Fortescue: Coming up short?

When Jim Chanos speaks, people listen. This time, he has Fortescue in his sights

a woman

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Fortescue Metals Group Limited (ASX: FMG) has been on the Foolish radar for a while.  We first covered in a controversial article on 24 October 2011 and a follow up on 15 February 2012, and highlighted the huge capital raising Fortescue was pursuing soon after.

The crux of our review was that based on analysis and comments from renowned hedge fund manager Jim Chanos, Fortescue exhibits a worrying number of signs of potentially being a value trap.

It was no surprise when it was reported today that Chanos is 'short' FMG.  This means that he has sold FMG shares, and expects to profit by buying back the same shares at a lower price if shares in the company fall.

A shopping list of concerns

Writing on the Fairfax website BusinessDay, Michael Evans reported that Chanos recently presented to a private investment forum, and was scathing of the company. Chanos reportedly called Fortescue shares a "value trap" and that shares will fall "materially".

As well as expressing concerns that the company has a "somewhat promotional management team", he expressed concern about Fortescue's business model, citing earnings before interest, tax and depreciation, or EBITDA, of $2.8b but with a capital expenditure program of $1.5b and increasing. Chanos also cited a balance sheet with more than $6b in debt — becoming even more concerning when any reversion to the mean for iron ore prices will dramatically impact FMG's ability to service its debt, and to maintain its capex program.

Not content to stop there, Jim Chanos noted his concerns including cost inflation in the Pilbara, shortages in staff and accommodation and the impact of the strong Australian currency to round out his 'bear' case on the company.

Lastly, Fortescue also runs the risk of being an architect of its own decline, with its capacity expansion playing a role in an oversupply of iron ore which would depress prices.

Litigious Company

Fortescue is certainly keeping its lawyers happy.  The well-publicised (and perhaps somewhat promotional) stoush with Canberra on the mining tax — replete with the threat of a High Court challenge — is just one of many high profile court cases making the headlines.

These cases include an action from ASIC alleging misleading and lack of disclosure by Fortescue, shipping disputes a few years back, and a current dispute with Leucadia.

In addition to these court cases, we are also well acquainted with Andrew Forrest's very public stoush with Wayne Swan.

In general, we attempt to keep away from litigious companies, as more often than not, legal disputes usually take up a significant proportion of management time and resources better spent on running the business.  We also prefer management with the consistent ability to settle disputes without resort to the courts.

Unless, of course, such companies are called IMF Australia Limited (ASX:IMF).

Foolish takeaway

Aside from his views on Fortescue, we found it very interesting that Chanos is 'long' BHP Billiton (ASX: BHP), meaning that he has bought BHP shares in the expectation that BHP will continue to do well.  In his own words: "BHP is a much more stable company. They see the cycle more than others do, they've been through it more than others have and it's been an interesting hedge for those that play it that way."

The ASX is already on the move in 2012, and Goldman Sachs experts recently said they reckon S&P/ASX 200 could top 5,000 next year. Read This Before The Coming Market Rally is a must-read for investors who don't want to miss out on the party. Click here now to request your free copy, before it's too late

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Motley Fool contributor Peter Phan owns shares in IMF. Take Stock is The Motley Fool Australia's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691).

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