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The Investment Case – Kumba Iron Ore

Can investors look beyond the Sishen Mine controversy?

ORAPA – South African diversified mining giant Anglo American currently holds majority stakes in two JSE-listed companies – Anglo Platinum and Kumba Iron Ore. While its relationship with the former has been under a great deal of scrutiny over the past couple of years, the way it deals with the latter has flown happily under the radar.

The primary reason is that Anglo American has, on more than one occasion, had to provide financing to support its prize platinum asset. So it has every reason to be concerned about Anglo Platinum’s performance and the returns on offer.

Kumba, however, is doing a very good job of running itself without intervention from its majority shareholder. This should give some encouragement to investors in Kumba, as it provides a good indication of the strength of the business.

“Anglo American has spent a lot more on Anglo Platinum than Kumba, for very little return,” says Cadiz Portfolio Manager Matt Brenzel. “Kumba, however, is basically self-financing. What it does require, it can mostly get of its own bat.”

History

The South African Iron and Steel Industrial Corporation (Iscor) was founded as a state-owned entity in 1928. The new company aimed to produce cheap steel, thereby encouraging industrialisation and creating employment.

In 1989, Iscor was privatised and listed on the JSE. A major restructuring of the business followed in 2001, when it unbundled its mining assets to form Kumba Resources. Two years later, Anglo American acquired a majority stake in this new company.

Kumba Iron Ore was created in 2006, when Kumba Resources was re-organised. Its coal and heavy minerals operations were spun off to the newly-created Exxaro Resources, while the iron ore-mining assets were retained under the new name.

Dividends

Although Kumba’s dividend was curtailed slightly last year, the company continued to pay dividends through the recession. This is in contrast to both Anglo American and Anglo Platinum, which suspended dividends in 2008.

From the maiden dividend of 80c paid out at the end of 2006, Kumba declared a total annual dividend (final plus interim dividend) of R10 for 2007 and R21 for 2008. This fell to R14.60 for the 2009 financial year. The interim dividend declared for the first six months of 2010 was R13.50.

Kumba’s dividend yield is currently a healthy 5%.

Which funds hold this stock?

Kumba is noticeably under-represented in South Africa’s leading unit trust funds. Of the five best-performing general equity funds over the last three to five years, only one – the Prudential Equity Fund – has any exposure to Kumba. Even that is a very small one, with just 0.34% of the fund invested in the counter.

In addition, only three of the top five mining and resources funds hold Kumba shares. Of those, two of them – the Nedgroup Investments Mining & Resources Fund and the Investec Commodity Fund – have decreased their exposure over the past year. The RMB Resources Fund, conversely, has grown its holding from 1.2% to 2.2% over the same period.

To see which funds are buying and selling the counter, visit Moneyweb’s UPDATED Unit Trust Portfolio Tool.

Why would an individual consider investing in this company?

Iron ore is currently one of the world’s most in-demand commodities. As a focused, iron ore-mining business, Kumba has benefited from the more than five-fold increase in the price of this resource over the last ten years.

Much of this demand stems from China, where rapid industrialisation and urbanisation have driven the need for steel. China’s appetite is such that it is also able to offset any reduction in demand from Europe. Kumba has traditionally shipped about 60% of its ore to China, 20% to Europe, and 20% to Japan and Korea. However, when demand from Europe slipped heavily in 2009, Kumba was able to redirect its exports and send 74% of its product to China.

Kumba has also shown its ability to increase production and aims to continue doing so. Production increased from 32.4m tons in 2007 to 41.9m tons last year. Given the strength of its resource base and project pipeline, analysts believe it should continue to meet its production targets.

“The big issue with any mining company as far as longevity is concerned is its ability to raise production levels through acquisitions, green fields development or brown fields development,” notes Cadiz’s Brenzel. “Kumba’s cash flow is strong enough to be able to grow the business without encumbering the balance sheet, and still pay out good dividends to shareholders.”

What risks does this company face?

Kumba has found itself at the centre of the uncertainty in which South Africa’s mining industry finds itself. The debacle around mining rights at Sishen Mine has thrown focus on the substantial challenges facing the local market.

Yet, the performance of Kumba’s share price hardly reflects great investor uneasiness. Kumba is 22% up this year, compared to the 2% drop in the share prices of the major diversified miners on the JSE, Anglo American and BHP Billiton.

“To some extent, investors are developing a thicker skin,” Brenzel believes. “Whilst there is an increased level of risk, they are compensated for this through the big dividend yield.”

Perhaps more telling is that Kumba is reliant on Transnet to rail its ore to Saldanha Bay for shipment. Any significant increase in production is therefore conditional on matching upgrades to the rail infrastructure.

“The biggest problem Kumba may face is if the local rail infrastructure can’t cope with its increased production.” Brenzel says. “Hand-in-glove with the company’s increased production schedule must be a commensurate increase in spending and infrastructural development by Transnet. In its favour, iron ore is shipped on a dedicated line.”

Transnet is already engaged in expansion activities on the Sishen-Saldanha corridor and has been in talks with Kumba and other miners with regards to creating capacity beyond 60m tons a year. There have been suggestions that a public-private partnership between Kumba and Transnet may be the required solution to ensure that a bottleneck does not form.

Where does this company’s growth potential lie?

Kumba aims to increase its annual production to 53m tons by 2013 and 70m tons by 2019. This will be achieved through a number of projects including increasing the size and depth of the Sishen Mine, new developments at Thabazimbi, and potential new mines in Limpopo and the Northern Cape.

Some analysts are however, predicting that global iron ore supply will exceed demand within the next five years. This will lead to a natural decline in iron ore prices, smaller margins for producers and lower returns on investment. Others foresee growing demand for at least the next 15 years. Which of these scenarios plays out depends very much on China.

“Stock piles in China have run quite high,” Brenzel explains. “Production of lower-grade ore by Chinese producers is contributing to that stock pile, as any price above $100 a ton attracts Chinese production. At current levels, there is a risk that stock levels will stop being built up or will even be run down.”

For more, visit Moneyweb’s click-a-company profile on Kumba Iron Ore Limited.

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