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Last week the Broker Buys column on TheBull gave us nine shares recently upgraded by some of Australia’s top research analysts.  From this list we selected one of Australia’s smaller iron ore mining operators, Atlas Iron Limited (AGO).

If you ask several Aussies on the street why we are known as The Lucky Country, you may get a variety of responses.  One you are most likely to hear is that we are blessed with abundant natural resources.

The three analysts who reviewed Atlas Iron all paint a bright picture of future growth for Australia’s mining sector in general and for AGO in particular.  

As you may know, Australia is now the largest exporter of iron ore in the world.  Two of the three largest iron ore producers in the world are Anglo-Australian companies – BHP Billiton and RioTinto.  The third is Brazil’s mining giant, Vale.  Lucky for us, the world’s largest importer of iron ore is China, our neighbour to the north.

While some retail investors may be ready to invest based solely on a brief summary of analyst opinion as we saw in the Broker Buys column, intelligent investors approach those conclusions with a healthy dose of skepticism and dig deeper.

Analysts research shares and stgelop their own investment thesis – their rationale for buying, holding, or selling.  What we often read on the Internet is an abbreviated snapshot of the full thesis.  However, when digging deeper, analyst conclusions are a good place to start.  Here are the highlights of the conclusions expressed by those analysts:

•    Strategic location – AGO’s two producing properties are situated within 150 kilometres of Port Hedland. The proximity gives AGO a significant cost advantage, as their ore can be transported by truck over public roads.

•    The company has two additional properties in the area under stgelopment.

•    An acquisition strategy is underway, with the potential for significant expansion of the company. The company recently acquired Giralia Resources NL (GIR).  Giralia has similar assets and the addition of their resource inventories should be a catalyst for higher earnings.  At the current time, the company is actively pursuing another junior Australian miner, FerrAus.  These acquisitions would turn AGO into a 3 billion dollar company.

•    Atlas Iron has a unique production model that takes advantage of low strip ratio mines, a substantial cost advantage especially when coupled with its strategic location.

•    AGO’s mines in current operation produce 6 million tonnes of direct shipping iron ore a year with production expected to double by 2012 to 12 million tonnes a year.

•    AGO is in a strong cash position, with operating cash flow of $120 million reported in the March quarter 2011 as well as total net cash of around $300 million.

•    The company recently reported their first profit -$30.1 million for the six months ending December 31, 2010

Where to begin?  How about profit.  If they reported their first profit at the close of last year, what have they been doing in the past?  Ideally, one would want to see an upward trend, losing a little less money each year.

We turn to the company’s website to look at financial statements within the annual reports for the last few years and here is what we find:

  2010 2009 2008 2007
AGO Net Profit (41,000) (63,000) (38,000) (16,000)

 

AGO’s fiscal year ends in September, so the numbers from the financials need to be interpreted.  For example, the loss in 2009 includes the last three months of 2008, when the Great Financial Crisis (GFC) began and global demand for most commodities dropped substantially.

Still, these sizable losses lead to the question of where Atlas is getting the cash to finance these acquisitions and keep operating?  In addition, how could they have such strong cash flow?

One might assume they have significant debt as well as weak liquidity, so let’s look at a few liquidity ratios, as well as their total long term debt.  To put these numbers in perspective, we will compare them to the Materials sector as a whole and to one of their competitors – Fortescue Metals Group (FMG).  Here are the numbers:

  AGO FMG Sector
Current Ratio 8.58 1.91 6.44
Quick Ratio 7.32 1.69 5.59
Total Long Term Debt 0 2,509m N/A

Surprisingly enough, it is the larger and more well-known FMG that carries a large debt with low liquidity.  AGO’s position is strong.  However, we still haven’t answered the question of where the money is coming from.  If not debt, it must be from equity financing.

Returning to the financial statements on the website we find AGO raised about 73 million in FY2009 and 123 million in FY2010 from issuing new shares.  As you know, issuing shares to finance operations and acquisitions rather than taking on debt is not always viewed positively by investors.  More shares dilute the existing shareholder equity.  

It is common for share prices to decline following announcements of equity raisings, with a resultant loss in shareholder return in the short term.  Therefore, it would be interesting to see how AGO has performed in total shareholder return over the past several years.  Total shareholder return is simply the capital gain plus the dividends shareholders would get in a particular time period.  Here is a chart of 1 year, 3 year, and 5 year average annual rate of shareholder return for both AGO and FMG.

  AGO FMG
1 year Total Shareholder Return (average annual rate) 88.6% 51.5%
3 year Total Shareholder Return (average annual rate) 12.3% -9.2%
5 year Total Shareholder Return (average annual rate) 42.3% 44.6%

 

The numbers appear to tell us the share market participants who invested in AGO suffered little from the equity raises.  Now let us look at some valuation ratios to see how the market perceives AGO.

  AGO FMG Sector
Price to Earnings (P/E) 15.1 12.03 13.29
Price to Earnings Growth (PEG) .06 1.22 .50
Price to Book (P/B) 5.0 1.73 1.6

AGO looks like an attractive opportunity for Growth or GARP (Growth at a Reasonable Price) investors.  The PEG Ratio suggests AGO may be undervalued in terms of its growth potential.  This ratio and the P/E are particularly impressive when you consider AGO has only recently begun to turn a profit.

While the company and the mining sector appear well-positioned, intelligent investors never put their money on the table without also considering the global outlook and its potential risks.  

As attractive as it might seem, you cannot escape the fact AGO produces one single product – iron ore.  As long as the demand for iron ore continues to rise, AGO should do very well for its investors.

Right now, that demand is strongest in China and if China stumbles, so will AGO.  If you have been following the share market of late, you know we are in a period of uncertainty.  There are those who predict China will surely fall and others who warn of another financial crisis similar or worse than the GFC.  

Suppose it all comes true?  What would happen to the value of your AGO shares?  We have a simple means of back testing that eventuality.  Here is a five year share price movement chart for AGO, that includes the onset and aftermath of the GFC:

#FOTO:1145:400#

Note that in the short span of three years, AGO’s share price has climbed back to where it was before the crash.  The risk assessment question you need to ask yourself is can I wait three or more years?

There are two conditions that should concern you.  First, if the capital you have invested in AGO might be needed for a home purchase, or a car purchase, or a college education, you should take that into account before you invest or in evaluating your current position in AGO.

The second is the dreaded “M” word – margin.  While the idea of investing using other people’s money attracts many investors of all types, dramatic drops in share price often lead to margin calls that can wipe out your investment to meet the call.  Excessive margin buying makes it difficult to hold on during market downturns.

If neither of those conditions applies to you and you believe in the China story, you might want to jump on AGO and enjoy the ride.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.You should seek professional advice before making any investment decisions.