This is Ocean Equities view on the UMC scene - a better read...

This is Ocean Equities view on the UMC scene - a better read than a lot of the posting going on!

News
The securities of UMC have entered a trading halt effective Oct 7th pending an announcement to the market in connection with “a potential change of control transaction involving the Company”. The securities will remain in pre-open until the earlier of the commencement of normal trading on Friday, Oct 9th or when the announcement is released to the market.

This proposed change of control transaction comes only a month after the proposed A$27.2m placement and 10 year 3mtpa offtake agreement with China Railway Materials Commercial Corp. Group (“CRM”) which was announced on Sept 8th. The proposed placement to CRM was for 20m shares securing an 11.4% stake at A$1.35/sh and is subject to: due diligence by CRM (and agreeing commercial terms for the offtake agreement); and CRM obtaining Chinese regulatory, and FIRB approvals which are expected to be satisfied by Dec 7th. Also on Sept 8th CRM announced a strategic co-operation and investment in another Pilbara iron ore developer FerrAus (“FRS”), securing a 12% stake, with CRM potentially securing a significant entitlement to iron ore offtake from FRS subject to CRM securing substantial funding for the construction of suitable rail infrastructure. The last date for satisfaction of the conditions for the proposed FRS transaction is Nov 30th.

On Sept 21st UMC announced a significant upgrade in the resource status at the Company’s flagship Railway deposit which has seen a 29% increase in total tonnage to 158.1mt. Importantly the resource includes a Indicated DSO bedded iron ore resource of 100.7mt and the Railway deposit mineralisation has been significantly extended, especially in the Boundary Zone, which lies on the BHPB tenement border, where thick high grade bedded iron ore mineralisation has been recorded. Holes UI842 & UI843, which are basically on the tenement boundary, have returned intersections of 180m averaging 62.5% Fe (1.87% Al2O3) & 182m averaging 62.04% Fe (1.89% Al2O3) respectively, with low impurities, from 38m below surface. These are the largest high grade intersections to date at the Railway project supporting the theory that the Railway orebody continues into the neighbouring BHPB tenement and could eventually form a very high grade 150-200mt pod similar to those at BHPB’s neighbouring Area C.

Analysis
In our view CRM’s proposed investment effectively created a deadline for the regional Pilbara neighbours, existing Pilbara producers and other 3rd parties to either buy UMC, thus securing its high tonnage/quality Railway deposit and highly prospective land package which is surrounded by existing infrastructure, or miss out with CRM, a large scale State Owned Enterprise (“SOE”), set to secure a strategic stakes in both UMC and FRS.

It is clear that CRM, other Chinese SOE’s and other Asian strategics (particularly the steel mills) have 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 coupled with the likely opening up of BHPB and RIO’s rail networks in the near term future. Indeed since Feb 12th when Chinalco announced it’s proposed, but failed, tie up with Rio Tinto there has been a proposed A$8.9b of capital committed into the junior sector from 8 transactions and we believe the key recurring motivation behind each of them is to diversify dependence away from the existing 3 major iron ore producers (Vale, RIO & BHPB).

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. In addition Fortescue continues to work with the Baosteel Group and CISA to secure an additional US$5.5b to US$6b in funding. To this end it is obvious that the Chinese are very quickly gaining a significant position in the backyard of BHPB and RIO’s traditional “cash cows”, to such an extent that they could potentially become a new competitor.

Foreign counterparty unlike?
Given the recent comments from Patrick Colmer, the GM of the FIRB, that the Australian government wanted the foreign share of greenfields developments in the resource sector to be below 50%, and around 15% for major miners, we would be surprised to see an Asian strategic investor (including CRM) as the proposed acquirer of UMC, particular given the primary objective of previous foreign investment has been to secure access to ore without taking control (as evidenced by the proposed deal between UMC and CRM).

. . . and Railway is worth more to BHPB or RIO . . .
As we have discussed at length in our iron ore research we believe it make sense for both BHPB and RIO to do deals with iron ore juniors who own high quality blendable resources close to existing infrastructure, particularly given the likely requirement to provide 3rd party haulage in the near-medium term future.

While at this stage, just off the back of the trading halt press release from UMC, it is extremely speculative to suggest that BHPB or RIO are looking to secure a controlling position in UMC we highlight there are a number of potential incentives to do so. Given that the Railway orebody extends into BHPB’s tenement (and likely forms a high grade 150-200mt pod similar to those at BHPB’s neighbouring Area C), BHPB have already committed funding to extending their Area C infrastructure (currently ~20km along strike) towards the Railway deposit (and over a number of UMC tenements), and the current strength of their balance sheet we believe the natural buyer of UMC would be BHPB. However, it must also be stated that RIO’s Yandicoogina/Hope Downs/West Angelas rail spur runs through the Railway lease and it must be highlighted that RIO acquired a 50% stake in Gina Rinehart’s Hope Down’s project.

