Is Mineral Resources’ boom over?

The miner had just hit a 12-month high when disaster struck. Is there worse to come?

Summary: Mineral Resources shares had risen by almost 50% in three months, but they plunged yesterday after Fortescue Metals took control of a rock crushing site being operated by its contract mining division. Some analysts are also concerned over the company’s high exposure to iron ore, and that mine-services contracting is set to slow.
Key take-out: The prime reason for Mineral Resources earning a consensus underperform recommendation is that its share price has run too far, too fast, and the iron ore price could be set for a fall.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Underperform (under review).

Not many stocks had been able to keep pace with iron ore miner and mine-services contractor Mineral Resources (MIN) over the past three months. But its 50% price rise between July 1 and yesterday was a prime reason for seeing it as a company likely to underperform in the short to medium term.

Now there are two more reasons. The price of iron ore looks fragile as China completes re-stocking ahead of the northern winter, and the contract mine-services division of MIN has just been dealt a savage blow by one of its most important clients, Fortescue Metals Group (FMG).

In a rare example of a miner exerting its right to re-take control of mineral processing from a contractor, FMG forced the MIN subsidiary Crushing Services International to hand back control of the operation after a fatality at the site.

Described as a “temporary step-in”, the action will have repercussions for MIN, not the least being that other clients will be taking a close look at the situation, but also because it could lead to increased safety-related costs at all crushing sites.

Last week would have been the ideal time for shareholders in MIN to take a profit although, with its shares regaining some lost ground today, it might not be too late to trim exposure to a company which is running into headwinds.

There are three reasons for adopting a cautious approach to MIN, a company with a unique business structure that has, until now, been able to ride the resources boom to perfection. They are:

  • The high level of exposure to a single commodity, iron ore, which is moving close to an inevitable price correction.
  • Exposure to mine-service contracting at the end of the building-phase of the resources boom, which is a time when mining companies cut costs or consider bringing services in-house.
  • Safety concerns, which could lead to higher costs in the contracting division.

The MIN share price has fallen sharply from the 12-month high of $12.35 reached last Thursday, dropping to as low as $10.62 yesterday. By the close of today’s session, it had regained 3.3% to $11.31, but a further fall is on the cards.

If it falls back below $10, it could be time to take a fresh look at the stock. Right now, it is best to wait for the dust to settle in the iron ore market and in the contracting division of the company, which has crossed the line between miner and mine-service provider.

A thinly-researched company, despite recently claiming a spot in the top 100 ASX-listed stocks, MIN is essentially the creation of one man, Chris Ellison. He retains a 15% stake in the business (27 million shares), a holding which ranks him among Australia’s 100 richest people.

Four years ago, as the MIN share price recovered strongly from the effects of the 2008 global financial crisis, Ellison made a rare appearance in the headlines, paying an Australian record price for a house ($57.5 million for a mansion built by another iron ore millionaire, Angela Bennett).

That burst of publicity was enough for Ellison, who has retired to his preferred low-profile life.

Ellison is a self-made man, who left school at 15 in his native New Zealand to try his luck in the Australian construction industry. He ended up in the north-west WA oil centre of Karratha as the Woodside-led LNG boom was starting in the late 1970s, and as the nearby iron ore industry was in idle mode, but which soon would form the backbone of his business interests.

Rather than directly enter the high-risk side of mining, exploration and development, Ellison followed the “pick-axe” route, developing an ore crushing and pipeline construction business. Both remain an integral part of MIN today, along with mine-camp contracting services and an expanding mine ownership division.

A difficult business to value

The business model, of extracting value at multiple levels of the mining process rather than being overly-exposed to a single facet, makes MIN a difficult business to value. Is it a miner, or is it a contractor? And there’s the complicating question: is it too exposed to iron ore, a commodity widely tipped to be heading for a significant price correction?

The recent strength in the stock’s share price is a pointer to both a reasonable financial performance in the year to June 30, and the recent securing of major new ore crushing contracts, including a job with Rio Tinto at its Nammuldi mine, which should underpin future revenue growth.

Pre-tax profit in the latest financial year rose by 29% to $385 million, but the after-tax net profit was up a modest 1.9% to $180.4 million despite an 18.5% increase in revenue to $1.09 billion. This was a sign that the company had to work harder for minimal gain, as margins tightened in the contracting sector and iron ore prices tumbled in the first-half of the year.

A 32 cents per share final dividend took the company’s full-year payout to 48c, an increase of 2c on the 2012 return to shareholders.

The chairman, Peter Wade, said in a note with the financial result that both mining services and mining activities achieved their respective performance targets.

Contracting volumes increased, with six ore crushing contracts starting during the year, while iron ore export volumes from the company’s small Carina mine increased, and a new mine at Phil’s Creek was beginning to contribute.

Wade noted how both the services and mining divisions “have significant exposure to iron ore markets” but he added that MIN expected the sector to provide increasing opportunities to suit its business model.

Divided opinion on growth

Impressive as the recent performance has been, the company’s heavy exposure to iron ore, either as a miner in its own right or contractor to that industry, is producing divided opinion in the investment community.

Some analysts are concerned about the high level of iron ore exposure, others about the squeeze on contractor margins across the resources sector, with a third measure of caution being the lack of exposure to contracting services outside the resources sector.

But the prime reason for MIN earning a consensus underperform recommendation is that its share price has run too far, too fast, at a time when the all-important, underlying iron ore price could be set for a fall back from its current $US134 a tonne closer to $US100/t.

UBS, for example, likes the leverage MIN has to iron ore volumes through its contract crushing services and price through its own mines, a structure which has “an annuity style offering that benefits from the down cycle”.

However, the upward price rush since early July has seen the stock comfortably exceed the UBS 12-month price target of $10.70, which is why it has switched its recommendation from buy to neutral.

J.P. Morgan has gone a step further and downgraded MIN from neutral to underweight, a shift which has occurred between an August 15 analysis (available on the MIN website) and a September 5 analysis of the wider contracting sector – a time which corresponds with a rise in the stock’s share price from $10.71 to $11.35.

In its latest assessment, J.P. Morgan noted that the stock was trading above its sum-of-the-parts valuation of $9.93 and faced two near-term risks: execution of iron ore production expansion and the iron ore price itself.

In reports written before the FMG incident, other brokers were less concerned. BBY rated MIN a buy, with a 12-month price target of $12.50, a value determined on September 9 when the stock was at $11.62.

Macquarie said MIN stock deserved an outperform rating after winning the Rio Tinto Nammuldi contract, but its 12-month price target of $12.27 is marginally above the current price.

Morgan Stanley is the most optimistic, tipping a $14 price target, noting that the stock seems set for strong “counter cyclical” earnings growth in 2014 thanks to its exposure to the volume of iron ore being processed and less to the iron ore price itself.

My view is that the MIN’s share price has done its best for now and there will be better buying opportunities later, just as there were in the first-half of this year as the stock retreated from $11.70 to around $8 by mid-year.

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