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Model Portfolio | Fortescue Metals Group Ltd (FMG)

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Analyst: Hugo De Vries, Analyst

As a pure iron ore miner and exporter, Andrew Forrest’s Fortescue (ASX: FMG) has always presented investors with a great proxy for the commodities price and its price expectations. So, when the iron ore price tanked from over US$220 per tonne to less than US$90, the FMG share price was going to struggle.

However, recent commitments made by the company seem to be transforming a former one-trick pony, into a potential global leader in the green hydrogen race. This was the reason for FMG’s outperformance to the broader market this week.  

FMG share price has always been tied to the IRON ORE price (Source: IRESS)

 

Iron ore price collapse 

All FMG’s revenue to date are generated from mining and exporting iron ore. Roughly 90% of the company’s exports end up in China, where the commodity is transformed into steel used in the countries behemoth construction industry.  

The drivers of the fall in iron ore prices over the last few months can be attributed to both a falling sentiment in the outlook for the Chinese property development market (in light of the Evergrande saga) and also steel output restrictions placed by Chinese policymakers.

The Evergrande episode has seen policymakers tighten financing. A Bloomberg index of Chinese developers is at the lowest level in more than four years after losing 33% in 2021. Shareholders of companies such as Evergrande, China Fortune Land Development Co., China Aoyuan Group and Yuzhou Group Holdings Co. are sitting on losses exceeding 70%. The property sector accounts for 30% of the countries steel consumption.

To reduce pollution ahead of the 2022 Winter Olympics, China introduced national steel output with the aim of capping production at 2020 levels. With the pollution cuts, steel manufactures are looking for higher-grade iron ore, to make emissions from smelters less intense, and more efficient.

Iron ore grade

Steel mills using lower grade iron ore require more coking coal in the process, which is another input price for producers to deal with. Therefore, they are incentivised to buy higher-quality iron ore. Unfortunately for FMG, the company’s iron ore tends to be of a lower grade than “benchmark” iron ore. This refers to the % of pure Iron in the export. In a bull market with record high iron ore prices, this isn’t as important, but when the lights are on and margins are compressed, this hurts the bottom line more.

Fortescue in FY21 received about 88% of the benchmark price over the past year. Low-grade iron ore dogged the company in previous years such as 2016 and 2018, so it has been an ambition to start delivering its high-grade iron ore goal.

While it hasn’t happened yet, the company has a plan for achieving this. They are:

  1. The new Eliwana mine came online in December 2020. This site produces a new product called “West Pilbara Fines” which has more than 60 % iron content. Once Eliwana is fully up and running, FMG estimated it would produce 40m tonnes per year. However, now running close to full capacity, Fortescue will produce just 17m in 2022 after a change of mine plans because of efforts to protect local Aboriginal cultural heritage.
  2. The second high-grade strategy is the Iron Bridge magnetite project. After many time and cost blowouts, completion is set for December 2022.  FMG expects it will produce 22m tonnes per year from 2024.

If all goes to plan, FMG will be producing 62m tonnes per year of high-grade products by the FY25. This would mean approximately 30% of FMG iron would be above 60% grade.

The recent boom leaves FMG in a good position

The recent iron ore boom has left the company with a strong balance sheet, and firepower to face an iron ore price retreat plus the ability to pursue different avenues to drive growth in the future. Of late, this is what has really been attracting the headlines, their commitment into green energy.

Fortescue Future Industries (FFI)

FMG has pledged 10% of annual profits to go into the FFI. FFI plans to invest up to US$600m towards clean energy projects. Amongst other technology FFI is pursuing its ambition to be the biggest global exporter of green hydrogen.

Green hydrogen is when you use renewable power to split water into oxygen and hydrogen. The group has already committed funds to develop a green hydrogen manufacturing plant in QLD.

The money is available from the unspent allocation of funds from last FY year. Development will be proceeding despite the squash in this year’s margins. Consensus has FMG profit for FY22 at around US$5.8bn, which would imply another US$580m would be granted to the FFI division.

We believe to get to commercially viable, green hydrogen must get to about US$2/kg.  Globally, the timetable to achieve this is likely to be the beginning of next decade. However, because of Australia’s unique location, position, and resources, we may be able to achieve this sooner, potentially around 2028/2029.

Some countries such as South Korea, Japan, Germany, etc. will not be able to compete, so they are likely to import from countries such as Australia. These nations are already planning to build green hydrogen containers or are in the process of re-designing existing LNG tankers to retrofit for the transport of green hydrogen.  

With the commitment from the Commonwealth Government, and their motto ‘tech over taxes’ this sort of venture could be brought forward slightly. FMG would be in the front seat to capitalise on this thematic. We, therefore, have a positive view about the move into green energy over the longer cycle.

With a commitment to net-zero by 2050, the gov has cited green hydrogen will play a very big part in Australia's green energy transformation, we believe there will be a significant increase in funding in this area over the next few years, FMG a key beneficiary.

Scope 3

FMG is the only company to have formally committed to Scope 3 on the ASX so far. Scope 3 emissions are the result of activities from assets not owned or controlled by the reporting organisation, but that the organisation indirectly impacts in its value chain. Along with this FMG has committed to net 0 emissions target by 2040.

September Quarterly Production Report

FMG’s operational performance in the first quarter of FY22 was strong with higher mining rates and in-line shipments boosted by lower cash costs.  Realised prices were weaker than the market expected and there were widening discounts for lower grade ore, which remains a key risk to earnings of FMG.  

  • Solid 1QFY22 result with no change to FY22 guidance
  • Cash flow generation remained strong
  • 1Q average revenue $118/Ton, 1Q C1 cost $15.25/ton, flat on-quarter
  • Net debt $175m at end of the quarter
  • Iron-Ore shipments 45.6M tonnes, up 3% on-year, down 8% on-quarter

 

FY22 Guidance, Sept Quarterly Presentation

 

High running yield

According to consensus estimates on Factset, the running yields at current prices sit high for FY22, FY23 and FY24 sit at 16%+, 10%+ and 6.8%+. Though Iron ore price are volatile, their average all in cost is very low at $15.25 per tonne.

Source: Factset Consensus Estimates

 

FMG is trading on free cash flow yields of 8-11% for FY23-FY25 using FactSet forecasts. The company’s fortunes will remain tied to iron ore price strength, and this is the medium-term risk.

Investment into Fortescue Future Industries (FFI) brings great potential and diversification to the company, in a space that will attract a lot of green investment. An inflection point for FFI will be when more specifics are disclosed about intended projects, CAPEX budgets, expected funding, and expected returns are provided to the market.


Whilst iron ore’s spot price remains in flux, its place as an underlying base resource needed for world growth remains steady. To account for this increased risk of this price uncertainty and volatility, we a maintain a smaller position. We remain strong believers of Fortescue’s ongoing place in the model portfolio.

 

Ownership Disclosures: 
Our fund partner Clime Asset Management (Clime) owns (FMG) on behalf of various mandates where it acts as an investment manager.

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