Fortescue Metals Group Ltd. FMG.AX
August 30, 2006 - 3:31pm EST by
louisc738
2006 2007
Price: 9.73 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,571 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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  • Iron ore
  • Mining
  • Basic Materials
  • M&A target

Description

SUMMARY

 

FMG is opening an iron ore mining in one of the top iron ore regions in the world (Pilbara – Australia) and close to Asian potential clients and nearby to BHP Billiton and Rio Tinto main iron ore operations. Based on a reasonable valuation, there is an upside of 43%. Leucadia National purchased 10% of the company in a PIPE transaction. The company owns the largest iron ore tenements in Australia. FMG’s mines would equivalent to 15% of CVRD’s iron ore operations, which is the biggest iron ore company in the world.

 

BACKGROUND

 

Fortescue Metal Group Ltd. is the owner of iron ore tenement interests located in the Harmersley Province of Western Australia, an iron ore province covering some 80,000Km2 of the southern half of the Pilbara region. FMG ownership covers an area of 34,000 km2 (equivalent to 13,127 square miles), which includes the Cloud Break and Christmas Creek deposits. The company has Australia’s largest iron ore land tenement portfolio and is listed in the Australia Stock Exchange.

 

Nearby FMG’s sites are BHP and Rio Tinto main operations in the iron ore business, so FMG will be the third operator in the region. Pilbara and Carajás region (owned by CVRD) in Brazil are the two top iron ore regions in the world.

 

FMG’s operations will comprise an open pit mine, 260 km (160 miles) heavy haul railroad plus port facilities capable of producing and loading 45Mtpa of iron ore into ships of 50,000 to 270,000 DWT capacities for attending the Asia market. The production of FMG will be equivalent to 15% of CVRD’s production.

 

The plan is to start the shiploading at end of January of 2008, and completion of commissioning and performance testing in the Mid-March of 2008.

 

The infrastructure capital cost of A$2.25 billion (or US$ 1.68 billion @ A$:US$ 0.75) includes a contingency of approximately A$ 270 million, but is not included working capital, interest during construction, or sunk costs.

 

By late March/2006 FMG has signed 25 provisional iron ore purchase agreements with Chinese steel companies representing a product off take of 36.4 Mtpa.

 

RESERVES (based on Snowden Consultants report – Appendix A)  

 

High Grade (Fe 60.4%)     359 mt  (proved 19.2%)

Low Grade (Fe 57.7%)      707 mt  (proved 7.4%)

 

Total                                    1,066 mt (proved 121 mt)

 

Inferred Resources               466 mt

 

Total (P+P+Inferred)         1,522 million of tonnes

 

Based on Proven+Probable reserves it is possible to mine for more than 20 years. Additionally, due to the extensive tenements owned by FMG (equivalent to 7 seven times the size of the state of Delaware), so there is some optionality in this company.

 

CAPITALIZATION

 

The company obtained the resources for the project through high yield bond issues of US$ 2,05 billion in August 14, 2006, plus a PIPE transaction, which included a subordinated note of US$ 100 million and a rights offering of US$ 300 million for 10% of the company, both subscribed by Leucadia National (ticker: LUK).

 

- Senior Secured Floating Rate Notes due 2011          US$ 250 million

- Senior Secured Notes 10% due 2013                       US$ 320 million

- Senior Secured Notes 9.75% due 2013                    €$ 315 million (US$ 401 MM)

- Senior Secured Notes 10.625% due 2016                US$ 1,080 million

- Subordinate Notes (4% on net sales) due 2019         US$ 100 million (Leucadia)

Sum                                                                            US$ 2,151 million

   Operating Lease                                                      US$   115 million

Total Debt                                                                US$ 2,266 million

PIPE transaction                                                         US$    300 million (Leucadia)

Resources available for the Project                        US$ 2,566 million

 

Leucadia National Transaction:

 

LUK paid US$ 300 million for 26,4 million shares that imply a price of US$ 10.36 per share and it is 50% above market prices. However when we deduct the present value of the excess interest that could be earned by the Note for 13 years, which is calculated as 4% on net sales, we got a price paid of US$ 100 million/26,4 million shares equal to $3.80/per share, that is approximately half of the current market price.

 

SHAREHOLDERS & MANAGEMENT

 

The company is controlled by three shareholders, as below:

 

The Metals Group Pty Ltd. (controlled by FMG’s CEO)         38, 7%

HMC Investors LLC (an USA hedge fund)                             14, 5%

Leucadia National Corp. (ticker: LUK)                                   10, 0%           

Sum                                                                                       63, 2%

 

Leucadia’s president (Mr. Steinberg) is now a FMG’s director.

 

The management is well experienced in the iron ore mining sector, some of them have worked before for BHP and Rio Tinto in the iron ore business at Pilbara region. I would like to emphasize that Leucadia National had done before investments in the mining sector, so this is not new for them.

 

VALUATION

 

Estimative done by some sell side analysts regarding the potential value that can be fetched by CSN’s IPO of its iron ore assets (Casa de Pedra mine) plus logistics implies an EV/EBITDA multiple between 5 to 6x. However, operations in Brazil are perceived to be more risky than Australia, and FMG is more close to biggest consumers of iron ore than CSN. The multiple used is below to the multiple that trades BHP Billiton and Rio Tinto, and CVRD (ticker: RIO), which is the biggest iron ore company and its main operations are located in Brazil.

