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FMG - Fortescue Ltd

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Latest recommendation report

Valuation: $7.70


Last updated:
24/08/20

Fortescue Rides Iron Ore Price to Strong Fiscal 2020, but Record Profits Unlikely to Last
Investment rating
Fortescue's accelerated development plans and unprecedented volume growth, fuelled predominantly by debt, saw the company rapidly rise to become the world's fourth-largest iron ore miner. Earnings grew considerably, and Fortescue established itself as a large second-tier player. Operating leverage is high, with margins are below those of peers BHP, Rio Tinto, and Vale, mainly due to the production of lower-grade iron ore, which attracts a discount to the 62% benchmark. Considerable debt repayment has lowered financial leverage and the balance sheet is now solid. Fortescue built its assets during the iron ore boom, meaning the unit cost of its installed capital base is higher than the established majors, who benefit from investments made when industry capital costs were much lower. Development of the 22 million tonne a year Iron Bridge magnetite mine should add a higher-cost but higher-value 67% grade iron product.

Event





Impact





Recommendation impact (last updated: 24/08/2020)
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Event analysis
Fortescue Rides Iron Ore Price to Strong Fiscal 2020, but Record Profits Unlikely to Last

No-moat-rated Fortescue Metals' fiscal 2020 net profit after tax of USD 4.7 billion was nearly 50% ahead of the previous year's USD 3.2 billion. It was slightly below our USD 4.9 billion forecast due to the mildly unfavourable timing of iron ore price realisation and a higher-than-expected effective tax rate. There is an approximate one-month delay between shipping the iron ore and prices being finalised. Higher profit versus last year was driven primarily by price, which rose 21% to USD 79 per tonne. Volumes were mildly positive, with iron ore shipments up 6% to 177 million tonnes. The strong result saw Fortescue increase total dividends by 54% to AUD 1.72 per share, slightly ahead of our AUD 1.60 forecast.

We make no change to our AUD 7.70 per share fair value estimate. While the fiscal 2020 result was strong, we struggle to see how the buoyant iron ore price can be sustained. It's hard to imagine external conditions getting materially better, and we see longer-term downside. On the demand side, we see a coming headwind as infrastructure spending to offset the COVID-19 downturn in China abates and as urbanisation and infrastructure requirements generally reduce. The peak of urbanisation has passed, and China's stock of housing and infrastructure is now relatively mature. We expect China's steel consumption to slow accordingly and for a growing proportion of steel to come from recycling at the expense of iron ore demand.

We see modest supply additions from Fortescue's Iron Bridge, Vale's planned 20 million tonne S11D expansion, and the 7 million-8 million tonne Samarco restart. Longer term, the restart of production from Vale's mines interrupted by the 2019 Feijao tailings dam failure is material. Production in 2020 is likely to be almost 100 million tonnes lower than we expected before the failure, or about 6% of global supply. We also see development of the high-grade Simandou deposit in Guinea as likely and material in about five years.



Previous close Market cap
$18.560 $57,146 Million
52 week high/low
$18.920 - $7.170
Sector
Materials
Intrinsic valuation
Moat rating None
Business risk Very High
Pricing risk --
Company beta 0.86
Sector beta 0.99
Year 06/19A 06/20A 06/21E 06/22E
NPAT ($m) 4,459.2 6,999.3 6,206.2 4,022.4
EPS (c) 143.9 226.5 200.6 130.0
% change 222.1 57.4 -11.4 -35.2
DPS (c) 114.0 176.0 140.0 78.0
Franking (%) 100.0 100.0 100.0 100.0
Yield (%) 20.9 17.2 7.5 4.2
PER (x) 3.8 4.5 9.3 14.3
Source: Aspect Huntley analyst estimates.


I am certainly no expert but the 450 shares I bought 17/07/2018 for $4.43 look pretty good now. I just wish I had been more diligent back in the late 1990's

But Hey one thing I know ........learn from the past for a brighter future.

Thank you for your replies.

All the best

bux
 
Andrew Forrest holds 35% of FMG. He will take $1.8 Billion in dividends this year.

