The income opportunity in Fortescue Metals

I met with the CFO and COO from Fortescue Metals (FMG) this week as they did the rounds following their recent full year results. There were some brief prepared comments that hit the high notes of the result but of more benefit was the discussion thereafter as we shot the breeze about the future of the WA Iron Ore miner. We currently have 3% of the Income Portfolio in FMG sitting on a paper loss of ~10%, not ideal but it’s important to look forward not back.

My short interpretation of FMG in terms of an income play remain intact, and I think FMG has every chance of delivering a yield of 7-8% inclusive of franking in FY19, which makes it a reasonable income opportunity, albeit a higher risk , more volatile one.

A few key points from their recent result

Like many of the miners it was slightly messy, although less so than RIO and BHP given those two had the added complication of asset sales through the period. For FMG, there was the initial view that the result was a miss simply given how they accounted for some aspects of it, however the underlying result was very close to where market expectations were.

Profit was inline and the dividend was a beat relative to the streets expectations, so nothing really new in the result, but that’s not the important thing now. What FMG will likely earn in FY19 and what proportion of those earnings will be passed through as a dividend is key.

It’s always hard to predict what commodity prices will do with certainty however if we assume current conditions remain as they are now, FMG should produce a net profit of $1.2bn in FY19 dropping down to earnings per share (EPS) of about ~33c. They have guided to a payout ratio of 50-80% of NPAT, so at the bottom of the range that would produce a yield of 5.70% grossed for franking, or at the upper end of the range it’s 9.18% grossed for franking. We doubt they’ll pay 80% out in FY19, instead if we assume 70% payout ratio (market consensus correctly sits at 72%) we get a dividend for the year of 23.76c. Based on $4.10, that equates to 5.79% plus franking, or 8.27% for the year.

The key is clearly around the likely profit for FMG  and there are a few variables here. Obviously commodity prices remain key however also the discount FMG is receiving on their lower grade Iron Ore relative to the benchmark. As the below chart shows, there is significant divergence of FMG away from their underlying Iron Ore price proxy. There are a few reasons for this according to FMG and the market more broadly. Tighter environment controls in China means that higher grade Ore is being more highly valued by Steel Mills at a time when Steel prices are very high. If Steel prices are high, margins are usually good and paying up for a higher grade Iron Ore makes sense. The environmental aspect I tend to think is there to stay, however Steel margins will turn at some point, and that should assist the demand for FMG Ore relative to others.

This chart shows that FMG’s iron ore pricing proxy is going up (and the discount reversing as well) but the share price is heading lower. Typically the correlation here is >90% according to Peter O’Connor at Shaw . The chart links this back through time to when the Iron Ore price was last trading at these levels = share price implied of $5.40/share.

Source; Shaw & Partners

FMG are taking steps to address the discounting issues in two ways

1.       New 60% product details - Fortescue to produce 60% iron content product, named West Pilbara fines, in 2H19 from existing operations. This puts a higher grade product into the market and gives FMG more flexibility in their deliverables.

2.       Eliwana Development - FMG have committed to develop the Eliwana mine and rail project to produce a product made from blending Firetail mine with the high grade product that will come out of Eliwana. This will again put a higher grade product into the market

Both of these approaches are obviously reactionary as a result of the ongoing discount applied to FMG ore, however it does show FMG has scope / capacity to react to market forces, and importantly, given their low levels of debt, they have flexibility which was not necessarily the case in the past.

All in all, FMG looks a good risk v reward play below $4.00. however if we’re correct on BHP and see that trade sub $30, as we expected, FMG would be around ~$3.75, so patience prudent just here.

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