Iron Ore – all roads, presently lead to Rome. Long term price upgrade forecasts are thicker than flies on a billy goat’s bum. Supply side constraints continue with Vale’s dams and Pilbara production now impacted by cyclones. Chinese steel mills producing record tonnages. The Federal Government is relying on bigger royalty payments to skip the deficit to surplus. FMG plans to spend $3.7 billion on a new mine which will ship 22 million tonnes of high premium earning magnetite to those steelmakers.
The outcome is the same – many different ways to get to the destination. The first step was our call some 18 months ago that resource majors were undervalued. The clarion call was last year when FMG was trading around the $4 mark and the company was undertaking a $500 million buyback. The share price is now bumping up against $8.00 and the announcement of the joint venture Iron Bridge mine means FMG in the future is less hostage to any price discounts on the standard 62% ore index for its normal 58% grade ore production. It is a company changer, in a long series of FMG improvements driven by management.
Iron Bridge will produce 67% content across a total production profile of 190 million tonnes, and FMG has moved quickly to escape the discount clutches by improving quality of its offering – a new 60 per cent blend called West Pilbara Fines (WPF). Iron Bridge will be fully integrated into the existing production and logistics footprint and when the discount closes up FMG can pump out as much direct ship hematite (DSO) as it can, and ship Iron Bridge’s 22mtpa as a discreet, premium option. Higher grade ore prices have been more stable than the 62% Fe bench mark price. Premium for the 65% price over the 62% price has averaged US$21/t (38% premium) since 2015.
If the quality discount hurts then Fortescue can blend all of its Iron Bridge entitlement with the direct ship ore (DSO). That would see more than 50 per cent of Fortescue’s portfolio sift through the 60 per cent grade level.
FMG’s current basket price, using current spot price, of around US$75/dmt (dry metric tonne), gives some idea of the inherent leverage in FMG’s business model. If those spot prices were to become the forever norm they generate an NPV ~A$20/share. The reality is FMG’s share price is currently factoring in a long-term realized price of <US$45/dmt. Although this assumption benefits from the current weakness in the A$/US$ and low shipping rates.
Iron Bridge has reserves of 716mt which underpins a mine life of more than 10 years. FMG will own 88% of Iron Bridge and funding its share of the project will see net debt/equity over the next two years increase from around 21% to just under 40%. Earnings per share are likely in the short term to be impacted by the higher debt load. It is possible FMG may lessen the burden by issuing a renounceable rights issue to the tune of around $500 million to fund Iron Bridge.
EBITDA forecast for the FY 20 year is around $4.4 billion suggesting earnings per share of 93 cents and a price earnings multiple of 8x. Dividend payout could be as much as 75 cents – a forecast yield of just under 10%.
FMG management has demonstrated discipline in paying down, and refinancing debt when opportunities prevail. And while Iron Bridge will be a short term drag on earnings as it gets into full development, the ore body significantly increases reserves and gives FMG much greater flexibility in dealing with the volatility of the iron ore price.
The FMG share price certainly has broken out. And a short term target is at least $8.30. For those prepared to ride out the China vagaries and iron ore price volatility, I think there is significant upside above this price. For those who bought in off the back of our suggested purchase at $4 a share, I think, if you start to see something approaching $9, it may be prudent to take profits
This is not a set and forget market.