Iron ore slumps. Time to buy Atlas Iron?

Chief Investment Officer and founder of Aitken Investment Management
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I think the performance of the ASX200 was encouraging yesterday. It’s not often that you see the Nation’s major export commodity in free fall and the companies that mine that commodity in free fall, yet the benchmark equity index only lose three points. In fact, when you strip out the negative points contribution from the major miners (down nine points), the broader industrial market was higher again.

The Aussie dollar was also completely resilient to spot iron ore, as were 10-year bonds, industrial equities and non-iron ore resource stocks. Turnover on the ASX crept over $4 billion.

Iron ore downtrend

This continues a trend. Spot Iron ore has fallen 31.5% since June 22. In that period spot iron ore has only had six up nights. However, during that period the ASX200 has advanced 7.5%.

There is something a little weird about all this. Surely if this truly was the end of iron ore as we know it, the ASX200 would be under heavy pressure, the Aussie would be in free-fall and bond yields would be falling because Australia’s budget surplus forecasts would be fanciful. Australian economic growth would also be being revised down sharply.

What I’m saying is the lack of asset class correlation of the spot iron ore price move, outside of iron ore equities, suggests this is an iron ore specific, short-term, game. In fact, all other commodities have been rising, increasing my suspicions about China Inc. manipulating the opaque spot iron price in a period of spot cargo tenders by one major producer. My point is that other Australian asset classes don’t agree that it’s all over for iron ore, in fact, they are pricing quite the opposite. Ditto the rest of the commodity complex in terms of global demand.

It will bottom

The conclusion I’m coming to is when spot iron ore bottoms, and that day must be extremely close with 60% of the industry losing money at these spot prices, the short-covering in major iron ore producers will drive the ASX200 into a new higher trading range. Hopefully this occurs as we concurrently jump the Jackson Hole hurdle this weekend.

I still think the 30-day ASX200 SPI futures charts look bullish, but to break out into a higher trading range it requires a rallying BHP (10% of the index). A rallying BHP can only occur as spot iron ore bottoms. That won’t be today. Some Chinese stimulus wouldn’t go astray either, but again, it’s all inter-related. Even though I have been wrong in the short-term on big miners, we are about 20 odd days into my new bull Australian equity market call and so far so good.

Atlas Iron Ltd (AGO) – Buy

Atlas Iron recorded underlying net profit after tax (NPAT) of $72 million (compared with our estimate of $106 million), and was softer than expected due to differences in operating costs estimates. Revenue increased by 5% due to a 22% increase in iron ore exports for the year. Cash operating costs for full-year 2012 were $44.9 per tonne, and at the top end of guidance of $42-45/t. Atlas declared a final unfranked dividend of 3 cents per share, which was in line with our expectations. It had $400 million in cash as at 30 June.

We believe Atlas Iron can pursue its Horizon 1 growth option without additional debt. Based on comments from the conference call, we think there’s been too much focus on Horizon 2’s capex draining capital and funding requirements. Atlas’s expansion beyond Horizon 1 could play out in many ways and could add significant value (i.e., staged developments, third party access agreements etc).

We don’t believe the market is factoring in Atlas Iron’s relatively low risk Horizon 1 production growth to 12 million tonnes per annum (Mtpa) rates by the end of 2013. However, we think Atlas is likely to hold this discount until a rail solution for Horizon II is illustrated. We expect this solution to be announced over the next six to 12 months.

  • Recommendation: Buy (unchanged)
  • Price: $1.40
  • Target (12 months): $3.30 (unchanged)
  • Expected Capital growth: 99%
  • Expected Dividend yield: 3%
  • Total expected return: 102%

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.

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