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Noble Group, an asset light commodity nomad

Izabella Kaminska | Feb 26 14:19 | Comment | Share

Earlier this month, Noble Group Asias biggest commodity trader by sales
rebuffed accusations by an unknown research group called Iceberg Research, which
had accused it of shoddy accounting practices that inflate profits.
On Thursday, Noble released its full-year results, recording headline net profit of
$132m after impairments on a range of assets and investments totalling $438m,
which generated a net loss of $240m in the last quarter.
In its statement the group emphasised the liquidity of its balance sheet even as it
assigned 35 per cent of net profits to the payment of a full-year dividend because its
business currently had little requirement for significant long term capital
expenditure.
But Iceberg Research was back with a another compendium of claims against the
commodity trader just ahead of the results, among them the proposition that the
companys operating cash flow may be being supported by the use of creatively
structured inventory repos.
As the report noted (our emphasis):
The divergence between Nobles net profit and operating cash flows (OCF) is
striking given its status as an investment grade company. Noble has recorded a
combined $2.7b net profit since 2009. However, its operations have lost $485m in
cash in the same period. OCF have continued to deteriorate since 2011, e.g. ($620m)
outflows in 9M 2014.
We believe the OCF would have been even worse without the help of inventories
repos.
The reason for the divergence between the paper profit and the OCF is the
remarkable increase in the fair values of unrealised commodities
contracts (or mark-to-market). These contracts surged from near zero
in 2009 to an unprecedented net $3.8b ($5.8b assets and $2b liabilities).
Nobles use of fair value inputs, according to Iceberg, dwarves those of their
competitors and is currently 3.5 times the level of Enrons contracts at its peak. The
company supposedly also books the entire profit for long maturity contracts the same
day the contracts are signed.
But Noble says its business model is strategically designed to be asset light. Rather
than holding value in physical assets like many of its competitors Noble secures
supply and demand through its physical contracts. That makes it different.
Contracts are transformed into profits with little or no need for cashflow thanks to an
active hedging programme. As products or supplies are delivered, cash is generated
and profit recognised and discounted against the M2M positions.
Speaking on an investor call on Thursday, Nobles CEO Yusuf Alireza said the idea
that mark-to-market positions fed directly into the companys profit and loss
statements was factually incorrect, because it failed to account for inventories or
short-term hedges that are rolled against contracts.

Furthermore, Alireza said the Iceberg author was believed to be a disgruntled junior
employee that we fired a year and a half ago.
Noble would not be taking legal action against the individual who they declined to
name only because it wasnt considered a priority for the management team. Our
focus is to deliver results. Our stakeholders will judge us not by an anonymous
blogger but our results, Alireza said.
In correspondence with the Financial Times, however, Iceberg has claimed to be a
team of people, not an individual operation, who wish to be valued on the quality of
their work, not their identities.
The second section of the three-part report series, in any case, focuses on the
discrepancy between the companys net profit versus its operating cash flows after
interest reclassification:

According to Iceberg, up to 68 per cent of the companys equity is effectively


represented by the net value of mark-to-market of unrealised contracts:

Iceberg has emphasised there is nothing wrong with valuing unrealised commodity
contracts and recording variations in the income statement what they question is
the consistently growing size of Nobles MTM positions. Normally, as commodity
cargoes are transported and delivered, contracts expire keeping the outstanding fair
value position stable, but in Nobles case fair values keep surging perhaps, notes
Iceberg, because the group may be struggling to convert these contracts into cash.
The comparison with industry competitors is striking:

Fair values, Iceberg further notes, are almost exclusively related to the companys
continuing operations, made up mostly of its energy and MMO divisions, not the
loss-making agricultural part.
Iceberg thus suggests Noble may have become an MTM-printing machine with
more and more positions having to be created to conceal previous poor
performances.
Asked about the M2M positions, Alireza stressed they resulted from Nobles nimble
status in the market, something which offered Noble greater resilience to the
cyclicality of commodity markets.
If Noble were an asset heavy trader, he added, they would insure supply by owning
mines or production sites, and they would insure demand by owning refineries. We
dont do any of that. The benefit is that the market feeds through our P&L every day.

Its a function of our business strategy and our commitment to have as much of our
balance sheet marked to market [as possible], its about risk management.
As an example of how the strategy works, Alireza referred to the current contango in
the oil market.
Right now, for the first time, we have significant contango, so we are taking
advantage of that by putting oil in storage, and we would hedge that market risk in
the forwards, he said. The mark-to-market exposure for Noble comes about because
of the disconnect between the spot physical cargo the company is storing and the
futures, but the intention, he noted, is always to ride the position until the carry
embedded in the contracts can be realised.
Though, if that reminds you of MF Globals famous repo-to-maturity trade, well,
thats probably because its not a dissimilar situation. Indeed, its not the legitimacy
of the contracts or even their value that is fundamentally in question, but rather how
the mark-to-market volatility ties in with the companys ability to fund such positions
over the long term. That, readers may remember, was also MF Globals problem.
Being an asset light trader may have its advantages, but it also puts pressure on
working capital. As an example, note the deterioration of working capital days at the
company since 2010 (chart from Iceberg):

But one function of the business changing nature, according to Alireza especially
with respect to its growing physical oil business is its ability to transact in a way
where buyers and sellers provide payments services for each other.
But herein lies another issue for Iceberg. Using counterparts as funders arguably
exposes the company to the same sort of short-term funding risk that came to
prominence in the 2008 bank crisis.
How Noble funds its inventories is consequently the issue as is the degree to which
it engages in inventory repos on financial reporting dates and how that contrasts
with the window dressing techniques used by banks to bolster liquidity positions
during reporting periods.
As Iceberg notes:
Under a repo, a trader sells commodity inventories to a bank and buys back the
inventories at a later date. In the third report, we will explain that Noble
always pays too much interest for the level of debt it reports. We believe

that inventories disappear at quarter end and this is a major reason


behind the unexplained level of interest.
On a side note, FT Alphaville has heard speculation previously, that Nobles finance
division was known to offer interest-based incentives to counterparties and internal
traders who cash-settle positions before the end of the month instead on the first of
the month as is the norm.
Iceberg stresses the concern with repos is not so much that they artificially reduce
the debt level but that they distort operating cash flows by creating an artificial
source of liquidity. The problem with repos is that they just buy time.
Their issue, fundamentally, is a lack of cash generation which would be even worse
if not for the use of repos and the incentive Noble has to keep rolling loss-making
positions forward so as to inflate its equity.
For Noble, it feels that this debate is not going to go away any time soon.
Related links:
MF Global and the repo-to-maturity trade FT Alphaville
Noble rejects improper accounting claims FT

This entry was posted by Izabella Kaminska on Thursday February 26th, 2015 14:19.
Tagged with Iceberg, noble group, repos.

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