Value Is In The Eye Of The Beholder

This story features OZ MINERALS LIMITED, and other companies. For more info SHARE ANALYSIS: OZL

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

I have no conclusive proof, but my gut has been more correct than not over the past four decades: I have a strong suspicion that the merger between mid-tier Australian commodity producers Oxiana Resources and Zinifex was more inspired by allowing local mining legend Owen Hegarty a glamorous exit than by the fact that the combined company, OZ Minerals ((OZL)), is now the country’s third largest diversified resources company, after BHP Billiton and Rio Tinto.

Few would dispute Hegarty has done a fine job in building Oxiana’s core gold-copper Sepon project in Laos from an unwanted Rio Tinto asset into one of the widely applauded success stories in the Australian mining industry. That’s why it’s such a pity that the final chapter of the Oxiana-Hegarty story is now reversing much of the goodwill built up over the past six years (the share price didn’t take off until 2002).

Many of today’s shareholders would have bought their first shares at prices below $1, which largely explains why ex-Rio Tinto staffer Hegarty became a hero to many of them: in November last year the shares peaked at $4.32. However, by the time Oxiana and Zinifex were effectively melted into one in June, Oxiana shares had fallen back to $2.50. Shares of the combined entity haven’t stopped sliding since. They recently hit a low of $1.62 and were trading at around $1.80 on Tuesday.

It goes without saying the company is rapidly losing its once iconic status in the market. Not only has Owen Hegarty been replaced by Zinifex’s Andrew Michelmore as the new CEO of the merged company, last week’s maiden half yearly profit report shocked many as it showed a dramatic fall in profits, substantially below what securities analysts had penciled in, and revealed what many had been suspecting: on a stand-alone basis the Zinifex operations would no longer have been profitable.

To make matters worse, the company announced sizeable write-downs, including from assets that had only been acquired by Zinifex in the lead up to the merger. All of a sudden, “restoration of confidence” has become the new tagline that is being used in reference to OZ Minerals. A large part of the company’s future appeal is directly linked to its ability to acquire additional assets, but investors have now turned cautious, if not sceptical. They prefer to wait and see what management under Michelmore comes up with first.

Adding to the general disgruntlement is the manner in which the board has handled the golden handshake for former golden boy Hegarty, the man who has been credited with introducing the phrase “Stronger Forever” (as opposed to the commonly used “Stronger for Longer” concept for prices of commodities). The initial proposal was to say thank you to Hegarty through a payout of $10m, but shareholders voted the proposal down at the general meeting. The board subsequently decided to pay Hegarty $8.3m without any further consultation. This hasn’t exactly improved the relationship with shareholders, to put it mildly.

So was the merger between Oxiana and Zinifex more about Hegarty’s golden handshake exit than about shareholders interests? Possibly. I find the tendency among stockbrokers and market commentators to derive often far-reaching conclusions from corporate transactions most of the time amusing anyway. History shows most large corporate mergers are ill-timed, destroy more value than they ever promised and more often than not their main objective is to satisfy the hungry ego from the CEO above anything else. The Foster’s ((FGL)) and Southcorp deal is probably the best such example in Australia from the past few years. I don’t see any reason why mining companies would be different.

From the stockbrokers’ perspective, the market has chosen to bluntly ignore all the lofty price targets and Buy recommendations as prices for the group’s main products (predominantly lead, zinc, gold and copper) all declined since the merger was consummated.

Probably the best way to illustrate this is through the regular appearance of one of the local industry veterans on financial television over the past weeks. On each appearance the case of OZ Minerals was discussed, and on each occasion the veteran declared he had bought extra shares. Each time the group’s share price had fallen further. Recently, the stockbroker offered he had finally stopped buying, stating sometimes the market is telling a story; better to listen and act accordingly.

