FMG 4.51% $17.37 fortescue metals group ltd

another perspective

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    Dryblower on seeing the bottom and buying cheap

    Monday, 17 November 2008 - MINING NEWS -

    SOME people say they can see the bottom. Dryblower’s not sure if that means the bottom of the stock and commodity markets, or the bottom of their beer glasses. What does seem fairly certain is that before we really get to the bottom we’re going to see more mine production cuts, and we’re also going to see more marriages of convenience.

    No one likes talking about the cuts which are hurting so many companies, and employees, across the mining industry. Sadly, they are a fact of life in a cyclical business – and boy oh boy, are we in the down leg of that cycle.

    Last week’s news that Consolidated Minerals had mothballed its nickel operations at Kambalda in Western Australia followed cuts in zinc, copper, iron ore and the postponing of a major alumina expansion project.

    All of the cuts reflect the fact that mining, perhaps more than any other industry, is an example of how the laws of supply and demand work.

    Excess demand causes prices to rise. Excess supply causes prices to fall.

    Another way of describing the situation is to see mining as a near-perfect example of the law of the jungle, big beasts eat little beasts – a trend which Dryblower suspects we might see evolve if the optimists who can see the bottom are not simply peering into their beer.

    The real question from this bottom gazing exercise is that if worldwide production cuts play their part in the keenly awaited metal price recovery next year then they will also trigger a fresh bout of takeovers as those companies with cash, and aggressive management, acquire those with assets and no cash.

    A theoretical example is Fortescue Metals Group. This is a high-profile business which has suffered a staggering fall in value over the past five months – perhaps to the point where the replacement costs of its assets now exceed its stock market value.

    Before looking at the question of why FMG has plunged so low, and whether its assets are actually worth acquiring, it’s interesting to consider some of the raw numbers – neatly ignoring the fact that one man, Andrew Forrest, owns a controlling 36% of the business.

    At its share price peak of $A13.15 on June 25 FMG was valued at $37.8 billion, a staggering number which made it one of Australia’s top 10 companies, also a staggering thought.

    The last time Dryblower looked, FMG had plunged to $1.90 and was valued at $5.3 billion with the fall from the peak an 86% crash in value – in just five months.

    If you ignore the spectacular nature of the destruction of value, ignore the fact that the peak value was utter nonsense, and ignore Andrew Forrest, it is interesting to think about the new valuation figure and ask whether an iron ore mine, railway and port in the Pilbara region could be built today for $5.3 billion.

    In other words, has FMG retreated to asset-value backing, just as many smaller explorers have retreated to their cash backing.

    Now take one more step into Dryblower’s fabulous fantasy land and ask this question. If FMG’s assets are worth $5.3 billion, who might buy them?

    The logical “boom time” answer of earlier this year was a Chinese steel mill keen to own a mine in Australia, or Brazil’s Vale group, or South Africa’s Anglo American, or Switzerland’s Xstrata.

    The logical answer today is none of the above. The buyer with most to gain is BHP Billiton. It would enjoy all the benefits of shared services, especially in Port Hedland.

    BHP Billiton would also find FMG an easily digestible morsel with that $5.3 billion value equivalent to less than one month’s revenue, or four months profit.

    The difficulties would be dealing with Mr Forrest, and in being satisfied on questions such as ore quality, reserves, mining equipment and port operations.

    BHP would never confirm (or deny) that it has run its ruler over FMG. Dryblower, after a few years of watching these things, knows full well that it will have.

    This leaves a final question, and one that can be asked of every company with a low share price. If FMG’s share price plunge has pushed it into the bargain basement will anyone buy, and if not, why not?

    Over the next few months, expect more questions like that to surface as potential buyers circle potential targets looking for reasons why shares have plunged in price and what is fair value.

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