While iron ore prices are high, Fortescue has more cards up its sleeve

High iron ore prices and supply disruptions in Brazil have many forecasting lower profits for Fortescue in FY21, but Stephane Andre from Alphinity Investment Management says market expectations are too bearish, and further upgrades could be ahead. Current forecasts have Fortescue receiving an average price of $75-$80 per tonne in FY21, well below current spot prices of around $125 per tonne. But he sees stimulus from COVID-affected countries like Japan, Korea and Taiwan, as well as continued demand from China helping to support prices.

Following Fortescue’s result on Monday morning, I spoke with Stephane to get his view on the company. In this Q&A, he tells us what attracted him to the company, and why he thinks more upgrades are incoming.

How long have you held Fortescue?

We took a position in Fortescue Metals Group early January 2019 as we held the view that the market had become too negative on FMG’s realised iron ore price, expecting that the large discount they were getting at that time for their slightly lower iron content ore would stay at that level for many years to come. A trip to China a few weeks before had highlighted that steel mill profitability was coming under pressure and their buying pattern was changing, shifting their preference towards lower cost FMG ore. The discount was narrowing. Using spot prices, we could see that FMG earnings could be double what the market was expecting.

A few weeks later, the tragic Vale dam collapsed occurred which had the effect of significantly tightening the market and sending the Iron Ore price up.

How big is your position in the stock currently?

Depending on the strategy we are down to between 1 and 3% active weight (above the 1.8% index weight) as we have been trimming lately on valuation grounds. The share price has lifted from below $5 per share to above $18 at time of writing; when you include dividends, this is a nice 330%+ total return in the just over 18 months.

Please outline why you’re attracted to the company

It’s an incredibly well-run company with a ‘can do’ culture that has kept improving its operational performance since it was founded, consistently beating its guidance by lifting volumes to new levels at the same time as bringing unit costs down.

Many remember it as the highly indebted company it once was; all its hard work has paid off and its net debt as of 30 June is a mere $300 million. This year its net operating cash flow was US$6.4bn!

In addition to being well-run and having a robust balance sheet, we are of the view that the new Eliwana mine and the Iron Bridge Magnetite project will further enhance Fortescue’s product portfolio, providing not only better grades of ore but also strategic options which have yet to be properly recognised by the market.

The company is importantly also firmly committed to sustainability, through high diversity standards, stretched emission reduction targets and effective water management programs amongst others.

In the short term, we still like FMG from an investment perspective as it fits perfectly our process, which is to invest in companies undergoing a positive earnings surprise cycle. Given the state of the iron ore market and where the market expects FMG’s earnings to be in 2021, we believe that more earning upgrades are to come.

Could you give us a brief overview of the dynamics of the iron ore market currently?

The market is extremely tight right now. This is driven by stronger than expected demand from China on the one hand, as it stimulates its economy through the good old infrastructure engine, and on the other hand by ongoing operational issues at the largest supplier in the world, Vale. The outcome of this is a very low level of iron ore inventories across the value chain, driving prices up.

While it is possible that Vale may now be in a position to substantially lift production after a number of significant impediments (rainfall, conveyor belt maintenance, COVID workforce impact, licensing constraints post the Brumadinho dam collapse), the demand in China keeps surprising on the upside, swallowing every tonne available and keeping the market tight. I believe it is likely to stay tight for a while, possibly for another 6 to 12 months, as there are no new sources of supply in the short to medium term. Demand will most likely stay robust in China and will also lift in COVID-affected countries like Japan, Korea and Taiwan. If that turns out to be the case, current market expectations of $75-80/t for 2021 versus the spot price of $125/t appears far too low, and FMG’s future earnings and cash flows will keep surprising significantly on the upside.

What were the key points of the recent result?

The quarterly production report released on 30th July 2020 provided most of the key information for FY20, with good price realization (86%), volume beat (178mt vs 175mt), cost control, and net debt reduction to $300m. Guidance for FY21 of 175mt-180mt with flattish unit operating cost was pleasing. The small capex increase of $50-$100m for the Eliwana project was minimal in the scheme of its $3-3.4 billion FY21 capex program.

The underlying result of U$8.4bn EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) and U$4.7bn NPAT (Net Profit After Tax) was largely in line with consensus. All eyes were set on the final dividend where expectations were 91cps. FMG announced a much better final dividend of A$1.00ps bringing total FY20 dividend to $1.76ps. This represents a 77% pay-out ratio, at the higher end of its 50-80% underlying NPAT distribution policy.

It was also pleasing to see a revised Climate Change Target of net zero emissions by 2040, with the path of reducing emissions by 26% from 2020 level by 2030.

How did the results compare with your expectations and those of the broader market?

The result was a typical FMG style result: clean with no nasty surprises.

Emphasis is shifting towards its growth and development projects. The new higher grade Eliwana mine is on track for a first train in December 2020 and the Iron Bridge Magnetite project is also on track, with its 67% iron grade expected to start contributing from mid-2022.

Has your position on the stock changed post results?

Our positive view on FMG has not changed, although we are cognisant that market expectations are lifting and have therefore trimmed our positions. Expectation for FY21 NPAT is a 10% decline to $US4.2bn which we believe is still too low. Annualising an arguably elevated iron ore spot price would infer $US7.7bn NPAT and A$2.8 per share dividend at 80% pay-out, this would be a 15% dividend yield. Our expectations are for a flattish to slightly higher result than FY20, well below the spot scenario but also well above market consensus.

The market is dynamic and all we know for sure is that expectations will be wrong. It seems however that there is still some buffer left for a positive surprise. While in any market this is a compelling value proposition, it is even more so in this current market environment.

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