 

We used the Base Case estimative available in the Offering Circular for the bonds issue, and the critical inputs, Iron Ore prices, are reasonable. Considering the Average Ebitda for the years of 2008 to 2013 which is US$ 852 millions we got the following value:

 

Average Ebitda US$ 852 million

Multiple                     6x

Enterprise Value US$ 5, 112 million

(-) Debt                 US$ 2,266 million

 

(=) EQUITY Value US$ 2,846 million

 

Nr of Shares:     267,12 million shares (including 2,8 million options in the money)

 

Value per Share $ 10,65 or AU$ 13,94 (@ US$1.00 = AU$ 1,3092)

 

This implies an upside of 43%; however I believe that as soon the project is implemented, the market will re-rate FMG and the upside may surpass what I have calculated. I am not given any value for the extensive tenements owned in one of the top iron ore regions in the world.

 

Another iron ore plus steel mill project that recently has done an IPO is MMX Mineracao e Metalicos S.A. (Bovespa ticker: MMXM3), however it has not released yet an estimative of its reserves according any standard. However, MMX has its operations scattered in Brazil, in three sites, and has to develop its logistics.

 

RISKS

 

      -    Execution risk which will be translated as cost overruns and other contingencies, that may require to raise additional capital on unfavorable basis (high dilution and/or high interest rates), however the company has put aside enough resources (US$ 470 million) to face this potential problem.

-         Delays in delivering mining equipment, shortage of big tires.

-         Delays in railroad construction due permitting schedules.

-         Tender offer by another company at low prices that caps the upside potential due to starting the mine operation. This happened with Canico Resources (nickel mine) which was purchased by CVRD (ticker:RIO) before finishing its project. However, this risk is mitigated because the three main shareholders effectively control the company and can block any offer.

 

CATALYSTS

 

1)      Undervalued asset in an oligopoly sector;

 

The global seaborne iron ore trade is tightly controlled by a few players: CVRD, the biggest; BHP Billiton and Rio Tinto, these are the big three, which have a market share above 70%, and they set the prices for the entire sector.

 

Second tier companies are comprised by Anglo American Plc. through its South African subsidiary (+/- 60% owned) Kumba Resources (ticker: KMB SJ); Cleveland Cliffs (USA) and its Australian subsidiary (+/- 65% owned) Portman Ltd. (ticker:PMM.AX), which produces around 8 Mtpa in Australia, and in Europe there is Lkab in Sweden.

 

The key barrier to entry is logistics and an ore deposit big enough (long life) with good grade in order to support the cost of building a railway plus port facilities. Besides that, the political risk and environmental activism risks have to be low, due the long term nature of the mining business and very few countries has both at low level as Australia and Chile.

 

CSN Steel (ticker: SID) is expanding its Casa da Pedra iron ore mine from 16 Mtpa to 49 Mtpa (including pellets production) in order to take advantage of the high prices by selling to other steel mills outside Brazil, but part of this additional iron ore will be used by CSN which is doubling its steel production capacity. CSN is studying to list its iron ore assets through an IPO of 10-30% in order to signal the market about its value included in CSN’s shares, as also it will provide part of the funding for the steel mill expansion. CNS’ iron ore mine grade is slightly below to Fortescue grade. Casa de Pedra mine has Proven+Probable reserves of 351 mt with a grade of 60,4% Fe content. Besides that the 20-F informs that total resources are 4 billion tones of iron ore. I think that when this happens, we will have better comparable company for FMG, because it will be the closest peer company, same size, grade, and the distance from port is 370 Km vs. 260 Km for FMG.

 

2)      Potential acquisition target

 

A few years ago Corus Steel (ticker: CS.L) tried to merge with CSN Steel (ticker: SID) in order to have access to high quality iron ore from Casa da Pedra mine and competitive slab costs. CSN is one of the few integrated steel operations in the world (mine, railway, port and energy); the only critical raw material purchased is metallurgical coal. CSN has operating margins of 33% and Ebitda margin of 43%, and the reasons for that are that it owns the sources of its main raw materials.

 

Other potential acquirers are Anglo-American Plc. which owns Kumba Resources (ticker: KMB SJ ), an iron ore mining company which operates in South Africa, and other big miners that may want exposure to the sector, such as: Xstrata (ticker: XTA.L). Also the big steel companies that would like to guaranty access to critical raw materials, such as: Arcelor-Mittal (which plans to have 50% of the iron ore consumption produced internally); Posco, Techint Group (Ternium Steel – ticker: TX), Chinese steel companies (e.g. Baosteel).

 

Someone may argue why I am not considering Fortescue acquisition by one of the big three, and my answer is that it will generate regulatory troubles with the anti-trust commissions. A few years ago CVRD (ticker: RIO) purchased Caemi, an iron ore mining company listed in Brazil, which also owned a Canadian iron ore operation called QCM. The European Anti-Trust commission forced CVRD to divest its stake in QCM, and due to other acquisitions in Brazil, CVRD had trouble with the local anti-trust commission. Therefore if either one, BHP Billiton or Rio Tinto, buys FMG, they are increasing its control over the iron ore deposits in the Pilbara region and this may create trouble with the local anti-trust authorities.

 

Catalyst

1) Undervalued asset in an oligopoly sector;

2) Potential acquisition target;

3) Coverage by brokerage houses;

4) Listing in stock exchanges outside Australia
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