I have added FMG to my SM portfolio, it was already part of my RL portfolio so a good chance to document the thesis. No DCF on this one, but a perspective on value and risks/opportunities for FMG and Iron Ore.
Low-cost producer of Iron Ore (US$13.93/wmt)
FMG is one of the lowest cost producers of Iron Ore in the world, which is a key consideration as a commodity seller and hence price taker. Ignoring market disruptions like a sudden glut (as happened with Oil with the Covid outbreak), the bottom of the price range for commodities is defined by the low-cost producers, which almost guaranteed that FMG will always be able to make a profit on selling Iron Ore. It also provides for massive margins as we have just seen when prices go up and supply is inelastic in the short-medium term.
Increasing demand for Iron Ore
Despite attempts by China to dampen demand for Iron Ore and reduce it’s price, China will continue to need increasing amounts for a very long time. Add to this an increase in demand from the US and globally as governments spend up big on infrastructure to get their economies out of Covid and the short to medium term outlook is high demand for Iron Ore as the core steal ingredient and a key input for infrastructure spending. While some marginal producers with much higher costs of production will help address this demand, it wont be enough and new large, low cost Iron Ore projects like those in West Africa are years away. Likewise, FMG is expanding it’s production with the Iron Bridge site and continues to focus on low cost production, so I expect it will continue to be a key player for many decades to come.
X-Factor
Twiggy and the Fortescue Future Investment (FFI) add value in terms of opportunity beyond current operations, adding a Call Option on new Iron Ore operations and alternative lines of business (eg Green Hydergine). There is also risks around poor investments, but Twiggy’s track record is strong, plus he has massive skin in the game (owns about a third of the company) and there is a solid management team in place to protect against value destruction. I expect very long-term value creating leadership – most uncommon for companies of this size and most valuable to shareholders.
Is it Good Value at $14.50?
In a market where a PE of 20 is low, FMG’s price seems exceptionally cheap at a PE of 4.35, but this PE is based of what can only be described as abnormal levels of profit last year due to very high Iron Ore prices (FMG average revenue of US$135/dmt). A dividend of $3.58 fully franked for the last year is worth $5.11 grossed up (franking credits added) which is a 35.3% dividend yield at a share price of $14.50… insane, but no one is expecting this to continue.
So, at $14.50 what are the expectations:
You would get a 10% return if FMG paid a $1.00 fully franked dividend ($1.43 grossed up) for 10 years and you were able to sell your shares for $14.50 in 10 years. For context, in FY19 FMG paid a fully franked dividend of $1.14 when they received an average price of US$65/dmt which due to the lower grade of their Iron Ore implies a market price of around US$80-90 for Iron Ore. So, Iron Ore prices would need to average around US$70-80 over the next decade and production and ore reserves remain stable to provide a 10% return.
This would be a base case from which you would deduct the risk of lower Iron Ore prices and value destructive investments but add the opportunity for higher prices and value increasing investments.
Conclusion
While I don’t see Iron Ore prices at US$200+ as anything other than an aberration, I do see prices around US$100 as more the norm over the next decade with global demand picking up. Also, if you support high inflationary expectations then commodity prices tend to do well, which adds additional support to higher prices. I don’t, but I am happy to be wrong and hold FMG as an inflationary hedge in my portfolio.
Given the base case value of $14.50, I see low downside risk and significant upside opportunity in not only the core Iron Ore business but also FFI. In fact, it was the FFI announcements that prompted me to buy in initially, simply because it told me that this was a company that was innovative and evolving – something very hard to value but with very high potential value!
Disc: I hold FMG in RL and SM.