And yet... He is still actively developing a suite of other business projects as well philanthropic interests.

Tattarang, formerly known as Minderoo Group, is one of Australia’s largest private investment groups and is owned by the Forrest family.
Our investment portfolio spans across agri-food, energy, resources, property, hospitality, sport and entertainment.
The group is made up of six business divisions: Fiveight, Harvest Road, SFM Marine, Squadron Energy, Wyloo Metals and Z1Z.
We believe in investing for growth and pursue opportunities in both the listed and unlisted space with a long term investment horizon.

https://www.tattarang.com/who-we-are/
 

For the short term at least the market is jumping into FMG. It's interesting that generally speaking mining shares are about "promise and possibilities". Companies are drilling holes and shares skyrocket on promising results and then inferred resources, potential profits (years away) before a shovel is actually turned. And of course FMG was similarly treated when it began it's process of becoming the third iron ore exporter in Australia.

But today the mines are built. The operating systems are well oiled. The contacts are lucrative. All the debt has been paid off. The profits are in real dollars and being distributed as fully franked exceptionally high yielding dividends.

And yet the analyst believes this will all contract severely within a couple of years and the SP will fall to well less than half it's current price despite all the runs on the board.

Even if the dividend dropped by 40% the return of $1.10 p/share would still make the current price of $19.50 good value. Strange.
 
joeno said:
$7.7 FMG valuation? Yeah and I'm valuing Tesla at around $150 a share
Click to expand...

I remember the days when people thought a $7 valuation was crazily optimistic, what a difference a couple of years can make.

----------

The way I value a company like FMG is to look at the cashflows and dividends they will generate under certain circumstances to give me a range of possible valuations, and then I rate which of those range of possibilities is likely to play out in the future and then base my valuation on that.

One of the most important factors for a company is their return on equity (ROE), and I have a method of valuing a company based on their ROE.

Based on the $93 Iron ore price they averaged last year, they had a return on equity of 44.6%, which is very high and probably won't hang around forever, although with the current $120 Iron ore price they are probably earning 60% ROE.

Based on different possible ROE figures that could be achieved these are what I believe the share price should be (if ROE averaged at the levels for the longterm)

45% ROE - $39.57
35% ROE - $28.20
25% ROE - $18.24
15% ROE - $12.36

Now I don't believe a ROE of 35% or above could be sustained over the longterm, but I do think that we will be above that level for at least this financial year, and that it will eventually settle some where between 25% and 35% meaning based on that metric a share price of $23 to $25 is very fair, so there is a great upside potential in my option, and a limited down side if the ROE did drop back to 25% or 20%

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I then also like to make an assessment of what the possible price people (including myself) would be happy to pay or hold at based on the range of possible dividends, and again I then pick which outcome I think is likely.

I think a fully franked dividend of 7% (10% gross) long term is pretty attractive, while alot of people would still be happy with a 5% dividend (7.1% gross).

So here is where the share price would be to achieve those dividend yields based on different dividends.

Current full year dividend ($1.76 full year) -
$25.16 (7%) - $35.20 (5%)

$2 / share (final dividend annualised)
$28.60 (7%) - $40 (5%)

$1 / share
$14.30 (7%). - $20.00 (5%)

$0.76 / share
$10.86 (7%) - $15.20 (5%)

---------

So based on the above metrics (and some others) my opinion of different price points is as follows.

$19.00 (pretty safe to hold at, should see very good dividend return)
$25.16 (probable result, and should produce a decent dividend retune)
$28.60 (possible outcome, may look to reduce holding, still a good dividend though so no rush to sell)
$33.00+ (blue sky valuation, requires $120+ Iron ore price for long time, definitely be reducing my holding back to maybe 10% of my current position).

-----------

As for the guys $7.70 valuation, I can't really see a way that is likely, I think it $33 blue sky is more likely than his $7.70 gloomy number, not that I think we are guaranteed $33, its just I think the surprise to the upside is more likely than the surprise to the down side at the moment)
 
Nice analysis VC. But can easily see $40 for Fortescue - about $100B market cap as the markets don't always go by such low PE valuations for "innovative" market leading companies like FMG. Which I would categorize it as. Whether this happens this year, or in a few years time i don't know. But i see this is where this stock is heading.

