Portfolio manager’s Letter July – August 2011
As I have said before, when buying stock in Leucadia National Corporation, you are essentially exercising an act of faith, not that this is essentially alien behavior for owners of Berkshire Hathaway. However, in this case the faith you are exercising is in Ian Cumming and Joseph Steinberg instead of Warren Buffett. Though their names are not nearly as well known as Buffett’s, they have established a similar record.
Since 1978 when they founded Leucadia, Cumming and Steinberg have grown the company’s book value at annual rate of 21.5% annually. While their investment results closely match that of Buffett, their basic investment style is very different. Despite this style difference, they have run a couple of joint ventures with Berkshire Hathaway that have been successful. Leucadia generally exhibits the kind of investment behavior that Buffett shuns. They fund startups and attempt to rescue of troubled situations, and their favorite holding period is a good deal short of forever. As general rule, Leucadia’s GAAP earnings are lumpier and even more meaningless than is the case with Berkshire Hathaway.
Perhaps a good way to understand the company, then, is to take a detailed look at one of its investments, and an interesting example of Leucadia’s style is Fortescue Metals Group. In August 2006, Leucadia invested in Fortescue Metals Group, an Australian start-up iron ore mine. Leucadia invested $400 million in exchange for 264 million common shares and a $100 million 13-year unsecured note of FMG maturing in August 2019. A year later, they invested an additional $44.2 million for almost 14 million additional shares. Interest on the note is calculated at 4% of the revenue from certain mine areas, net of government royalties and a 10% Australian withholding tax.
As a result of this equity infusion, Fortescue Metals Group went around the world and raised $2.1 billion from other large investors. With this money in hand, Fortescue Metals Group dug a mine, built a gigantic ore processing facility and a train loader, bought 15 new G.E. rail engines, 976 Chinese ore cars, laid 280 kilometers of railway with a rotary train unloader which dumps ore on a two meter wide (6.56 feet) conveyor belt, a huge sorting yard, and a huge dinosaur-like ship loader on a newly built dock in a newly dredged part of the port in Port Hedland – all of this being accomplished in 21 months.
Fortescue Metals Group shipped its first ore in May 2008 and in 2010 shipped a total of 40.9 million tons, for $3.9 billion in revenue. Fortescue Metals Group has nearly completed its expansion to 55 metric tons per annum (“Mtpa”) and has announced plans to expand further to 155 Mtpa.
We all know that Buffett would never become involved in a start-up operation, and this mine was not only a start-up, but one in an industry with a lot of competition and several large and very successful international companies (BHP Billiton and Rio Tinto). Clearly, CEO Andrew Forest has done an incredible job to get this operation going.
So while it is clear that Steinberg and Cumming operate in a different world from Buffett, it is also true that there is more than one way to make a buck, and making a buck is definitely what they are doing with Fortescue Metals Group.
What can Leucadia expect to get back from their $442 million?
In the first quarter of 2010, Leucadia sold 30 million of its 264 million common shares of Fortescue Metals Group for $121.5 million or $4.03 a share against an average cost in 2006 of $1.23 per share.
Interest on their $100 million note (4% of revenue) amounted to $40.4 million in 2008, $66.1 million in 2009, and $149.3 million in 2010.
In June of this year, Fortescue Metals Group announced that Leucadia sold another 92 million shares of Fortescue for $618 million. So, to date, Leucadia’s $442 million has returned $121.5 + $40.4 + $66.1 + $149.3 + $618 or $995.3 million. Not a bad start, but as they say in the old song the “best is yet to come”.
Leucadia is still left with 4.9% of Fortescue Metals Group, worth $980 million or so, and, better yet, eight years of payments on their note. In 2010, Fortescue Metals Group produced 40 million tons of ore. For this year, it expects production to reach 55 million tons. By 2014, it expects 90 million tons on the way to a peak of 130 million tones, leaving the rather pleasant prospect (pleasant at least for Leucadia) that their $100 million note might yield and annual return in its final year somewhere north of $400 million. Of course, future results are speculative and are dependent upon the price of iron ore and, therefore, on continued demand for steel by China.
In its 2008 annual report, Fortescue Metals Group raised its estimate of liabilities under the Leucadia note from $400 million to $4 billion ensuring at least a return of 3100 percent on its note. If this does not award Leucadia the Olympian Gold Metal for most usurious $100 million note in history I certainly would be surprised.
Andrew Forrest, the CEO of Fortescue Metals Group, threatened to try to dilute Leucadia’s interest in the $100 million note, but so far this attempt has been blocked the Australian Courts. In any event, with good luck, this investment is certainly at least a ten bagger just based on the return from the note.
Fortescue Metals Group’s estimate of its total production by 2017 including mining areas not covered by the $100 million note runs to 355 Mtpa.
With Leucadia’s remaining stock position worth just short of $1 billion when this year’s production is valued at 55 Mtpa it leaves us with the thought that perhaps the stock’s value will eventually equal some mid-single digit multiple of today’s value. There are of course great uncertainties. For example, can Fortescue Metals Group introduce 355 Mtpa of new production into the world market without having some impact on market prices? In addition, I, as investment manager, think it likely that China will experience economic problems in the not too distant future, and that the extent and duration of these problem is pretty much impossible to predict.
Yet, Jeremy Grantham says that commodities have entered a “new normal” and if he is correct, any successful investment program will need an effective way to hedge the rise in commodity prices. With Fortescue Metals Group, it seems that Leucadia does indeed own a successful commodity hedge.
With Leucadia’s present total market capitalization at $8.4 billion it may be that Mr. Market is currently not only undervaluing its interest in Fortescue Metals Group but he may be offering the rest of Leucadia for nothing. In any event Fortescue does present a good example of why, even though Cumming’s and Steinberg’s style is very different from that of Buffett, it can still be successful.