28/11/2013 - 10:28

Forging ahead or overreach?

28/11/2013 - 10:28


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It’s too early to pass judgement in the case of Forge Group’s troubles, but the signs aren’t encouraging.

Forging ahead or overreach?

Just a couple of months ago I was wondering if Clough would rue the day it had sold out of Forge Group, or whether it had been smart to exit this stock at the top of the market while avoiding unmanageable risks.

A clash of cultures, I was told, had led to Clough’s move. It did not have enough shares to dictate the play at Forge and found that its way of doing business was different to that of its associate.

A few months ago, Forge shares hit a six-month high on news that a joint venture it was involved in had won a major contract on Gina Rinehart’s Roy Hill project.

With many resources projects’ construction phase winding down, big contracts that guarantee large slabs of ongoing work are harder to come by; so the market was obviously buoyed by Forge’s win, and it looked as if Clough might have missed out, even though it sold down at a better price earlier in the year.

But two months after that Roy Hill win, Forge went into a 24-day trading halt from which it emerged today.

It appears that Forge might have some explaining to do as it faces up to accounting for some earlier deals that, apparently, have soured, or at the very least not lived up to expectations.

As the trading halt dragged on it became more obvious that Forge had a very complicated situation that could not easily be solved by management.

If, as seems likely, the Forge story turns from one of contract-winning growth to yet another rapid expansion gone wrong – with contract write-downs and an expensive capital raising, as was the speculation, averted by a debt deal which will no doubt come with its own high costs – then questions will be asked of anyone who was in a position to know what was taking place, or should have.

The market spoke early, knocking 85 per cent off Forge’s pre-trading-halt price, but we will have to wait a little longer to see what the longer term view of investors.

As most readers would know, I am not particularly quick to pull the blame trigger because we all have experience of situations that rapidly alter. Nevertheless, there will be answers sought from past and present management, directors and even the auditors.

I suspect the first place investors are going to look is at management. Oddly, in the case of Forge, none of the senior management highlighted in the accounts had been there for a full 12 months at June 30, so there is potential for such a new team to miss things as they learn about the business.

Then again, each of the senior managers achieved 100 per cent of their possible performance bonus – and it was not insignificant. All but one achieved at least 30 per cent of their remuneration via performance-related cash bonuses, which totalled nearly $750,000 between the team that was there on June 30, and more than $1.5 million when you include managing director David Simpson’s $800,000.

Given the furore around remuneration reports, you have to wonder what might have been if the current troubles had been public before Forge’s annual meeting, held a fortnight prior to the trading halt.

I will leave my judgement until we have heard more, but it looks like Clough’s decision was prescient.

(Note: this column was written earlier in the week but has been amended slightly to recognise post-trading-halt events)

Mineral Resources

Meanwhile, over in Applecross, a very different story is unfolding. My sources suggest the board and management of Mineral Resources was unusually forthcoming about its strategy in these uncertain times.

Mineral Resources is an unusual beast. It is both a mining company and a mining services company, having assets in own right but also skilled at running other companies’ mines, setting up camps or operating bits of infrastructure, especially in the Pilbara.

Hybrid models such as this are not usually welcomed by the investment community but Mineral Resources’ size, strategy and the big stakes held by founding shareholders mean it has had less need to impress distant institutions, which don’t generally like such mixed-investment stories.

Even though the company is getting bigger, it is using free cash to fund expansion rather than turning to more fickle markets that might not understand its business model or easily fit it into a big portfolio.

From what I can see, Mineral Resources is applying its mining skills to negotiate strong service contracts for relatively small and isolated assets that are valuable on paper due to the price, but are hard to get under way in this capital-constrained world.

Mineral Resources is doing deals where the asset owners can monetise resources that might otherwise be left in the ground by selling ore that Mineral Resources mines to Mineral Resources at the mine gate.

Mineral Resources is banking on its own mining capability, plus economies of scale generated by multiple deals, to profit from pockets of ore that might otherwise have been put in the too-hard basket.

In the current market, that gives Mineral Resources a position of strength in negotiations, which at least offers the owners of these assets the chance to get something from them at a time when the world outlook is uncertain but iron ore prices have remained surprisingly high.

Of course, investors at both ends of these deals want to be reassured there isn’t too much risk involved. I gather that is a strong selling point for the way Mineral Resources puts its deals together.

In its February announcement of a deal with Iron Ore Holdings (which has been delayed due to heritage issues), Mineral Resources said the key elements of the arrangement were “structured in a manner that provides appropriate protection to the parties against the risk of adverse operational and economic conditions whilst ensuring the parties also share in the upside from fluctuations in iron ore prices”.

Furthermore, Mineral Resources managing director Chris Ellison said the deal provided the opportunity for both companies to work to their strengths.

This is a very particular strategy that could, I suspect, only have been created by circumstances particular to Western Australia.

Here, the entrepreneurial spirit has been set free in a big mining province governed by well-understood laws that provide the flexibility for the business people to decide the risk and reward they want.


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