Description

Recent new iron ore supply has caused the price to fall from a peak of $180 to $60. Slower demand for steel in China has hit demand. Iron ore futures are pricing $40 by late 2018. Against this backdrop the Street is bearish on Fortescue Metals (ticker: FMG AU), a $10.2b USD market cap pure-play iron ore miner with operations in Australia’s Pilbara. Of the analysts that cover the company only a few rate it buy.  First I’ll describe the structure of the iron ore industry and why it is a decent business. Then I’ll review the long investment thesis for Fortescue. FMG AU may be worth up to AUD $8.50 over the next two years based on 10x P/E and 6x EV/EBITDA as long as iron ore prices remain above $50 vs current $60 spot price.

Iron Ore Industry Structure

• Iron ore is more of a logistics and scale operation than a mining operation. The business involves moving dirt with high iron ore content ~55-65% from an open-pit mine to the steel mill. The Pilbara in Australia (BHP, RIO, and FMG’s mines) and Vale’s Brazilian operations are the only places in the world where the iron ore content is 55-65% and can be shoveled straight into a blast furnace. Other iron ore mines exist in the US, Canada, China, India, etc, but the iron ore grade is much lower, in the 10-40% range, so the iron ore needs to be processed through an upgrading mill which adds significant cost. This cost structure results in low cost industry players (BHP, RIO, VALE, and FMG) with all-in-cash breakeven including maintenance capex of $25-30/ton and the rest of the industry with $50-60/ton costs.

   

• The four majors control about 72% of seaborne iron ore supply with RIO at 23% share, VALE 22%, BHP 16% and FMG 11%. Each of the four majors generates the bulk of their earnings and FCF from iron ore so they all care about maintaining adequate margins, despite the sell side narrative about the companies pursuing market share over margins over the last few years. BHP generates ~50% of earnings from iron ore, RIO ~80%, VALE ~90%, and FMG 100%. When iron ore prices increased from $20/ton in 2005 to $180/ton in 2011, the majors expanded their operations to meet increased demand from China. Also several new high cost mines opened, incentivized by high iron ore prices. The new supply has virtually all come online already with only 2-3% supply growth this year and 0-3% next year vs 7-10% annually for the last 3 years. In the last 1-2 years, high cost mines in China have been shut and replaced by low cost Pilbara mines which drove iron ore from over $100 down to $60 where it is today. But the low cost mines only supply 72% of seaborne supply, the remaining 28% of the market need $50-60 iron ore prices to incentivize production which may result in a more stable iron ore price than consensus expects.   

• There are significant barriers to entry in creating a scale operation in a low cost region including securing land rights and ~$15b of capex. Once mining operations are built in the low cost region, there is low maintenance capex and a virtually endless resource base unlike most commodities where mines deplete. These characteristics make low cost iron ore mines strong free cash flow generators and high quality assets. The best way to show the value of a low cost iron ore mine is to look at RIO and BHP’s FCF generation and share performance during the 1970s-2005 when iron ore was flat at $12-20/ton. RIO generated a 12% CAGR for shareholders over the 17 years from 1988-2005 with positive FCF each year. Likewise, BHP generated a 13% CAGR over the 30 years from 1975-2005 with positive FCF in virtually every year. This is much better than the 6-8% CAGR generated by big oil companies like Shell and Exxon over that same period. BHP and RIO generated these attractive returns for shareholders while iron ore prices were flat for 30 years because of the strong FCF characteristics of a low cost iron ore mining operation.

Indications the majors are being more disciplined

• FMG and VALE announced a JV to blend their iron ore at Chinese ports in order to receive better realized prices. The cooperation of the #3 and #4 players is a good sign that the industry is working together and unlikely

   

• It has been suggested that VALE, RIO, and BHP increased production in order to bankrupt FMG before they could complete their Pilbara mine. FMG’s net debt peaked in June 2013 at $10.5b, but the company has since fully ramped its mine and significantly deleveraged the balance sheet to $5.2b vs $2.5b of annual FCF. The majors have accepted that FMG is here to stay.

   

• VALE, RIO, and BHP each announced slight production guidance reductions after 1Q results even though iron ore prices were in the $50s and their costs are in the $25-30/ton range. This indicates that the majors are maximizing margin over volume. When the companies reported 2Q results, their production missed estimates which is supportive of a stable iron ore price environment.

   

• There may have been management changes for the leaders of the iron ore divisions at BHP and RIO which might be driving a new found volume discipline.

Fortescue Long Thesis

• FCF is coming back to shareholders. FMG is a low cost ($28 breakeven) iron ore pure-play with operations in the Pilbara in Australia. The company is entering cash harvest phase after spending $15b of capex between 2011-2014 to ramp its mines. In a $50 iron ore price, the company generates AUD $1.22/share of FCF, a 25% FCF yield to equity. FCF generation has first gone to deleveraging the balance sheet with net debt falling from a peak of $10.5b to $5.2b at June 30th, 2016 and is now approaching the board’s target leverage of 40% gross gearing ratio. Going forward, the strong free cash flow will likely be returned to shareholders via a significantly increased dividend. Assuming a $50 iron ore price vs $60 spot and a 40% net income payout ratio, FMG can pay AUD $0.33/share, a 7% dividend yield at today’s price vs current dividend of 1.5%. FCF is about $0.40/share higher than net income because capex < D&A. Thus even with a $0.33/share dividend, FMG will retain $0.89/share of FCF to continue to deleverage.

   

• Valuation. At $50 iron ore price, FMG trades at 5.0x P/E, 3.2x EV/EBITDA, 30% FCF yield to equity, and 26% FCF yield to EV on 2017 earnings. Using 10x P/E and 6x EV/EBITDA which is a long-term average for mining companies including pre-crisis (also a discount to BHP, RIO, and VALE peers at 7x EV/EBITDA and 23x P/E), I estimate FMG’s fair value is AUD $8.50 at a $50 iron ore price (spot $58.08). A $10 change in long-term iron ore price drives a $4.00 change in the fair value. At $40 iron ore, FMG is worth $4.50 and at $60 iron ore, FMG is worth $12.50.

Risks: Global slowdown, especially China, impacts iron ore demand negatively. Unexpected increase in supply. This is a mining stock and leverages to changes in iron ore will dramatically impact the value of the equity.

Catalyst

Street begins to accept that iron or prices have stablized. If iron ore remains above $50, FMG generates significant FCF and street EPS and EBITDA estimates will move higher.

• FMG’s board may authorize a dividend increase in the next 3-6 months. The company indicates that once FMG reaches a 40% net gearing, the board will re-evaluate the dividend policy. FMG’s net gearing fell below the 40% target as of June 30th, 2016 so I expect a dividend increase soon.

   

• US steel companies like X, CLF are breaking out which lends support to undervalued iron ore names continuing to work.