Dryblower wonders whether FMG is the world's most overvalued mining company

Dryblower’s Quiz: Is Fortescue Metals Group the world’s most overvalued mining company, or is it a business with a sky-high share price which could easily fund expansion, perhaps into copper?
Dryblower wonders whether FMG is the world's most overvalued mining company Dryblower wonders whether FMG is the world's most overvalued mining company Dryblower wonders whether FMG is the world's most overvalued mining company Dryblower wonders whether FMG is the world's most overvalued mining company Dryblower wonders whether FMG is the world's most overvalued mining company

There's a lot in those questions which have their origin in the remarkable 135% rise in FMG's share price over the past 12 months courtesy of an iron ore boom delivered through a combination of Chinese demand and sluggish Brazilian exports.

The net result is that iron ore rose last week to around US$112 a tonne for high-grade material and an even more remarkable $98/t for second-grade ore.

The effect on FMG's cashflow has been electric because even if it is producing a relatively low-grade ore it is doing so at a cash cost of around $14/t which means every tonne is theoretically generating a gross profit of $84/t.

Revenue in the 12 months year which ended on June 30 is likely to have topped $13 billion and earnings before tax and other charges could be as high as $8.5 billion, up 40% on the previous year.

Precisely how well FMG has performed will become clearer over the next few weeks as reporting season rolls around, starting with the company's quarterly report next week and then the full-year profit statement on August 24.

Investors have been rushing to get a slice of FMG and its extraordinary profits which should lead to a generous annual dividend payout of more than $1 a share with a cheque for $1 billion going to the company's founder and chairman, Andrew Forrest in what could be Australia's biggest ever personal cash payment.

Great news as that is for Forrest and his fellow FMG shareholders there is no doubt that at some time the iron ore party will come to an end. Perhaps because of Brazil restoring production or because China's appetite for steel fades - or both.

But even if the iron ore price retreats to a long-term trend of around $60/t, FMG will remain handsomely profitable, albeit less profitable than it is today.

It will also be a company fully exposed to a single commodity, a position which can be good while the price for that commodity is high, but it is not a desirable structure over the long term.

Forrest knows that, which is why he has been diversifying his own fortune into a variety of other business interests which range from oil exploration to beef production.

FMG, however, remains a pure-play iron ore producer and while it has a number of interesting exploration projects in the outback of its home state of Western Australia as well as for copper in Ecuador and Argentina it does not have production outside its WA iron ore interests.

That one-trick pony status will eventually change either through exploration success and mine development, a slow process, or it could change quickly via an acquisition and FMG has the firepower to buy almost anything it likes.

Two sources of capital are housed in FMG. Spare cash from today's iron ore profits and a very valuable share price which could be used, either in the form of a share-swap takeover or via an issue of new shares.

Forrest would be loath to water down his position, though a change to the capital structure could also be a way for him to trim his exposure to one enormously valuable asset so he can continue with his private diversification plans.

Last week's activity in FMG shares which saw the stock hit an all-time high of A$16.66 on Wednesday before easing to a close on Friday at $16.39 could have simply been a rush by private investors wanting a slice of next month's dividend.

Institutional investors, however, were almost certainly not participating in the stampede, if they were following the advice of the investment banks they generally turn to when it comes to high-priced shares.

The banks, almost universally, reckon FMG is enormously overpriced with the current consensus view being that the company's share price should be around $12.76, not $16.39, a difference which implies a share-price fall of 22%.

Whether FMG is overpriced, or not, the key point is that it has just entered the exclusive ranks to be one of Australia's top 10 listed companies, and at $50.5 billion it is worth five-times the BHP spin-off, South32, a company seen by some analysts as a tasty takeover morsel for FMG.

Whether Forrest is at all interested in a bag of BHP leftovers seems unlikely, but he could well be interested in a pure copper play, or a mix of copper players.

OZ Minerals, currently valued on the stock market at $4 billion could be his for $6 billion, with Sandfire tossed in as a useful addition for, say, $1.5 billion. Two acquisitions which could form an instant copper division rather than mess about with exploration which might lead nowhere.

The point is that with a record share price Forrest can do what he likes and given the track record of the man he's unlikely to sit around waiting for the iron ore price to fall and for FMG's shares to slide, diminishing is bargaining power.