looking forward for 50% increase in sp, page-5

JP Morgan

Mount Gibson Iron Ltd

? Underweight
Previous: Neutral
MGX.AX, MGX AU
Downgrading to Underweight on valuation

While Mount Gibson’s full year earnings were below expectations, there were
some encouraging signs with EBITDA increasing 26% in the second half of
FY2013, and free cash flow a healthy A$86 million in the year. However, with
the stock up more than 40% in the last three months (and now trading above
our price target), and the overhang of potential M&A still around, we are
downgrading to Underweight on valuation.


? Weaker than expected earnings in FY2013: Mount Gibson reported
underlying NPAT of A$92.9 million, down from A$181 million in FY2012
despite substantially higher revenue. Earnings fell below our estimate for
the period of A$128 million and consensus at A$106 million. The final
dividend was 2cps for a total of 4cps for the year. This represents a cash
outflow of only ~A$45 million for FY2013 despite cash reserves of A$376
million at the end of June 2013 and little growth capex going forward.
? The company’s acquisition strategy remains an overhang, in our view:
The company has previously flagged a growth strategy through M&A, and
has been targeting steel raw material companies/assets (particularly iron ore
and/or coal) for some time. In our view, this strategy represents an overhang
on the stock, given the uncertainty around how the group could look going
forward.
? Stock has outperformed peers in a rising iron ore price environment:
Driven by rising iron ore prices, Mount Gibson’s stock price has increased
~40% since mid-May, outperforming most of its peers (Atlas -7%, Aquila
+16%, Gindalbie 0% and Grange +41%). While we believe iron ore prices
could remain at elevated levels (refer to our note of 6 August 2013 - link),
we see little reason for the outperformance from Mount Gibson relative to
peers.
? Downgrading to Underweight on valuation: With the stock trading above
our (unchanged) 12 month price target, we are downgrading our rating on
Mount Gibson to Underweight. Our June 2014 price target remains
A$0.65/share at a 15% discount to our DCF. The discount is to account for
the potential for cash to be deployed through M&A.

Downgrading to Underweight
While the stock trades at low forward multiples and is ~45% cash backed, the M&A
strategy creates uncertainty, in our view. We remain concerned that the company
could spend the cash that it currently held on acquisitions rather than distribute to
shareholders.
With the stock trading above our price target, we are downgrading to Underweight.
Our June 2014 price target remains A$0.65/share at a 15% discount to our DCF
using a 10% discount rate. The discount is to account for the potential for cash to be
deployed through M&A.
Upside risks to our Underweight recommendation are: 1) potential for the company
to crystallize the value of its infrastructure in the mid-west once Tallering Peak
expires; 2) potential for higher than expected prices and cash flow generation; and 3)
possibility of mine life extensions through exploration and development.