In essence, OZ Minerals’ position today is representative for large parts of the metals and mining industry; not just in Australia, but worldwide. The group might be Australia’s third largest diversified commodities producer, one standout feature remains that OZ Minerals’ product portfolio only consists of base and precious metals; there’s no exposure to oil, nor to any bulk commodities.

Arguably, leadership in the resources sector has this year shifted to crude oil while bulk commodities such as iron ore and coal should still see new record high prices in the year ahead. Base metals zinc, lead and nickel already peaked last year and are unlikely to return to former price levels in the foreseeable future.This may not necessarily be the case for copper and gold, but prices for all metals have come down significantly over the past weeks as a change in focus by global fund managers from inflation to slowing economic growth caused large scale funds outflow. OZ Minerals is far from the only one in the sector whose share price has fallen to twelve month lows, or worse.

While the current correction across the commodities spectrum seems far from over, it may well be that investors have once again pushed share prices for the likes of OZ Minerals too far down (as they tend to do under this type of circumstances). To put this in concrete numbers: the weak first six months performance will likely reduce OZ Minerals’ earnings per share (EPS) for the current fiscal year to December 2008 to circa 6c – this is less than one third of the pro-forma 21c that is considered the reference EPS for FY07. Not exactly something to have investors and shareholders cheering at your annual meetings. It also makes the shares relatively expensive as it implies a price earnings ratio of nearly 30.

However, next year should see profit growth explode, driven by increased production volumes and (hopefully) higher product prices. Current consensus EPS forecast for fiscal 2009 is 26c implying growth in the order of 332%. There is a catch, however, as most securities analysts are currently using price forecasts above current spot prices for lead, zinc, copper and gold. But even if one takes current spot prices as a guidance, next year’s EPS should still be at least 100% higher than this year’s forecast. (It would make the shares far less cheaper than they currently appear, though).

All of this explains why the consensus price target for the shares currently stands at $2.49, some 38% above the current share price.

Investors should also take into account that with the share price at around $1.80 the estimated dividend yield for the shares is 4.6% for 2008 (8.2c) and 4.9% for 2009 (8.9c). The short term should see cash flow fall by year end, but analysts nevertheless estimate the group’s balance sheet should be able to accommodate an acquisition in the order of $2.0-3.0bn.

As such, the current environment for base metals is a mixed blessing for a company such as OZ Minerals. It keeps the share price down of small to mid-tier companies in the sector which then automatically become potential targets. On the other hand, it also depresses OZ Minerals’ own share price, as well as future cash flows and profits.

Put very simple: at current prices for lead, zinc, copper and gold OZ Minerals shares could be categorised “relatively cheap”. Were prices for these metals to drop further, however, today’s share price wouldn’t look cheap at all. If, however, you are of the view that base metals prices are likely to recover once the current correction has run its course, current share price levels for OZ Minerals could potentially turn out to be an absolute bargain.

Analysts at Citi, for instance, have a more bullish view than most others in the market. Not surprisingly, Citi has a price target of $2.90 for the shares. Current forecasts include the price of gold gradually rising above US$1000/oz over the next three years; copper rising from an (estimated) average price of US400c/lb this calendar year to US550c/lb in 2010; and with zinc expected to average US100c/lb for each of the three years between 2008 and 2010. The latter might hold the key to the near term share price as Deutsche Bank analysts have a more subdued view regarding price developments for zinc and as a result they don’t see the Oz Minerals share price appreciate substantially from here for possibly up to 12 months.

If Deutsche Bank’s concern proves to be the correct one, shareholders of former Oxiana will have one more reason to complain about Owen Hegarty’s final decision: the large exposure to zinc was brought along by Andrew Michelmore’s Zinifex. (On general consensus expectations the price prospects for Oxiana’s main products, copper and gold, appear much better than for the ex-Zinifex materials zinc and nickel).

It is probably a fair assumption to make that the gap between price targets and the share price won’t close until metals prices find a base and confidently start rising again. This doesn’t only apply to OZ Minerals, but to most resources companies in general.

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