. . . but Fortescue has greater incentive to deal
However, in our view Fortescue has a greater incentive to look at the various Pilbara development companies than either BHPB or RIO despite the fact that it would not be able to enjoy the same level of synergistic benefits as BHPB or RIO given its location (Fortescue’s existing rail is ~120km away from the Railway deposit). The greater incentive to deal largely comes from the fact that Fortescue’s infrastructure continues to have excess capacity and production continues to struggle to ramp up (particularly because of grade control and alumina levels – both of which potentially would be improved with securing ore from the Railway deposit), and we believe a new US$5.5b+ capital investment provides Fortescue a clear mandate to look to regional corporate activity with high quality and neighbouring iron ore juniors with the aim of: improving the capacity utilisation of its infrastructure networks; improving its product spec’s; and providing near term incremental production with minimal capex. While significant additional “infrastructure funding” from the Chinese may be a nearer term reality we believe that the majority of mines that are expected to supply the ore for Fortescue’s expansion plan’s remain very much conceptual (refer Exhibit 9 to 11).

Furthermore, given Fortescue’s strong relationship with the Chinese steel mills and strategic investors, we expect the Chinese to look to leverage their current and future potential investments in Fortescue by increasing infrastructure utilisation and access to 3rd party ore, either through additional MGS’s, JV’s or direct asset acquisitions. We believe that Fortescue would be able to truck haul up to 6mtpa from the Railway deposit potentially from early 2011.

A bid from another 3rd party in our view is unlikely
While there are a number of other 3rd party’s, including other Pilbara iron ore juniors, other Australian based iron companies, and/or other industrial companies (eg Lion Asiapac Ltd and Mineral Resources who are currently in a bidding war for Polaris) who would potentially be interested in securing a controlling position in UMC we believe it is unlikely that a 3rd party would be willing to invest a significant sum of capital into a project that currently does not have an proven route to market.

What price is likely under a control transaction?
In our view the quality, size and location of the Railway deposit warrants, and will ultimately provide a scale of production of at least 5mtpa, potentially 10mtpa+. While the Railway deposit has a significant in the ground value we believe the most appropriate benchmark for what price would be required to be paid in a control transaction is the current proposal from CRM.

We believe that UMC directors would not be able to recommend to shareholders a bid of less than the A$1.35/sh offer from CRM. Under most occasions a hostile offer sees a significant premium beyond current or board recommend transaction level. A very good current example is Polaris, where the Polaris board recommended the offer from Australia-listed mining services company Mineral Resources, which is offering $A67m in scrip for the iron ore developer. The offer from Mineral Resources is a 26% premium to the last trading price of Polaris and a 53% premium to the 3 month VWAP. Subsequently Malaysian-backed joint venture Lion-Asia Resources has made a A$94m cash takeover bid (conditional on securing at least 50.1%) – that is a 40% premium to Mineral Resources and cash not paper.

Re-rating across the junior sector?
We believe completion of a change of control transaction, at a likely significant premium to the current share price, in UMC will be a significant catalyst for the junior sector. The initial reaction of the market was to see FRS up 14% on UMC’s trading halt (likely to be driven from speculation of a further Chinese investment in a similar way CRM co-invested in both FRS and UMC). However, we believe the likely emergence of another groundbreaking domestic transaction will lead to a re-rating of the Pilbara junior sector.


Further details on the Railway deposit resource upgrade
UMC on Sept 21st announced a significant upgrade in the resource status at the Railway deposit which has seen a 29% increase in total tonnage to 158.1mt. Importantly the resource includes a Indicated DSO bedded iron ore resource of 100.7mt and has been significantly extended, especially in the Boundary Zone where thick high grade bedded iron ore mineralisation has been recorded.

The resource upgrade has provided the Company further confidence in planning an initial 3mtpa truck haulage mining operation, as it continues planning for the commencement of production in early 2011, and includes an additional 157 RC and diamond drill holes since the Feb’09 resource estimate. The strong increase in Indicated high grade Bedded DSO Marra Mamba ore augers well for a high conversion rate of Indicated resource to Measured resource as drilling continues.

Since the Feb'09 resource estimate there has been:

An increase of 29% in the total resource category to 158mt at 58.03% Fe with 3.42% Al2O3 (Indicated and Inferred Category)

An increase of 32% in DSO Bedded Marra Mamba ore to 100.7mt at 60.3% Fe with 2.62% Al2O3 (Indicated Category)

The Company now has increased confidence in the geological continuity of the bedded high grade DSO iron ore based on the predominate 100m by 80m spaced drilling that formed Indicated resource. It is important to highlight that the quality of the deposit (ie tonnage, Fe grade, impurities) has improved as a result of infill drilling and it is likely the proposed 50m by 40m drill programme for a Measured resource (which will provide the required level of confidence to commence mining) will likely to also exhibit similar results. The 32% raise in tonnage at an increased level of confidence is of particular importance because the high quality bedded DSO ore is the principal ore type planned for initial phase 1 production.