Sons feeling the strain

Our immediate task was to decide whether we needed to revise our recommendation. After all, we have consistently supported Sons since issue 85/Aug 01  (Buy - $7.75). The problem was, as we said in our special email update shortly after the profit warning, that there was a startling lack of detail from the company.

It didn't help that management took several days to come clean, during which time most of the damage was done. Frankly, shareholders have a right to expect better from one of Australia's oldest listed companies, especially one with a proud track record of transparency.

As a result, since issue 112/Sep 02 (Buy - $4.95) the share price has fallen 46%. Now that more information has been released we've had to establish whether we made a mistake in our original rationale for calling the company a Buy - always a possibility - or whether the sell-off is an opportunity to pick up stock cheaply.

Well, this is one occasion where the outcome is less clear cut than, say Macquarie Bank . There are two issues responsible for the gloom and doom. The first is a production problem at Sons' Tarmoola gold mine. A wall slippage - a not uncommon event - has made it harder and more costly to get at the gold. The problem can be fixed but will slow production for a while.

It's the other issue - a cut in tantalum production forecasts for this year from 2.3m pounds to 2m - that's really done the damage. Sons is the world's biggest producer of tantalum, a 'new age' metal used in mobile phones and other modern products.

The global slowdown in telecommunications isn't helping demand but, although the cut is bigger than we expected, it's hard to imagine the price of tantalum going anywhere but up in the long term. Now, here's the twist to the knife.

One of Sons' big strengths is its lucrative 'take or pay' contracts with its two main customers, Cabot Corporation and HC Starck. This, bizarrely, has also become its Achilles' heel. Sons locked in those contracts at a time when tantalum was selling for more than twice its current price.

Now, there's nothing stopping Sons from enforcing the contracts and extracting its pound of flesh. But who will it benefit if one of its main customers goes broke? As a result Sons has renegotiated parts of the agreement and cut its forecasts.

This is the main reason why we're not reiterating our previous recommendation - this is a material change in the company's circumstances. Sons has also been criticised for its hedging position, currently $643m out of the money, which has dragged up lingering memories of the ugly Pasminco hedgebook.

This is less of a concern - Sons has fixed both sides of the equation by locking in the gold price and the Australian dollar conversion rate. But this alludes to an important point. Unless you're buying the diversified resource stocks - namely Rio Tinto and BHP Billiton - investing in companies like Sons is inherently more dangerous, being heavily dependent on the price of just a few resources rather than a great many.

But that's not to say we're changing our minds. Whilst we're not reiterating our previous recommendation we are sticking to our guns. No doubt the company will struggle to regain the market's confidence but it is making money and the tantalum market should pick up - eventually.

To sell now would be to panic at a time when the situation, in all likelihood, won't get much worse. With a good, if less certain, dividend yield of 7.5%, Sons of Gwalia is a LONG TERM BUY for those with the patience to wait until the tantalum market improves.