what i emailed clients tonight

Iron Ore Holdings (ASX: IOH)

It won't be too often that I will email you regarding compelling value in a company or an opportunity like the one building momentum in Iron Ore Holdings (ASX: IOH). This is a company I have followed for some time and watched the management execute a well funded strategy to shore up commercial quantities of iron ore.

The time has come that they now have the ore and the focus is shifting. The next step for IOH is to prove feasibility of the project and then commercialise it through exports. A catalyst could be Fortescue Metals (FMG) announcement on Friday of a 1 billion tonne iron ore discovery adjoinig IOH that FMG want to develop by 2014. We hold IOH in the Model Portfolio and can see 2011 will be a defining year for the company.

Our subscribers have had full access to the initial report that was written justifying inclusion in our holdings, as well as a number of follow ups in the Trading Diary. For now we will simply look at valuations as the path forward becomes clearer.

IOH is vastly undervalued when it comes to a peer comparison and firstly we should understand why the market would discount so heavily for risk. The key concerns are:

- The move from explorer to producer is capital intensive and often requires heavily discounted capital raisings.
- There is no takeover premium as the stock is tightly held, with Kerry Stokes holding over 50%.
- No Feasibility studies have been commissioned to date.
- The forward plan and milestones have not been announced to the market.
- Formal negotiations with Rio Tinto were not completed for the Phil�s Creek mine gate sale, nor Iron Valley development. No other negotiations have been signaled to the market.
- Iron Valley has a high level of phosphorus that can be blended with other ore for export.
The issue here is time, not price. IOH is selling at a discount and if you have the time to wait until production comes in three to four years, your reward will be great. Below I have used three different examples to illustrate the potential value locked into IOH�s 647Mt resource.

Based on M&A activity:

Iron ore explorer�s shares normally sit on a value over 50 cents per tonne of iron ore depending on resource quality and location to existing infrastructure. The premium applied to takeovers normally takes this valuation between $1.30 (BHP paid for UMC) and $2.10 (Atlas Iron paid for Giralia).

Making the following assumptions we can use the above figures to determine an approximate valuation:

- A takeover is unlikely due to Kerry Stokes holding and commitment to commercialisation.
- Current iron ore prices have grown since the time of UMC's takeover, reflected more in GIR's price.
- JORC resources may increase to well beyond 700MT this year.

At 50 cents per tonne: 647MT x 0.5 = $323M or $2.35 a share.
At $1.30 (UMC) per tonne: 647MT x 1.3 = $841m or $6.12 a share
At $2.10 (Giralia) per tonne: 647MT x 2.1 = $1.294bn or $9.88 a share.

Discounted Cash Flow:

FMG has a two ports, three hubs strategy, which involves increasing production from 55Mtpa to 155Mtpa by 2014. Cloudbreak is part of FMG's Chichester Hub and located approx 35km from IV and targeting 55Mtpa. Of this, they already have 17Mtpa committed, leaving potential growth in output of 38Mtpa from the south with an IOH/FMG joint venture that should also include Brockman Resource (BRM). In the diagram below I have overlayed IOH's Iron Valley in brown and BRM's 1Bt Marillana deposit in white to demonstrate their close proximity.



Without the completion of feasibility studies and understanding of likely production numbers, it would be too bold to make a discounted cash flow valuation. However, let�s create a similar situation to help understand the valuation metrics by looking at a synthetic compare called �Pay Dirt Limited�. They have the opportunity to enter into a small JV initially producing 5Mtpa iron ore in 2014 at Location A. This will grow to 10Mtpa output in 2016, and at the same time they will commence 10Mtpa production at a second mine called Location B.

Let's make the following assumptions in respect to Pay Dirt Limited:

- Pay Dirt Limited have 150m shares on issue priced at $2.00.
- IO price = $150/tonne until 2016, then drops to $120/tonne
- AUD remains around parity. Any fluctuation would positively correlate the iron ore price.
- Production costs = $50/tonne at Location A until 2016, then drop to $40/tonne. Costs at Location B remain $50/tonne.
- Pay Dirt Limited production = 5Mtpa to 2016, then 20Mtpa.
- Location A requires $1.5bn capital. $1bn comes from debt and $500m comes from a capital raising at $2.00 a share. Share capital is increased by 250m and debt repayments are $80m per year.
- Location B is partially funded through Location A cashflow ($800m) plus raising $700m at $5 a share, adding 140m shares on issue.
- Debt funding costs are 8% pa
- NPV discounted for 10%

In this scenario, an NPV10 calculation gives us a share price of $17.47 a share for a 20 year operation. This would be a very aggressive approach by Pay Dirt to have 20Mtpa from two mines with $1bn in debt, but it illustrates what sort of valuation could be possible in Net Present Value terms, i.e. the value of the money invested in the company's future operations is worth presently.

EV/Tonne of Resource:

The Enterprise value of IOH stands at just $226.6m as at Friday's $1.70 per share close. Using data supplied by Fosters Stock Broking (and available on the IOH website), we can see IOH is currently valued at one seventh the Enterprise Value per tonne of resource when compared to emerging producers, such as WPG limited in South Australia, and incredibly one thirteenth the value of Atlas Iron (AGO). Coincidentally, the AGO comparison would derive a similar price to the discounted cash flow analysis above.

Summary

I believe IOH will be testing new highs over $3.00 this year if successful negotiations can be made to realise the value of their resource through commercialisation. In three years you might not get much change back from a twenty dollar note.