow from its coal business or spinning off the business in its entirety may be needed to clear the coal overhang.

Nonetheless, the fact that the guidance for other divisions remains unchanged reflects management’s view that FQ4 will be weaker Q/Q in key commodities. With the implied production run-rate for FQ4 lower than FQ3, I think expectations are low, and should Glencore deliver production towards the upper end of its guidance, shares could re-rate.

Source: Glencore FQ3 ’20 Production Report

Disappointingly, there remains no update on marketing since last quarter, when management guided toward marketing EBIT reaching ” the top end” of the $2.2-3.2 billion EBIT range in fiscal 2020 due to a “very strong” H1 ’20. As such, my base case remains for marketing EBIT to be c. $3 billion for the full-year.

December Update is a Potential Catalyst

The Investor Update presentation scheduled for December 4th will see Glencore update its medium-term production and capex guidance, along with its fiscal 2021 unit cost guidance. The company will also provide new Scope 1 & 2 long-term emissions targets and update its Scope 3 commitment, which should help attract ESG flows. The key detail I will be looking out for is on the deleveraging progress – assuming management successfully delivers on its August target to reduce group net debt to c. $16 billion by the end of the year, I think there is room for the company to resume dividends as soon as fiscal 2021.

Additionally, I also look forward to updates on strategic initiatives for 2021, from the management transition in coal (CEO & Head of Coal to retire) and zinc (Head of Zinc retired in July) to mitigation plans at Koniambo, which continues to struggle – in stark contrast with the successful Katanga ramp. Lastly, any updates on the regulatory front, especially with the DOJ investigation, will be worth keeping an eye on.

Final Take

Overall, I am neutral on Glencore shares, despite the c. 11% FCF yield (equivalent to c. 9% P/FCF). I think the valuation fairly reflects the regulatory risks, including ongoing investigations by the US DoJ, along with operational challenges at key growth assets. Glencore’s highly levered balance sheet also leaves it vulnerable to macro risks, and pending key strategic actions such as an accelerated deleveraging or a spinoff of the coal business, I am hesitant to buy into the Glencore story.

Data by YCharts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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