Category: Financial Markets

Business Strategy and Outlook 

Fortescue Metals is the world’s fourth-largest iron ore exporter. Margins are well below industry leaders BHP and Rio Tinto, and some way behind Vale, meaning Fortescue sits in the highest half of the cost curve. This is a primary driver of our no-moat rating. Lower margins primarily result from discounts from mining a lower-grade (57%- to 58%-grade) product compared with the benchmark, which is for 62%-grade iron ore. The lower grade is effectively a cost for customers, which results in a lower realised price versus the benchmark. In the five years ended June 2020, the company realised an approximate 26% discount, compared with the benchmark average for 62% iron ore fines.

Fortescue has done an admirable job of reducing cash costs materially versus peers. However, product discounts remain a competitive disadvantage. To this end, the company will add about 22 million tonnes a year of iron ore production from the 61%-owned Iron Bridge joint venture. Iron Bridge grades are much higher, around 67%, which should allow Fortescue to meet its goal to have most of its iron ore above 60%, assuming the company chooses to blend it with the existing products.

Financial Strength 

Our fair value estimate for no-moat rated Fortescue Metals to AUD 13 per share from AUD 15.10 per share previously. The shares have gone ex-entitlement to the final dividend, an unusually large AUD 2.11 per share or 14% of our previous fair value estimate. The latest financial results were astoundingly strong for the iron ore miners, Fortescue included. Rio Tinto generated an annualised return on invested capital from its iron ore operations of more than 100% in the first half of 2021.

Despite being a relatively high cost producer, once product discounts are considered, Fortescue’s annualised return on invested capital for that same half was nearly 70%. This is part of the reason the iron ore price has fallen in recent times, but the price at nearly USD 150 per tonne is still well above the price required for the iron ore majors to make a reasonable return.

Fortescue Metals Group’s balance sheet is strong, thanks to the elevated iron ore price and accelerated debt repayments. Net debt peaked near USD 10 billion in mid-2013, roughly coinciding with the start of expanded production. By the end of 2020, net debt had declined to USD 0.1 billion. The operating leverage in Fortescue, and the cyclical capital requirements, there is a reasonable argument that Fortescue should run with minimal or no debt on average through the cycle.

Bulls Say’s 

• Fortescue provides strong leverage to the Chinese economy. If growth in steel consumption remains strong, it’s also likely iron ore prices and volumes will too.
• Fortescue is the largest pure-play iron ore counter in the world and offers strong leverage to emerging world growth.
• Fortescue has rapidly cut costs and significantly narrowed the cost disadvantage relative to industry leaders BHP, Vale, and Rio Tinto. If steel industry margins fall in future, it’s likely product discounts will narrow significantly relative to historical averages.

Company Profile 

Fortescue Metals Group is an Australia-based iron ore miner. It has grown from obscurity at the start of 2008 to become the world’s fourth-largest producer. Growth was fuelled by debt, now repaid. Expansion from 55 million tonnes in fiscal 2012 to about 180 million tonnes in 2020 means Fortescue supplies nearly 10% of global seaborne iron ore. However, with longer-term demand likely to decline, as China’s economy matures, we expect Fortescue’s future margins to be below historical averages.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.