Fortescue: earnings, FCF rise unlikely without iron ore revaluation

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Sergei Zavalnyuk

Summary of investments

From the Portfolio Manager’s Desk

At HB insights, we cover Australia-based miners in depth. Australian commodity majors saw a huge rise in FY21/22 despite the broad selloff in shares. Iron ore, however, did not enjoy good fortune. Names heavily exposed to the resource was reassessed downwards this year. For example, Fortescue Metals Group Ltd (OTCQX:OTCQX: FSUGY), the Australian iron ore giant which still trades on an FCF yield of around 11%, and investors benefit from a dividend yield of 10.84% [FSUGY’s dividend is not discussed here, capital appreciation is the focus instead]. FSUGY also recorded its largest quarter of tons shipped, potentially explaining its latest relief rally on the chart. Despite this, it is down 5% since the start of the year. Note that this article discusses capital appreciation and does not look at the company’s dividend.

The stock now trades at 6.5x trailing earnings and is highly correlated to volatility in iron ore markets, as shown in Table 1. With price visibility on the commodity outlook cloudy, we derive a fair value estimate of $20.02 for FSUGY. Therefore, we assess the stock as a reserve. A positive shift in the consensus iron ore forecast is the main upside risk to the thesis.

Exhibit 1. Close causal relationship between iron ore market prices and FSUGY stock price

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Data: Refinitiv Eikon, Tradingview

To note: As a reminder, Fortescue is located in Australia and its FY22 exercise ended in June. It has therefore published its results for the first quarter of fiscal year 23/24 for the 3 months ended September 30, 2022. This corresponds to the third quarter of fiscal year 22 in the United States. As such, we’ll be speaking in terms of Q3 FY22 to avoid confusion for our readers.

Record Fe shipments in the third quarter of FY22 means the balance sheet is in good shape for a strong increase in investments

FSUGY intends to invest US$6.2 billion [note, all dollar figures from hereafter are quoted in USD, unless otherwise stipulated] to completely decarbonize the company and go beyond its traditional markets by 2030. It claims to save $3 billion in the process, bringing net investment to $3.2 billion, with additional net savings of $800 million a year from there. [a deeper review of Future Fortescue Industries (“FFI”), and its decarbonization plans, see: here].

Its FY22 third quarter results were therefore well received in a tight iron ore (“Fe”) market. Prices for iron ore cargoes with 63.5% Fe delivered to Tianjin are down 38.9% from March highs, after peaking in July FY21.

Recent developments have altered the supply and demand figures for spot Fe in the future. Consensus estimates fell accordingly, from an average of $130/tonne to $91.25 in FY24, as shown in Figure 3. Despite this, Fe futures rose 20 % in November following revised Covid-related travel restrictions from China.

Despite the rise in cases, Beijing said it would reduce quarantine periods for close contacts. Additionally, it extended a key financing program to its struggling real estate sector, totaling 250 billion yuan. As default risk and overall defaults are increasing in the sector, the cost of funding has increased, forcing government intervention to help the segment. The outlook for iron ore therefore remains mixed.

Exhibit 2. Iron Ore 63% Fe, CFR China – 20% November Rally as China Potentially Eases Covid Policy, Intervenes with CNY250Bn in Real Estate Sector

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Data: TradingEconomics

Exhibit 3. Consensus Iron Ore Forecast for Fiscal Years 22-26

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Data: Refinitiv Eikon

Exhibit 4. Major iron ore shipments from May 2022 to date

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Data: HB Insights, Refinitiv Eikon

As for FSUGY’s third quarter of FY22, it shipped Fe shipments of 47.5 million tonnes (“MMT”), growing 400 basis points year-on-year and a record high for the quarter.

It cut average earnings by $87/dry metric ton (“dmt”) with 85% of the Platts 62% CFR achieved for the quarter and 72% for the calendar year. Note that the iron content of 57-58% of the firm [lower-grade] resource sees it suffer a discount from the reference price of 62%. Net direct costs [C1 costs] rose 300 basis points to $17.69/wet metric ton (“wmt”), primarily due to fuel costs and other inflationary factors. The costs have been offset by a favorable AUD/USD pair which has returned to the range over the past 2 months.

Exhibit 5. Summary of quarterly operations of the FGUSY [Australian fiscal dates shown].

