Agree to disagree on China?
Fortescue Chief Nev Power yesterday said he was confident that the iron ore price would rebound to the US$120/tonne level following its recent weakness. We have been scanning the Chinese economy from a number of angles for some time now, and the indications we see are rather less optimistic. Remember, before 2002 the iron ore price averaged between US$15-$20/tonne. Currently US$90/tonne. History suggests that the maintainable price might be significantly below present levels, even after the large declines.
At the opposite end of the market to Fortescue, nano-cap Merchant House makes industrial boots in Tinajin, close to Beijing, and has been making them ever since Deng Xiaoping began the process of economic reform some 30 years ago. For FY2012, Chairperson Loretta Lee reports rising input costs, increasing wages, and new taxes and regulatory burdens. She states: “It is becoming increasingly obvious that China is no longer the world’s low cost factory”. The implications for China’s exports and the flow on into areas such as fixed investment should not be underestimated.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Paul Rehill
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This is BHP’s iron ore production over 13 financial years from 2012 to 2000 respectively (in million tonnes):
159.5, 134.4, 125, 114.4, 112.3, 99.4, 97.1, 96.7, 84.2, 73.7, 67.9, 65.9, 59.8
This is a moderate p.a. increase in iron ore production over 13 years. Compare this to FMG’s incredible ramp up targets and production:
Target FY13: 86.5 mtpa
FY12: 57.5 mtpa
FY11: 40.9 mtpa
FY10: 40.1 mtpa
FY09: 27.3 mtpa
FMG’s June FY12 annualised shipping rate was 71.3 mtpa and it is targeting 155 mtpa by June FY13. I wonder if FMG is shooting itself in the foot by dramatically increasing supply after comparing this to BHP’s much slower compound increases in production.
I get very concerned when a company’s total debt/NPAT exceeds 5 times and at FY12 year end, FMG’s ratio was 8501m/1559m=5.5.
Sure they had $2.3bn in cash but this will be used up by their 6.2bn FY13 target CAPEX which compares to FY12 CAPEX of $6bn. So more debt is needed.
Analysing FMG’s FY12 cash flow:
Net CF from operating activities = $2808m
Interest and finance costs = -$584m
Net CF from investing activities = -$5990m
Dividends paid = -$251m
So, operating CF in excess of net investing CF and dividends = -$4017m
This cash flow deficit was funded by net debt financing of $3628m and a decrease in cash on hand of $389m.
Turning to the income statement and doing some rough back of the envelope calculations (ignoring changes in iron ore inventory), revenue/production = $6681m/57.5m = $116 per wet metric tonne.
Operating profit/sales revenue = $2612m/$6681m = 39.1%.
Operating profit/wet metric tonne produced for FY12 = $2612m/57.5m = $45.43.
Assuming that a fall in iron ore revenue per tonne reduces FY13 operating profit per tonne dollar for dollar, a fall from $116 to $80 would reduce operating profit per tonne to $9.43 on 86.5m tonnes of production for FY13. But after deducting interest financing cost and some allowance for tax, FMG would make a very small profit, $24m.
This is very back of the envelope, but the problem I see is profit compared to debt going forward with huge operational leverage against the iron ore price. FMG’s share price could explode on higher iron ore prices or implode on lower iron ore prices with its own rapid supply expansion adding to the demand-supply iron ore price dynamics. Hence, FMG could be shooting itself in the foot by not following BHP’s more moderate iron ore production expansion path which would require less debt on the balance sheet.
I am unsure what FMG’s debt covenants are. I wouldn’t touch FMG unless this debt-capex expansion works out well and it has hardly any debt years down the track and trades at a discount to IV. But I’m interested in how it plays out but probably need to wait until FY15 or FY16 for any substantial reduction in debt on the balance sheet.
The other thing to note was return on adjusted starting equity for FMG was approx. 68% and 64% for FY11 and FY12 respectively. For BHP, I have 72% and 48% respectively for FY11 and FY12 on ending equity (it would be more on starting equity) for the iron ore customer sector group. Hence, the high returns have attracted supply but more supply and global recession demand shocks can reduce ROE quickly.
Andrew Legget
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great post Paul, very interesting stuff. Thanks a lot.
Itswill_ang
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Roger, thanks to your view from 6 months ago about iron ore, I have stayed away iron ore related stocks. I have decided to also skimmed BHP at $35 from my portfolio and decided to go and do more research on industrial stocks.
On another note, John Hempton is hedge fund manager whose blog I closely follow and he wrote an extensive analysis of FMG in his blog back in May12.
It seems that Mr. Forrest is trying to put some sort of physiological floor on the FMG stock price when he bought again this week. I bet bankers who lent FMG money must be sweating at the moment and I kinda have a feeling that they must have lent money to FMG with a strict borrowing covenants which might force FMG to raise capital and sell assets if iron ore price stays at this level over the next 1 year or so.
Andrew Legget
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I have read the Fortescue messages about iron ore with interest as soon as Jim Chanos came out talking about them being on his short list due to high leverage and falling iron ore prices. It does seem that now at least Roger i think you find yourself on the side of the crowd for once. I read an article the other day about an investment bank forecasting an iron ore price of around $83 etc.
Time will tell whether he is on the ball or whether he is sticking his head in the sand. Very glad that i decided a long time ago to ignore mining and resources.