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Sep 18, 2012

Fortescue: the prophet and the loss

The disaster unfolding at Fortescue, and the desperate attempt by billionaire Andrew "Twiggy" Forrest to cling on to his fortune prove again that when Jim Chanos says something, it’s worth listening.

Adam Schwab — Business director and commentator

Adam Schwab

Business director and commentator

The disaster unfolding at Fortescue, and the desperate attempt by billionaire Andrew “Twiggy” Forrest to cling on to his fortune prove again that when Jim Chanos says something, it’s worth listening. Chanos is the founder and president of short-selling hedge fund Kynikos Associates — and he has again proved that he is far smarter than billionaires and over-paid, bumbling executives.

Chanos is most famous for being instrumental in predicting and telling the world (through his relationship with Fortune’s Bethany McLean) about the impending collapse of Enron. Chanos also famously shorted Tyco before its share price collapsed, and as a 26-year-old, controversially exposed then Wall Street darling, Baldwin-United (which would soon file a then-record $US9 billion bankruptcy).

But Chanos also appears to have a close interest in Australia — with the world’s most famous hedge fund short correctly forecasting the share price collapsed of Forrest’s Fortescue and in 2007 of the once-mighty Macquarie Bank.

In 2007, before the global financial crisis, Macquarie Bank, under the guidance of the famed Allan Moss, was riding high. Its share price peaked in early 2007 at $98 and its model of creating, housing and spinning infrastructure assets spawned a raft of copycats such as Babcock & Brown and Allco. But while Australians fawned at Macquarie’s seemingly inevitable ability to create money (it was dubbed the “Millionaire’s Factory” by Stephen Mayne), Chanos saw through the mirage and dubbed Macquarie as his preferred “short” out of any business worldwide.

In 2007 Chanos observed that Macquarie’s “underlying economics … are flawed. Being the top bidder for these assets and then flipping them into the trusts leads to an unsustainable economic engine at the trust level. And when that breaks down all of the fees and whatever’s being paid begin to break down.”

Macquarie hit back at Chanos (still on its website) with a raft of laughable claims, which of course were later proved wrong. Moss also fired back, lecturing Chanos that:

“[Macquarie’s] business is a lot more than infrastructure and real estate, although infrastructure and real estate are very important … [What are Macquarie’s businesses?] Well, they’re tollways. How bad does it have to be, really, before the people in this room get on the bus? How bad does it really have to be in economic terms before you cut down on water?”

Moss would soon depart from Macquarie, selling most of his shares and leaving with an estimated $80 million in wealth (as well as tens of millions in remuneration from prior years). But while Macquarie’s allegedly star employees collected billions in remuneration, five years later, Macquarie investors have seen the value of their holding drop by almost 70%. It appears that the only people to make money out of Macquarie were Jim Chanos and the bank’s grotesquely overpaid executives.

Not long after his percipient Macquarie prediction, in 2010, as commodity prices continuing their ascent to record levels, Chanos bucked the trend and forecast that China’s glorious run of growth would slow. Chanos noted that:

“China has embarked on a capital-spending bubble the likes of which the world has never seen … buildings are going up with no tenants, roads are built with no traffic, shopping centres are built with no tenants or customers, yet they continue to be built and they continue to be planned … China is Dubai times 1000, if not a million … at some point, all of this (ill-advised) investment will come home to roost.”

Chanos’ China prognosis would also prove accurate, as the nation’s leaders struggle to continue its economic mirage and asset prices continue to plummet despite widespread consumer price inflation.

The China warning would transpose to a company more reliant on China’s continued boom than anything for its continued survival. In April 2012, Chanos turned his attention to Fortescue, in what appears to be an eerily accurate prediction, Chanos noted that Fortescue had:

“… about $2.8 billion in EBITDA (earnings before interest, tax, depreciation and amortisation) but it’s got a capex (capital expenditure) program last year of $1.5 billion, and it’s going up … increasingly, with any kind of reversion to the mean of iron ore prices to $US100 per tonne or less, we’re going to see a dramatically lower ability to service the debt and to service the capital programs they have. And a stock price materially lower than it is today.”

Like Macquarie’s Moss, Forrest would take aim at Chanos, accusing him of having a short position in Fortescue and claiming that “we have seen China defy its sceptics by doing just what it said it would do. It has already delivered its 12th five-year plan despite the smoke in the background from global economies.”

At the time of Chanos’ comments, Fortescue’s share price was about $6 — merely five months later and Fortescue shares are less than half that amount, closing at $2.99 last week.

Forrest’s judgment appears even more flawed given that the billionaire spent more than $135 million in June of his own money purchasing Fortescue shares in a ham-fisted attempt to flush out shorts such as Chanos. Forrest’s ploy doesn’t appear to have worked, with the collapsing iron ore price rendering his frantic buying futile and very costly.

In a further vindication of Chanos’ views, last week Fortescue is understood to be desperately attempting to have lending covenants waived on its $9 billion in bank debt and the stock is currently in a trading halt after losing a further $1.5 billion in value.

If one thing can be learnt: when Chanos says something about a company, it’s far more likely to be correct than the desperate retorts of self-interested executives.

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