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FMG – the sought after coin toss

Gullible young journalists often were sent on wild goose chases, to the mirth of the senior colleagues. Errands like go buy tomorrow’s newspaper today. An oldie but a goodie, as pranks go.

Much of tomorrow’s news is created by the noise of 280 Twitter character messages. Portents of those market messages are sometimes very readable today.

Australia’s current account deficit, for instance is the smallest it has been as a share of the economy since the 1970s and the trade surplus is near the largest it has been since the 1950s. The RBA says the current strength in Australia’s balance of payments is at risk because of threats to the world trade system.

And that message is being hammered home at 1600 Pennsylvania Avenue Washington. It’s not just the American economy but the global economy stupid, to paraphrase a former “I didn’t inhale”, Democrat president.

Australia’s trade story is based around resources, education, tourism and agriculture. And pessimistic observations are in a worst case scenario, Australia’s GDP growth could fall 50%. If China reduces significantly its demand for our exports.

A prolonged trade war could significantly shift those surging trade surpluses.

At the mine face, major Australian iron producers like FMG have put their finger to the trade wind with no significant production cuts expected to its 170 million tonne annual production. In its FY 19 results this week FMG said China’s iron ore stock pile had fallen from a peak 163 million tonnes to 118 million tons. China steel production was up just over 9% in the first half of this year. 

Chinese steels mill generally buy on a one month time lag. Recent iron price falls are yet to kick in.  Mill profitability it’s a safe bet will improve at current lower prices. And stockpile tonnages are likely to increase as China’s local infrastructure stimulus continues to kick in.

If longer run ore prices fall back from around $80 a tonne  to $65 a tonne, FMG’s earnings will be impacted. EBITDA estimates for FY20E are reduced by 15% to $6.0bn and FY21E by 5% to $4.0bn.

In these circumstances FMG could sustain a ~70% payout ratio for a potential div yield of 13.7% (div of A$1.04). But dividend payout could drop to around 60% in FY21E for a dividend yield of 7.1% (div of a$0.52).

So, unless you are a doomsday prepper, FMG remains a hugely valuable cash generative machine. Particularly at zero interest rates. And trading on a very reasonable prospective P/E ratio of about 8x. Tell me you can find that valuation/ dividend in the Australian banks.

What seems to be different this time, compared to the last iron ore price meltdown to $50 a tonne, is all three major Australian seaborne producers, relentlessly drove down production costs. FMG’s C1 cost is expected to be around $USD 13.25 a wet metric tonne – just behind BHP’s $US12.90.

FMG believes net debt of $2.1billion is about optimal and it won’t sit on cash it does not need. So, on the flip side if iron prices stabilize the dividend payout ratio remains high.  In FY19 FMG generated EBITDA of US$39/dmt of iron ore sold compared to a 5-year average of $25/dmt. And FMG believes it can sustain over time an average EBITDA level of around $25/dmt. Which gives us some comfort around dividend assumptions.

My target price assumption for FMG has dropped to around $8.00 from $9 plus previously. But with the current confusion between risk and uncertainty I think FMG gives us our most sought after coin-toss odds. Heads, I win; tails, I don’t lose much.

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