Once-mighty Citic Pacific was almost destroyed by a currency-hedging scandal in 2008. Today, the Chinese conglomerate is again caught up in crisis as it pours cash into the much-delayed Sino Iron mining project in Western Australia, a black hole that has swallowed over $10 billion to date.
The iron ore mine in the Pilbara region is the biggest single investment in Australia by China Inc. and is expected to be the world’s largest source of magnetite, a lower-grade iron ore.
The project was beset by problems from the moment Citic Pacific, majority-owned by state-run Citic Group, paid an initial 415 million Australian dollars ($374 million) for the mining rights in 2006. It became the first in a string of problematic investments in Australia that were designed to reduce China’s reliance on the “big three” of the iron ore trade: BHP Billiton and Rio Tinto, the two Anglo-Australian giants, and Brazil’s Vale.
There have been instances when Chinese companies overpaid, such as Sinosteel buying Midwest Corporation for A$1.4 billion at the top of the market in 2008. And then there were the failed deals, such as Aluminum Corporation of China’s $19.5 billion bid to double its stake in Rio Tinto.
But the Sino Iron project is by far the costliest, and a lesson in why investors should be wary of companies ultimately controlled by the Chinese government, where corporate strategies are often swayed by national interest.
Citic Pacific announced on Feb. 20 that losses at Sino Iron, one of three core businesses along with specialty steel and Chinese real estate, doubled to 1.6 billion Hong Kong dollars ($206 million) in 2013. The mine finally made its first shipment on Dec. 2 last year, four and half years behind schedule, but only one of the six 4-million-ton-a-year production lines is in operation. The others will not be completed until 2016.
The Hong Kong-listed company had never mined iron ore before and ran into unforeseen cultural issues with Australian management and regulatory hurdles, including stringent labor laws. The main contractor, China Metallurgical Group Corporation also had no Australian experience and was surprised to find out it could not bring over thousands of Chinese laborers to work on the project.
Citic Pacific also has a long-running legal dispute with Australian billionaire and member of parliament Clive Palmer over royalty payments, as well as the asbestos that has been detected at the site.
“The ironic fact is that in meeting the major milestone of the first export shipment, our company’s financial results will suffer in the short term,” said Chang Zhenming, Citic Pacific’s chairman. “I want to prepare you for these realities,” he confessed at last month’s results announcement.
He also told the company’s long-suffering shareholders that as of Dec. 31 last year, the company had invested $9.9 billion and counting, compared with an original budget of $2.47 billion.
The growing consensus among analysts is that the mine may never be economically viable. The spot price of iron ore has dropped almost 20% since the start of the year — it peaked at about $190 per ton in February 2011 — and plunged as low as $104.70 on March 10.
Citigroup analysts said in a Feb. 20 note that it might settle at $90 within two years. Hundreds of millions of tons of new production is coming on line just as Chinese growth is slowing and over-capacity in its steel industry is being tackled. It is exactly the wrong time to be ramping up production on a high-cost mine for low-grade iron ore. Tim Murray, managing director at Beijing-based research firm J. Capital Research, calculates that Sino Iron can only cover its interest bills even if the price of iron ore recovers to $120 per ton.
“We do not see any scenario where the iron ore division can make a profit let alone repay debt,” Murray said.
Citic Pacific’s only forecast on cost is that it will remain “high” until the mine is in full production, at least three years hence.
The scale of the cost and schedule overrun has so shocked Beijing officials that instead of leading the way for a new generation of Chinese producers in the region, Sino Iron is among the disastrous deals that have made the government more cautious about state-owned companies investing abroad. Last year, the State-owned Assets Supervision and Administration Commission of the State Council started a much stricter vetting process for these investments.
The failure of China to establish any substantial iron ore mining presence in Australia has seen Beijing re-focus on its domestic mines. It has encouraged large steel mills to take over highly fragmented, local iron ore mines in an effort to cut costs and raise efficiency. This strategy was stepped up this month when state-run Ansteel Mining announced that it would consolidate a number of mines. “This marks a strategy for our country to break our reliance on imported ore, and to support the transformation of our steel industry for international competitiveness,” the Metallurgical Mines Association of China said in a statement.
Citic Pacific’s share price has recovered from a low of 7.90 Hong Kong dollars in June last year to trade above 10 Hong Kong dollars, lifted by a 9% increase in its full-year net profit. The improvement was propped up by asset sales and a 519% rise in profit from its specialty steel division, and the good news is likely to be just a blip, according to analysts.
“We believe it requires something of a leap of faith to see significant value creation,” Citigroup said last month, cutting the company’s target share price from 7 Hong Kong dollars to 6 Hong Kong dollars. In November, credit rating agency Moody’s further downgraded Citic Pacific’s junk-bond level debt from “Baa1” to “Baa2” because of “lingering risks associated with the company’s Sino Iron project.”
Shareholders who heed their bearish views may want to cash in while they can.
This story was originally published at asia.nikkei.com, 25 March 2014