- Interest rates are low and likely will go lower in Australia to prevent a market / property crash, which means profitable businesses overall will be bought at an even higher PE ratio. Unprofitable and risky companies will be dumped.

- 10PE is already very good for FMG. Further to that their profit margin is high and expenses low. That means they can scale up, expand and become a bigger company than it is today. I believe this is much harder to do when you're strapped for cash, have profitability issues and are already "too big" like Vale.

- There is no existential threat to Iron Ore unlike oil products. 3rd world economies are growing and they will need Iron to build their machines and skyscrapers. $200AUD/ton iron doesn't seem crazy. Even if iron prices decrease, FMG is safe due to industry low COGS.

 
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Yeah, it all just comes down to the what the average Iron Ore price is over time, we are in a very good position with current over prices, and even much lower ore prices.

So I don’t see a dooms day scenario from here, (although fluctuations are bound to happen) We will just have to wait and see whether from here we get a wonderful result or maybe just a good result.
 
Everything eventually boils down to P/E. There's a few different ways to get there, but everything eventually boils down to P/E.

In many ways, in this economy, a lower ROE is actually better (assuming the aggregate return isn't lower) in a way because the bigger the company the better they can weather this storm.

I said the other day that FMG is worth $20 easily. It's looking like it'll crack it soon
 
Forward looking PE is the name of the game. But it's where the challenge is.

A growing innovative and high margin business can be a bargain at 50 prior year PE. Not saying FMG is worth $100 a share now... but hey nobody thought any tech companies could grow so much and run on such high PEs. Apple at 2tril market cap. Tesla at 1000 PE. yowzers

 
Well dumping interest rates will always raise P/E and that's exactly what we've done and are on record as stating no intention of raising them for bloody ages, so this is the new normal now.
 

The higher the ROE, the higher a PE is justified to be.

The lower the ROE, lower the PE is justified to be.

———————

Think about it this way.

Imagine company A, earns $1 per share, and has $5 of equity per share it has a ROE of 20%.

while company B, also earns $1 per share however it has $20 of equity per share, it has a return on equity of 5%.

Let’s say both companies retain their $1 and it gets reinvested at the companies ROE rate.

In year 2 company A’s equity has grown to $6 and they will earn $1.20, while company B’s equity grew to $21 and their earnings only grew to $1.05.

both companies earn $1 in year 1, but the retained earnings in company A caused a higher profit growth because of their higher ROE.

the end result is that because company A can retain earnings and genera 20% returns on them it is a far more valuable business than company B who is only going to earning 5% on those retained earnings.

This has a huge affect on valuation, because company A is probably worth paying a PE of 20 for because each dollar of retained earnings can potentially produce more than a dollar of share price growth, where as company B is probably worth much less, because each $1 retained probably produces less than $1 of share price growth.
 
Of course - but that's just factoring future earnings (and thus p/e) into account.

Like I said, there's a few ways to get there, but everything still ends up at p/e.

Also like I said before, depending on the business, I'd actually rather a bit lower roe if it came about as withholding profits as cash to act as a buffer or something like that. Sure beats raising it through borrowings later on if the proverbial hits the fan again.

FMG isn't one of those businesses though. It's in way too good a shape to need to forego dividends for a while.
 
over9k said:
Of course - but that's just factoring future earnings (and thus p/e) into account.
Click to expand...

Yeah, thats what investors do.

Like I said, there's a few ways to get there, but everything still ends up at p/e.
Click to expand...

Kind of, but its not about what the PE is today that's important, it's about how the future earnings related to the price you are paying today.


I am not sure what you mean by that, P/E has nothing to do with whether earnings are retained or not.

FMG isn't one of those businesses though. It's in way too good a shape to need to forego dividends for a while.
Click to expand...

My ROE based valuation takes into account what portion of the earnings are paid out as dividends and what is retained inside the company, an puts a multiplier on the equity based on my required return and the estimated longterm average return on equity.

let me show you how I got to the valuation.

