Source of the opportunitySince Feb 12th when Chinalco announced...

Source of the opportunity
Since Feb 12th when Chinalco announced it’s proposed, but failed, tie up with Rio Tinto there has been a proposed A$8.9b (A$500m ex Fortescue) of capital committed into the junior sector from 8 transactions (6 ex Fortescue). News of further invested capital, commercial agreements, mergers and acquisitions, potential access to 3rd party rail from Fortescue, BHPB and RIO, and juniors entering production or being fully funded into production (with infrastructure access), has highlighted the potential to unlock the significant value of a number of current iron ore juniors in the Pilbara.

The recent wave of corporate activity has generally been at a premium to the prevailing share price and acted as a catalyst for the individual companies involved, as these transactions have: provided immediate access to capital; significantly advanced the project’s development; and often provided a strategic partner for funding and/or co-development. These events have acted significantly in de-risking the project/company and as a result the proposed investment price has generally acted as a floor price in the secondary market, or indeed been a springboard for outperformance.

Current iron ore market conditions
Despite weakness in the spot iron ore price in recent weeks and an apparent current oversupply of steel in China, the fundamentals of iron ore supply/demand have greatly improved from the start of the year and have resulted in upgrades to the markets nearer term price and volume forecasts. The landed iron ore spot price still remains above the implied benchmark price supported by the collapse in freight rates at the same time - the current spot price is a ~18% premium to RIO’s non-China benchmark price for JFY09/10.

The spot price is now back towards a level at which Chinese domestic ore producers have previously cut production. There is estimated to be ~200mt of supply that has restarted and is marginal or loss making at between US$60/t and US$80/t and may be turned off again. We believe this provides a floor price and some visibility that spot prices will soon stabilise, while also providing a favourable outlook for further benchmark prices in the medium term.

What has been very evident in the recent growth cycle of the Chinese steel industry is China’s increasing dependence on foreign sourced iron ore which we believe has accelerated a secular trend. Given the high cost structure of the majority of existing Indian and Chinese producers, which historically have supplied ~50% of China’s iron ore demand, a significant portion of marginal and loss making supply shut down when iron ore prices and freight rates collapsed late last year. Given the declining grades and increasing cost of the majority of Chinese and Indian production we expect China’s dependence on the seaborne market to increase, particularly given the forecast growth of Asian steel capacity in the medium to longer term.

Analysis
As with any bulk commodity, a successful iron ore project is very much a logistics’ story and delays/curtailments of infrastructure expansions support a stronger for longer price environment particularly given recent favourable forecasts for steel demand post the crisis. These factors coupled with: the sudden about face by RIO with Chinalco; the secular trend to lower quality iron ore operations in the future; recent cut backs to capex; and the potential implications of a successful BHPB/RIO JV, in our view have acted as a trigger to renewed interest in the Pilbara iron ore junior sector.

We believe recent significant scale investments by large corporations into the Pilbara including: Valin into Fortescue; Baosteel/CISA’s commitment to Fortescue (due for completion by Sept 30th); Baosteel into Aquila; CRM into UMC and FerrAus; Wah Nam into Brockman, provide a new regional landscape for potential infrastructure development. Furthermore, renegotiation of existing State Agreements in the imminent future holds the highest potential for the traditional incumbents’ railway networks being opened up since they were formed in the 1960/70’s.

The value and strategic importance of the Pilbara has historically resulted in a significant number of commercial agreements and ground breaking deals. Given the level of foreign capital invested into this region we expect to see existing investors increasingly look to leverage their relationships and investments, particularly in the wake of the propose BHPB/RIO JV.

While the quality of the deposits and economics of each project in the junior iron ore sector are generally significantly different we have attempted to illustrate the potential re-rating from securing infrastructure access for Australian iron ore juniors/developers. A number of companies have very attractive assets (both in terms of quality and scale) in favourable locations to existing infrastructure and significant value can be unlocked if a commercial deal can be secured.

Risks
While we continue to believe the secular demand story for iron ore, driven by the urbanisation and industrialisation of the highly populated developing nations (primarily China and India), we expect stock performance to be largely driven by market sentiment and as such exposure to the pure play iron ore sector remains a high risk, high reward proposition.

Pilbara peer group Market Cap Page No. Last news flow
Atlas Iron Ltd (AGO.AU) A$715m P7 Announces friendly acquisition of Warwick Resources (Sept 8th)
BC Iron Ltd (BCI.AU) A$88m P8 Begins test mining following the Nullagine JV with FMG (Sep 17th)
Brockman Res. Ltd (BRM.AU) A$227m P9 New largest shareholder secures 13.44% stake on market (Jun 29th)
Ferraus Ltd (FRS.AU) A$109m P7 Secures a strategic co-operation & A$12.6m placement with CRM (Sep 8th)
Fortescue Metals (FMG.AU) A$12.6b P9 Secures interim pricing & offtake subject to US$5.5-6b capital investment (Aug 18th)
Giralia Resources (GIR.AU) A$177m P3 Maiden Mt Webber JV resource (Sep 14th)
Iron Ore Holdings (IOH.AU) A$83m P3 Significant resource upgrade for its Iron Valley deposit (Aug 17th)
Polaris Metals NL (POL.AU) A$84m P9 Recommends proposed takeover by Mineral Resources (Aug 20th)
UMC (UMC.AU) A$108m P6 Secures a strategic co-operation, offtake & A$27.2m placement with CRM (Sep 8th)

