Is this as good as it gets for this ASX mining behemoth?

Second-best profit on record at US$6.2 billion, analyst beating numbers, and a better-than-expected dividend. And it’s a good thing, too. Increasing concerns about the Chinese property sector and the demand for steel, central banks trying to engineer an economic slowdown, and falling commodity prices all have the potential to weigh on the share price moving forward. 

I’m speaking, of course, of iron ore behemoth, Fortescue Metals Group (ASX: FMG). In this wire, I sat down with Sean Fenton from Sage Capital, who suggests this could be as good as gets for FMG. Also, strap yourself in for his outlook on the broader market. 

"We're pretty cautious on iron ore, and that's probably going to be the biggest driver going forward. There's a fair bit of uncertainty at the moment," said Fenton

Fortescue Metals Group (FMG) FY22 KEY RESULTS

• Revenues down 22% to US$17.39 billion
• Net profit down 40%, US$6.20 billion
• Underlying EBITDA of US$10.6 billion
• Cash on the balance sheet of US$5.2 billion
• Capital expenditure (CAPEX) US$2.7-3.1 billion
• Interim dividend of 121 cps, down 43%
• Earnings per share of US$2.01
• FY23 guidance of 187-192mt of iron ore shipments

Note: This interview took place on Monday 29th August 2022. Sage Capital does not hold Fortescue in its portfolios. To learn more about the Sage Capital Equity Plus fund, click the link below: 

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What were the key takeaways from this result? What surprised you the most?

The key takeaway is that the businesses humming along quite well. 

They've been at their current production rate for years and they're steadily replacing reserves. Iron Bridge is getting pretty close to production now, and there have been some blowouts along the way - I guess that's out of the way now so there's no further CAPEX required there and they'll start to come online and we'll see some higher grade iron ore over the next few years. 

Other than that, the results are pretty much in line in terms of what we expected and what we already knew about, i.e. realised prices, discounts to benchmark, production, and everything else. So, a pretty solid operating performance.

Boring is good in some ways.

What was the market’s reaction to this result? Was this an overreaction, an under reaction or appropriate?

It's about right when you consider the big move down in the US overnight. And at the end of the day, the stock at the moment is much more like a futures contract for the iron ore price. Given its solid, underlying operating performance, it's not surprising too much in terms of production or costs. There are always question marks over the CAPEX and the amount of investment being directed to future industries, but this is really just about market risk appetite and the iron ore price, and both of those were quite weak over the weekend. It's actually holding up pretty well, trading pretty much in line with BHP and RIO.

Would you buy, hold or sell FMG on the back of these results?

Rating: Sell

We're pretty cautious on iron ore, and that's probably going to be the biggest driver going forward. There's a fair bit of uncertainty at the moment. Clearly, Fortescue’s profit was down a lot from last year. That's simply because the iron ore price has fallen and the discounts on the low-grade iron ore that they produce have widened over the year.

If anything, we expect that'll continue.

What’s your outlook on FMG and its sector over FY23?

If you look at the fundamentals of iron ore in terms of demand, you've got a huge chunk of it from Chinese property and fixed asset investment. Infrastructure investment's another big part of that, and steel also goes into global manufacturing. And of those, the Chinese property market's in pretty dire straits, with developers pretty much all insolvent, land sales, property sales, all down 40% plus year over year, and basically, with the developers all being insolvent it's hard to see property demand not being under pressure. They're stepping up some infrastructure investment, but funded by local governments who are under funding pressure, and it doesn't seem to be enough to really move the dial. And, of course, the global manufacturing cycle is rolling over with central banks all tightening rates. 

Absent some major supply disruption as we saw with Vale a couple of years ago, then it looks like it's heading further south to us. 

But it seems that the market is pricing in expectations that China's going to come in and stimulate far more aggressively than they have been, so the market's actually priced for good news. We actually see downside risk to most of the iron ore stocks from here.

Are there any risks to this company and its sector that investors should be aware of given the current market environment?

Aside from what we've already discussed, not really. I think Fortescue have done a good job in terms of operationally meeting their production guidance over recent years. You've got Iron Bridge starting, but these are broad bulk earth movement operations. They're not overly technical, so assuming that grades will pan out as planned, we don't see a lot of risk around production and cost. The sensitivity is really just going to be around the iron ore price and the grade discount realisation there.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

Rating: 5

I'm probably more terrified [than excited or cautious]. It's probably past cautious, not seeing a lot of value in markets at all.

It's not so much the market's expensive. 

Prices are reasonable compared to where earnings are, but we're just faced with an outlook that we haven't seen in a long time in terms of inflation getting out of control. 

And the things that make us most concerned are central banks are tightening to control inflation. We haven't seen aggressive central banks really since the late 80s. It's been a long time. They're prepared to sacrifice growth for inflation, so we see some big downside sensitivity in terms of risk of recession and big earnings falls. It's not expensive, but we just see a lot of downside earnings risk. And then in the background there, you've got this massive energy shock rolling around the world, which is most acute in Europe, but increasingly so in US and other markets, which is going to feed those inflationary pressures and gives some real dilemmas to central banks. It's a high-risk environment and we see much more risk to the downside.

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