Above I said FMG would be worth $28.20 today if it was going to earn 35% ROE, that is based on me having a 10% required return, that means I can pay $28.20 today and my return over time will be 10% based on the company earning 35% return on equity and paying out 80% and retaining 20%.

the calculation goes like this.

$6 of equity per share earning 35%, means I can pay the following

$6 of equity x 80% = $4.80 x 3.5 = $16.80 (first 80% of equity where earnings paid out)
$6 of equity x 20% = $1.2 x 9.5 = $11.40 (remaining 20% of equity where earnings retained)

$16.80 + $11.40 = $28.20

So if I want to average a 10% return over time, and I believe that FMG will average a 35% return on existing and retained equity, the share is worth $28.20 to me today, if its selling for less than that it is undervalued.

Here is 2 tables that give you the multipliers to use based on your ROE estimate and your required return.

1 table is for earnings that are 100% paid as dividends the second table is for earnings that are 100% retained, when a company pays some and retains some, you split the calculation like I did above.

 
This is going to sound speculative - but *if* we believe FMG has better tech, a more innovative mindset from its teams, and a lower cost structure than other big miners like BHP and RIO and can sustain this, then I don't see why FMG can't diversify into other products like BHP does. Into uranium mining, copper (good prospects in the future) and met coal.

Or expand it's iron ore operations to other regions. They can buy unprofitable companies or assets for cheap and leverage their existing low cost systems to turn them around.
 

Where did you get those multiplier tables? From Richard Simmons? From a Roger Montgomery book?

By the way I must tip my hat to you sir. You were completely on the money with Fortescue Metals. I remember your analysis back when it was $7 or $8 per share not even a few years ago.

But I never invested in Fortescue or any mining company despite your previous excellent analysis really because I never liked commodity companies because they are difficult to analyze (cost of production can swing a lot from year to year as can commodity prices) with too wide a range of likely outcomes and the fact they are price takers.

Also I noticed with mining companies generally (not talking about Fortescue specifically) once you get too big its hard to keep growing because they have to find bigger and bigger new deposits to keep growing at a reasonable percentage rate.

Either one of a few things happens to mining companies once they hit a certain size. Production growth slows/stalls dramatically, they take over other mining companies at inflated prices, often creating multi-billion dollar write downs some years later, they find new deposits but with higher costs or lower grade products, thus reducing their overall margins and ROE.

I think Fortescue will avoid overpaying for takeovers (if they do make a takeover it will be sensible) because Andrew Forest has billions of dollars of his own money on the line so unlike the executives of BHP or RIO, etc who are playing with other peoples money he has a lot to lose from a bad takeover. But some of the other problems I mentioned could occur in the next 3 or 4 years. Who knows though I am just guessing and could be completely wrong. I do not know enough about Fortescue to make an accurate assessment.
 
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Yep, Those tables are from Roger Montgomery’s book “Valuable”.

I totally understand your thoughts on miners being commodity businesses, that’s why I do a range of valuations based on different ROE levels, and then and try and work out which is the most likely situation, while also figuring how comfortable I would be with some of the other outcomes.

As for being a “Price Taker”, I think it can be a bit of a misconception that “Price Takers” can’t have competitive advantages, for a price taker being the lowest cost producer of a commodity is a very big competitive advantage.

as for having sensible ways to deploy capital, I think FMG has done very well with this for the following reasons

1, They don’t mind paying out big dividends if they don’t have uses for the capital (my valuations were based on 80% payout, which lowers the valuation)

2, They have a lot of good options for new mines when it makes sense, especially in magnetite.

3, they have a list of Existing projects under way that is soaking up capital and will have decent returns on equity.

4, they have shown that they are willing and able to invest vertically in their system in smart ways eg buying ships, tug boats, power stations, gas pipelines etc these have been good uses of capital.

5, they seem to be avoiding rushing into silly Merger and acquisitions, and instead are running a low cost exploration strategy.