Highlighted Research
Sep 18th UMC “Transformational transaction with CRM”

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News
UMC on Sept 8th announced a proposed A$27.2m placement and 10 year 3mtpa offtake agreement to China Railway Materials Commercial Corp. Group (“CRM”). CRM has taken an 11.4% stake at A$1.35/sh, a 32% premium to the prior closing price and 46% premium to UMC’s 60 day VWAP. In addition UMC has announced a 1 for 10 non-renounceable rights issue of new listed options to existing shareholders at an issue price of A$0.10/sh to raise ~A$1.6m. Each new option is exercisable at A$1.35/sh and will expire on 30/9/11. The shares are being issued within the Company’s ASX listing 15% capacity. The placement is subject to: due diligence by CRM; CRM obtaining Chinese regulatory, and FIRB approvals which are expected to be satisfied by Dec 7th.

CRM is a large-scale Chinese state owned enterprise whose major businesses are providing all materials for the operation of railway systems and trading steel. In 2008 CRM traded over 10mt of steel materials, one of China’s top 3 steel traders, with revenues of ~US$20b.

Also on Sept 8th CRM announced a strategic co-operation and investment in another Pilbara iron ore developer FerrAus (“FRS”). CRM is to invest A$12.6m in FRS via a placement of 22.9m shares, securing a 12% stake, at a subscription price of A$0.55/sh (3% premium to the last close price and 0% premium to the 60 day VWAP). Subject to substantial funding for the construction of suitable rail infrastructure CRM will receive significant entitlement to iron ore offtake from FRS.

On Sept 15th UMC announced that it’s Non-Executive Chairman Phil Crabb (also Non-Executive Chairman of UMC’s largest shareholder Thundelarra), stepped down and was replaced by Alan Birchmore. Alan is a long standing member of UMC’s board and has significant experience in listed multi-national resource companies. Alan has also been Chairman of several WA Government enquiries and Statutory Authorities including his current role at the Fremantle Ports.

Analysis
We believe a number of issues have been holding back UMC’s share price of late including the market’s concern of an imminent funding coupled with a lack of visibility for the Company’s path to market and a perceived overhang of legacy shareholders. We believe the proposed transaction with CRM makes significant steps towards addressing these.

· Funding - Post completion, UMC will have cash reserves of ~A$37m which we believe is sufficient for the Company to delineate a Measured resource, complete feasibility studies and secure the various required permits to enable the Company to enter construction/production.

· Path to market – UMC has continued to hold various discussions with the Port Hedland Port Authority and WA Main Roads, and we believe CRM’s proposed investment is structured such that UMC is now fully funded to enter initial production. In our view the 3mtpa offtake agreement illustrates both UMC’s and CRM’s confidence that under a worst case development scenario, UMC will be able to execute a profitable 3mtpa truck haulage operation.

While we believe that the quality, size and location of the Railway deposit warrants, and will ultimately provide, a scale of production of at least 5mtpa, UMC’s ability to develop this deposit independently is critical in order to determine and maximise its share in the economics of a more optimal development strategy in what is a rapidly evolving regional corporate and infrastructure landscape. This transaction further illustrates UMC’s ability to execute favourable commercial transactions, an attribute that will be critical in securing the required access to infrastructure.

It is clear that CRM has taken a favourable view on iron ore in the Pilbara and the likely access/development of infrastructure required to unlock the value of these deposits. CRM has taken strategic stakes in two of the juniors with the largest high grade Marra Mamba resources in the region. Given the significant investment of Asian strategic investors into the region, CRM’s links within the Chinese government/steel industry and CRM’s expertise in infrastructure solutions, it is more than likely that further capital will be invested beyond its initial ~A$40m. As UMC’s CEO Matt Hogan has stated CRM “may be involved in infrastructure solutions to assist commercialisation of the Railway Deposit”.

Financial and/or strategic investment into iron ore companies has generally acted as a positive share price catalyst; indeed FRS is up ~35% since CRM’s investment. The scale, structure and premium of CRM’s investment into UMC in our view are extremely favourable. At current prices CRM’s offtake agreement is worth ~A$2.3b and provides an NPV value of A$1.32/sh assuming a trucking operation and Railway’s current 76.1mt DSO resource only. As previously discussed we believe this is currently UMC’s worse case initial production scenario and we see significant valuation upside. As our analysis in the “Pilbara Iron Ore sector review” report illustrates producers and developers who have secured access to infrastructure are trading at A$130/t EV/capacity.

Key Events / Valuation Triggers
Near term news flow is expected to include: imminent resource upgrade to Railway to include the Boundary Zone; assay results from the complete regional exploration/resource definition drilling programmes; further development of the ongoing engineering, metallurgical/ore sample testwork & permitting programmes; results ongoing infrastructure strategy discussions; the Sep’09 quarterly activities report and completion of the placement to CRM.