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As a reminder, Fortescue is located in Australia and its FY22 exercise ended in June. It has therefore published its results for the first quarter of fiscal year 23/24 for the 3 months ended September 30, 2022. This corresponds to the third quarter of fiscal year 22 in the United States. (Fortescue Q3 FY22 Business Update)

Capital expenditure for the quarter was $653 million, or $2.8 billion over the last 12 months of spending, versus $3.2 billion year-over-year. The turn in CapEx reflects the schedule, and management has retained the CapEx guidance for FY23.

On the balance sheet, gross debt is unchanged at ~$6 billion and FGUSY pulled in a CFFO of $3.3 billion for the quarter. It was flat in Q2 FY22, but up from $1.06 billion in Q3 FY21. It left the quarter with $2.8 billion in net debt after paying its previous dividend of $2.4 billion.

As shown in Figure 6, the stock is still trading at an FCF yield of around 11%, while net debt is 40% debt/equity and 1.0x gross debt/EBITDA. Unfortunately, given its run-rate, FSUGY retains a balance sheet capacity to finance its future growth in my opinion [including the 10% of net profit allocation to FFI, and retaining a payout ratio of 50–80%].

Exhibit 6. FSUGY is still trading at an FCF yield of 11% while deleveraging at 40% debt/equity.

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Data: HB Insights, FSUGY SEC Filings

Directions maintained in the context of improving the capital budgeting cycle

FSUGY retained its C1 forecast for hematite at $18-$18.75/tonne with an AUD/USD exchange rate assumption of $0.70. This corresponds to our expectations. It plans FY23′ Fe shipments of 187-192mm tons, including 1mm tons from its Iron Bridge site. It should be noted that each $0.01 [1 cent] the delta of the AUD/USD pair impacts the C1 cost by approximately $0.15/tonne.

It guides CapEx from $2.7 billion to $3.7 billion [excluding allocation to FFI] which we believe to be a reasonable estimate. We are forecasting FY23 unit costs of $18.60 for ongoing operations, not including Iron Bridge.

It is not unreasonable to expect that FSUGY will maintain double-digit ROE, ROA and ROIC over the next 3 years, as shown in Appendix 7 this time.

Exhibit 7. Estimated return on capital to increase additional tax-adjusted income in fiscal year 25

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Data: HB Insights estimates

Steel margins [particularly in China] are also key to the bullish scenario for the future. In practice, mills will minimize operating expenses by switching to lower quality and cheaper ore when their operating margins tighten. Being in the top 3 low cost iron ore producers, if it happens, bodes well for FSUGY. Note that BHP Group is currently the cheapest producer at ~$12/wmt, compared to FSUGY’s T3 FY22 at $17.69/wmt.

Therefore, with the strong start to the third quarter of FY22, we believe that FSUGY is well capitalized to meet the above guidance. A broad trending market and the latest relief rally at the Fe spot are also supportive of the same.

Evaluation and conclusion

With the decline in iron markets this year, iron ore spreads have compressed. Until a revision in the Fe spot forecast or market prices return to previous highs, this will have an upward impact on FSUGY’s FCF and EPS in the coming years, according to estimates. .

As shown in Figure 8, we see a slowdown in earnings and FCF growth over the next 3 years. This is supported by a $14.8 billion decline in forecast revenue for FY23, as we also expect average realized cargo prices to decline by 63.5% fe this year.

Thus, our FCFE NPV of $20.22 reflects a cost of capital of 7.29% and a terminal rate of 5%. We also see FGUSY trading on a quarterly FCF yield of 4.1% in FY23 [8.3% annualized from semiannual].

Exhibit 8. FGUSY forward estimates, FY23–FY25 with corresponding NPV.

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Note: Dates shown are for US fiscal year (Data: HB Insights estimates)

Net-net, FSUGY remains a market leader in Fe production and has benefited enormously from the latest feedstock supercycle. The outlook, however, appears weaker as Fe markets normalized in FY22, leading to a sharp decline. Despite this, investors have the same opportunity to reprice the stock should commodity prices rise substantially once again. This is a major upside risk to the investment thesis. With our DCF deriving a price target of around $20, we rate FGUSY as a hold.

Editor’s Note: This article discusses one or more securities that do not trade on a major US exchange. Please be aware of the risks associated with these actions.

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