sell fmg

FMG is the ultimate bull market stock but the credit crisis sees global growth cooling. Is it now a case of straw hats in winter or abandon
ship? It’s hard to believe FMG has come this far, but you have to hand it to Forrest. He is highly motivated and despite many sceptics,
he did it again. Exactly what has been built though is an open question. It’s typically Forrest size – huge – but is this a genuine cracking
of BHP’s and RIO’s Pilbara iron ore duopoly? Proof won’t come for a year or 2 once production rates, operating costs and maintenance
capital costs stabilise.
Viewing FMG through Anaconda’s prism shows interesting similarities. Anaconda Nickel (ANL) was Andrew Forrest’s previous venture.
You can argue ANL and FMG are different. ANL was a nickel miner using new technology on previously uneconomic, low grade ore.
FMG is in iron ore, a much simpler crush, size and ship operation. Beneath the surface, similarities appear. Financing was via US debt.
Construction and expansion plans fast tracked. Huge deposits in vast exploration acreage but lower grade and previously considered
marginal. Promotion appeals to nationalistic sentiment.
ANL is now Minara Resources (MRE). In Forrest’s days it was a pioneer with an exciting concept. Nickel laterite deposits were cheap
and extensive. If low cost production was viable, expansions could bring huge upside. ANL floated in 1994 and Murrin Murrin
remarkably started production in early 1999. Targeted ‘Stage I’ capacity was 45,000t of nickel and 5,000t of cobalt a year. A ‘Stage II’
expansion was to immediately follow to more than double output to 115,000t of nickel and 8,500t of cobalt from late 2000. Post
expansion operating costs of less than A$0.35/lb were expected. Even at today’s lower nickel price of A$9.00/lb, the expansion if
delivered as planned would generate pre-tax operating cashflow of A$2.2bn a year and a market capitalisation probably sufficient for
the ASX Top 20.
Murrin Murrin was just one prong in ANL’s ‘Three Nickel Province’ strategy. A further 108,000t of nickel and 6,000t of cobalt was to
come from Mt Margaret at a similarly low cash cost of US$0.55/lb. At US$3.50/lb nickel, ANL estimated a NPV of US$2.83bn with a
25% annual return on the initial A$2.0bn capital cost. Construction was to start January 2002 with production from late 2003. Another
project – Murchison – was similar and set to follow Mt Margaret. ANL also promoted the Broad Arrow project and Cawse in a joint
venture with Joe Gutnick's defunct Centaur Mining and Exploration. All up target production was 350,000t of nickel a year by 2010,
equivalent to about 25% of current global supply.
Murrin Murrin was plagued by start-up issues. British diversified major Anglo American, a 25% shareholder at the time, pushed for new
management. Anglo took the unusual step of publicly criticising the board in April 2001 saying it had ‘lost confidence’. It added
‘Anaconda’s governance practices and speculative style of its management do not provide the sort of leadership required to elevate
Anaconda from its current status into a responsible, reliable, world-class producer’. In a further letter to shareholders in May 2001,
Anglo asked ‘What is wrong with Anaconda?’ citing ‘too much debt, over ambitious expansion plans, poor corporate controls, unrealistic
forecasts and failure to deliver’.
Forrest resigned as CEO in November 2001 and from the board in May 2002. A strategic review refocused on Murrin Murrin. Other
plans were cut or mothballed including expansions, new mines, a water pipeline, a gas pipeline, a rare earths mine, a 100,000tpa
magnesium smelter and chemicals and fertiliser plants. Exploration ground was cut but by February 2003 Anglo had enough and sold.
ANL was recapitalised via a 14 for 1 rights issue at 5c a share in 1H03 raising A$323m. A 15 to 1 share reduction followed. Most of the
proceeds – A$207m – went to secured debt holders who settled for less than 30c in the dollar. ANL changed to Minara in December
2003, just in time for an incredibly powerful surge in the nickel price and a move to profitability.
Murrin Murrin cash costs are disappointing and near the worst quartile of the cost curve. Production has exceeded 30,000t only once, in
2006. MRE’s 60% share is about 20,000t. The company delivered to shareholders is a far cry from the investment promoted.
So where do we sit on FMG? It could be a great idea. If it works upside is huge but now is not the time to buy. We are not saying FMG
will fail, but need to wait until the concept is proven and risk subsides before factoring in substantial potential upside. Upside is
sufficiently large for investors to wait yet still be able to participate. If FMG works, decades of expansions may lie ahead but some key
questions need to be answered first. Certainty will only come with time.
Concerns centre on revenue, costs and capital requirements. We don’t yet know how much FMG can produce or the quality of the ore.
Consensus continues to look for higher iron ore prices from April 2009 but the outlook is poor. The chance of an increase looks remote
and at worst case prices could halve, though the current Aussie dollar collapse is sure to help earnings if it stays down. Severe volume
cutbacks are another very harsh worst case consideration. It’s a double edged sword if you have large amounts of US$ denominated
debt like FMG does. The market moves much quicker than analysts and is pricing for serious uncertainty and downside. Pure play iron
ore miners like FMG don’t have the proven low cost base and diversification that BHP and RIO do, either by product or geography.
FMG’s customers are all Chinese. BHP and RIO are still acceptably profitable even if iron ore prices halve.
We don’t yet know the sustainable capacity of FMG’s mine and infrastructure. Accelerated construction and widespread use of Chinese
components could pose problems. The company used new technology with mining machines, common in coal mining but unproven in
hard iron ore. ANL suffered high levels of capital expenditure in the first few years and much of the rectification work became semi
permanent – an ongoing cost.
Fortescue Metals Group Ltd (FMG)

With FMG’s balance sheet weak and expansions moving full steam ahead, it is not well placed for a hiccup. Debt and equity markets
are frozen, like even Warren Buffett says he has never seen. As he said last week, you can’t always rely on the kindness of strangers to
survive. If the iron ore price falls significantly or FMG suffers extended teething issues, the company may not be in a position to play out
its hand. We have not modelled FMG as we don’t yet have sufficient confidence in production rates, prices and costs to do so.