So I am pretty confident that the cash flows they produce throughout the cycle will be either paid out or invested in smart ways, and the Mistakes BHP made shouldn’t be repeated here.
 
Not to mention their credit rating compared to everyone else at the moment is absolutely spectacular so they could raise a massive amount of capital virtually overnight if they saw a need.

FMG should really be heralded as one of those amazing aussie success stories (taking on the big guys at bhp, rio, vale etc and winning) but instead all we get is sour grapes every time twiggy's on the news.
 

A few points, firstly I am interested how come a clever guy like you decided to use a valuation table from Roger Montgomery's book when its been proven time and time again on this forum that he is a snake oil salesmen with a checkered history and little idea of what he is talking about. Now you may have assessed the valuation methodology on its own merits completely aside from Roger and decided its a worthwhile tool that can be applied in certain situations. I assume that this is the case and fair enough then.

I never said being a price taker means you can't have competitive advantage. Low cost of production is indeed a source of competitive advantage that is real and meaningful. If you can stay in the best quartile in terms of cost of production for the majority of commodities over a full cycle you will usually make a high return on equity. I am in 100% agreement there. I will however note on this point that in the mining game where companies sit on the cost curve relative to competitors has shown a habit of changing dramatically over time as its both volatile and subject to many factors outside the company's control. While it is a competitive advantage in many cases (not specifically talking about Fortescue here) one must be extremely wary of the sustainability of such an advantage.

Overall I think you have solid arguments for investing in Fortescue and your analysis has been both logical and correct.

I must say though that in hindsight I am rather surprised that the world is experiencing the worst economic downturn in since the great depression and yet Iron Ore prices remain this high, as do the share prices of Iron Ore Miners!! I understand the China stimulus story and the inflation trade, low interest rates, etc but I am still surprised.

If anybody had told me 12 months ago "next year the world will experience the largest economic downturn in in over 80 years yet Iron Ore prices will remain high and Fortescue shares will record highs amid the downturn" I would laughed at them! And yet here we are! On top of the fact that you analyzed the situation well and acted accordingly you also had good luck on your side which supercharged your returns on Fortescue.
 

What ever your opinions on Roger (I don't have strong feelings either way, I didn't recommend his book I just shared the tables), The Tables are just a reference guide to show which multiplier to use based on the two inputs, its based on simple maths so it doesn't really matter who's book it comes from, if the math is correct the tables are accurate.

E.g. if the end result you want it a 10% return, it just a mathematical fact you can pay $3 for something that produces $0.30 in cash flow to you, or pay $7.22 for something that compounds that $0.30 at 30%pa.

Of course there is more to it than just looking at the current performance and assuming that things will compound to infinity, but thats why I explained I look at multiple possible outcomes at different ROE's and also use other valuation methods, and in the past have gone into a lot of detail explaining my thoughts as a whole on the company and the industry.



Agreed, but I don't think that FMG's position on cost is at risk any more than any other companies own competitive advantages, whether that is Coke, Apple or Tesla, each companies "moat", could be drained some how in the future.

Saying that, there is some very solid facts that create FMG's Low cost position, that would be very hard for competitors outside of the Pilbara to match, and aren't as fickle as consumer preferences can be over time.


I am not really that surprised, as you would understand the Iron price is based on Supply and demand, So you have to look at both Supply and Demand to see what is happening and both have been affected in ways that people don't think of at first glance.

Demand - The industries that have been the most affected by the down turn were not big Steel consumers in the first place, where as some of those being stimulated are big steel consumers, and it doesn't matter if you drink a beer at the pub or at home you still pop a steel bottle cap (and consume steel in many other ways)

Supply - Australian Sea bourne Iron ore is only one component of supply and it has remained pretty steady being shipped directly into the Chinese industrial centres along the coast, however other sources of supply such as scrap metal also forms a significant part of supply which for months were heavily reduced as collection networks distributed around regional china and other nations were locked down, also Chinese mines suffered shut downs due to the lock downs, and even those that could produce were choked off by transport restrictions, then you have brazils mining areas which have been affected by covid19 too, and that has slowed some supply from there.
 
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