Faith and Fortescue Metals
Board: Berkshire Hathaway
As several people here have said, when buying stock in Leucadia Corp., 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 these 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 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.
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. 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 went around the world and raised $2.1 billion from other large investors. With this money in hand, Fortescue 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 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 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.
What can Leucadia expect to get back from their $442 million?
In the first quarter of 2010, Leucadia sold 30 million shares of Fortescue for $121.5 million or $4.03 a share against an average cost of $1.23.
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 announced 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, worth $980 million or so, and, better yet, eight years of payments on their note. In 2010, Fortescue produced 40 million ton 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 $480 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.
Andrew Forrest, the CEO of Fortescue, 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 could turn into a ten-bagger, and it does offer 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.