Rudi On Thursday

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

FNArena has written quite a few stories about iron ore in the past eighteen months. In the second half of 2006, when most experts in the market seemed to assume the benchmark contract price would go up one more time, we suggested this may not necessarily prove correct. This view was backed up by feedback from our industry sources.

It turned out the view was correct. From early 2007 onwards we were quick in notifying our readers that overall expert sentiment was shifting in favour of further price increases for future years. And then again. And again.

As we are approaching another round of annual price negotiations between the world’s most powerful oligopoly –Companhia Vale do Rio Doce (CVRD), Rio Tinto ((RIO)) and BHP Billiton ((BHP))- and their main customers in Asia, most securities analysts are banking on two more price rises.

The first one, which relates to the Japanese fiscal year that starts on April Fool’s day next year, should see a price rise of some 30%, or more, the following year should generate another but much smaller price rise, probably in the order of 5-10%. All this is not necessarily true. It’s what is currently being put through valuation models at stock brokerages to assess what type of rating should be placed on certain ASX-listed stocks, among other things.

This week I came to realise that we probably haven’t written one single negative story on iron ore yet. It is then that I realised this would be the first one. Call it more of a warning.

No matter how positive the undertone has been in all our previous stories –and there have been many- never at one point did we truly envisage that iron ore would develop into the next market craze. But it has.

Sometime before the August correction a few securities analysts started to argue the case for Australian producers to seek compensation for the freight differential with other countries, Brazil in particular. All of a sudden prospects emerged for a virtual doubling of next year’s contract prices.

Investors needed to know no more. Iron ore companies have been the flavour of the month, and that’s after they became the default flavour in the first half of the year already. The problem now is not so much one of value, but more of risk. Similar to what happened with uranium stocks earlier –when everyone and his dog simply went stir crazy about it- is that many iron ore related stocks are being priced at high expectations.

This does not necessarily mean these expectations won’t be met. For all we know the upcoming negotiations between the three oligarchs and their steel customers will result in another significant price rise and many shareholders will be walking around with big smiles on their faces for many weeks.

The problem with such a scenario is however that it becomes high risk, or to put it in non-financial language: it is rather unlikely, but by no means impossible.

When one talks to securities analysts and other experts about the upcoming negotiations, most will agree the foundations are in place for another significant price rise. But once the discussion touches upon the 50% price increase potential most get cold feet and clammy hands. Some of them simply don’t believe the Chinese will – ever – agree to a price rise of such a magnitude, no matter how tight the market has become.

For Rio Tinto and BHP Billiton there’s a fine balance in play between shorter term financial benefits and longer term customer relationships. Management teams at both companies know the market situation won’t always be like this, so no use in burning bridges that may come in handy a few years down the track.

This is why most securities analysts will mention the 50% option in their research reports, while putting 25-35% in their valuation models.

We’ve all experienced the uranium madness that lasted until June this year, so the next question should be an easy one. What is the main characteristic of a market craze?

Answer: investors price in the best scenario possible. This is why owning shares in many iron ore companies in Australia has now become higher risk. Again, I am not trying to say there is no more upside for the companies involved, but any progress from here comes with disproportional increased risk.

An example is Mount Gibson ((MGX)) whose shares touched $2.84 on Tuesday. Even in early March this year one could have still bought the same shares at around 70-80c. If you happen to be one of the shareholders who did buy the shares at the time, good on you, but at Wednesday’s closing price of $2.76 the market is effectively pricing in a price rise of 50% next year.

This means that even if the big three producers negotiate a price rise of 50% the shares are already there.

This is the main reason that UBS initiated coverage on the stock with a Sell today. The broker has so far penciled in a 35% price rise and simply refuses to put the current valuation higher than $1.60.

Analysts at Shaw Stockbroking already covered the stock, but they rate it a Sell too. Shaw has penciled in a 30% price rise but obviously sees some value elsewhere as its target stands at $2.00. While this is significantly higher than UBS’s target, it is also significantly below the current share price.

Another common mistake investors seem to be making is to look at the valuation of a company such as Fortescue (not a producer yet) and then conclude their little mid-capper should be trading at similar multiples. This is almost every time wrong, if only for the simple fact that iron ore is above all an infrastructure story. This means size matters, as well as access to key infrastructure such as roads, ports and rail. Fortescue is looking at becoming the world’s biggest independent producer.

Because of the importance of scale, and of infrastructure, most medium sized companies will find it hard to become a mini-Fortescue. A logical way out is thus to join forces. That’s why Murchison Metals ((MMX)) in the mid-west region of Western Australia is trying to buy neighbour Midwest Corp ((MIS)). It is a public secret that both management teams tried to work out a friendly merger earlier this year, but that went nowhere.

Analysts believe Murchison’s offer might ultimately be successful, simply because the advantages of a combined entity (larger scale, relatively less investments to reach the same goals, twice) look so compelling.

UBS initiated coverage this morning with a Buy for each of the separate entities. Keep in mind that the key factor in this story is that both companies need the development of new rail and port infrastructure for their growth prospects.

UBS, and others, believe the sum of both is poised to turn out larger than two. For starters, the analysts foresee up to $400m in savings simply by sharing infrastructure and equipment.

The broker has placed a target price of $6.50 on shares of Murchison, but regular readers of our daily Australian Broker Call will know already that Merrill Lynch has held a $7 target for the stock for a while now.

UBS’s target for Midwest is $5.90.

Another key factor to watch out for is whether your iron ore hopeful of choice is proposing to mine haematite or magnetite. The first is high grade material with at least 55% iron in it and the preferred product of Rio Tinto and BHP Billiton, the second is lower grade and often demands extra processing costs. The latter means your average producer of magnetite will make less profit and will therefore trade at a lower valuation.

However, that does not necessarily mean one can only find value among producers of heamatite. Mark McDonnell of BBY has been a big fan of Grange Resources ((GRR)) for a while now and his view is the company is ridiculously cheaply valued, especially after signing a key agreement with Rio Tinto to access Rio’s neighbouring tenements.
McDonnell had a wrap about it on CNBC recently. Readers interested can find his views in audio and video via the following link:
http://www.cnbc.com/id/15840232?video=555821296

Last but not least, the sector will go through a consolidation phase as mid-sized companies feel the pressure to up-scale and as larger companies, such as Fortescue, Rio Tinto, BHP and possibly even CVRD will look at cherrypicking the best assets at the right price.

Don’t forget, OneSteel ((OST)) is a major exporter as well. Any surprise in the upcoming contract negotiations is bound to deliver the company’s bottom line a nice bonus. This should translate into a higher share price.

Till next week!

Your editor,

Rudi Filapek-Vandyck

(As always firmly supported by the fabulous team of Greg, Chris, Joyce, George, Grahame, Terry and Pat)

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