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The China Call Option

Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window.

For Fortescue Mining (FMG), the future as Donald Rumsfeld put it – is more about the ‘known knowns than the unknown unknowns’ of reverse driving on a dark night.

The latest half year result sheeted home the fact, that the company is well on the way to achieving its targeted expansion of 155 million tonnes per annum of iron ore production, with a production run rate of 8.5 mln tonnes shipped in December alone.

The fact is FMG is an Australian dollar denominated call option on China. And there are plenty of China bears preaching to a diminished audience that the GDP growth days of the Middle Kingdom are behind it. ‘Collapse is imminent’ seems to be their enduring message. That call is fading fast.

There is plenty of data to suggest China’s demand for steel has not reached saturation point. China’s new politburo is committed to steady GDP growth of 7% pa. Urbanisation and infrastructure will continue to drive demand particularly as the Chinese consumer steps up to the plate.  China’s steel intensity use as measured against other Asian and Western nations, believe it or not, is still well below its peers – Japan, Taiwan and Korea.

China’s growth profile will always have attached volatility, and particularly in FMG’s case, with single commodity exposure. But the performance of the iron ore price has significantly confounded consensus forecasts of a 2013 run average of $120 -130 a tonne.  Currently around $150 a tonne, the price is not showing any signs of pegging back. In fact, it is forming a new base at these higher levels which has had some China bulls forecasting prices of $200 plus a tonne.

Similarly, I don’t think we are going to see iron prices trading well under $100 a tonne. Unless of course there is a calamitous world event – in which case it is last man switch off the lights, please.

FMG’s operating cost is just $50 a tonne. This will fall over time.

And as FMG’s debt to equity levels fall from around 60% to 30% over the next couple of years, while it refinances $5 billion of debt, either through the sale of infrastructure assets or through repayment from the growing cash mountain,  the operating margin will fall to the bottom line and hopefully directly into shareholders pockets, through higher dividends. In the December half, FMG delivered EBITDA of $US1.1 billion and a net profit of $US 478 million

FMG has yet to formulate a policy on a set dividend payout ratio. But the company is acutely aware of the need to attract sticky investment money like that from SMSF’s. So, do not be surprised to see FMG potentially paying a fully franked 5% dividend to shareholders, potentially by 2014-15.

Australian investors generally will be the last to the FMG party. There is an enduring disbelief (tall poppy syndrome if you like) attached to FMG’s success.  In the interim, expect to see European and American investors take up the slack in FMG’s share price as it trades under $5.00.

As FMG has developed (deservedly) the reputation as the third force in Australian iron ore industry it will, in my view, become the first force in resources delivering annual returns to its shareholders which will put its competitors to shame.

An optimistic view is in trying to predict the future, and in doing so, does sometimes help create the future.

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