Fortescue Metals Group (FMG) – Dirt Cheap

Company Overview

Fortescue is a well-known Australian success story.  A former stockbroker buys some mining leases in the Pilbara, is blocked from accessing BHP and RIO’s rail infrastructure, so he builds his own debt-funded railway.  Nowadays, Fortescue is almost debt-free, generates masses of cash every year, and has the lowest C1 production costs in the industry (ore grades notwithstanding).

Why I bought

What excites me the most about FMG is the low price – at $4.84 it is 6x FY17 earnings, for what is a very solid business.  Commodity businesses have disadvantages being price-takers, but that just means you need to be laser-focused on minimising or maximising 1 or 2 key variables – in this case production volumes and production cost.

FMG’s business is very easy to model, and based on a revenue realisation, will be cash flow positive even if we see a 12 month or longer period of sub $40/T prices.  While demand may ebb and flow depending on China and the developing world, there is a huge overhang of expensive production that can’t keep producing at a loss forever.  FMG’s position as the lowest C1 in the world gives it a strong moat, off the back of a huge infrastructure and supply chain that is already in place.

While they aren’t going to double production overnight, at 6 times earnings I’m happy for them to keep punching out $3-4B every year of free cash flow, particularly when then debt is fully repaid and FMG rolls on as a money-printing machine.

Risks

Safety

Safety is top of the list for mining companies, and FMG’s TFIFR has improved dramatically over the past few years.  There is no reason to assume they are any more exposed than other mining majors to safety risks

Long-term drop in IOP

I see this as the biggest risk, more to medium-term cashflow than the viability of the business.  There is likely to be impact when Vale ramps up to 90mT of new production from their 66% Fe S11D mine next year.  Due to the long lag between new mine development, you get periods of very high prices and periods of very low prices.  Due to FMG’s position as a low cost producer, they will be able to weather any storm.

Production interruption

An obvious risk that would seriously impair earnings.

Poor deployment of excess Capital

I am concerned about FMG’s desire to explore new mine opportunities in Gold and Copper tenements in NSW, SA and Ecuador.  Admittedly I am not an expert on the mining industry, but I would have thought that it makes more sense to either buy back shares or return excess capital back to shareholders than it does to focus on non-core exploration.

Ore Grades

FMG’s ore is 58% vs the Australian Benchmark of 62% and Vale’s S11D of 66%.  This means FMG sells their ore at a discount to the benchmark rate which results in a revenue realisation of 75-80%.  The risk is mills in future want higher grade ores or negotiate for greater discounts (this could also go the other way if new mill technology allows producers to get better results with low-grade ores).

Summary

While FMG has a few minor flaws and is in a competitive industry, their cheapness justifies making this a part of my portfolio.

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