"Putting aside what the recent movements in FMG's price have been and that it seems to be "much loved", have you developed an estimate (or even a rough opinion) of its fair value?"@hfrench,
Since you asked, yes, I do have an opinion of what I believe to be fair value for FMG.
My central estimate of FMG's intrinsic value is around
$6.60/share (with a
bull case value up to
$8.20/share). (Derivation follows below.)
Valuation Methodology:
Because it is a cyclical commodity producing company, as a matter of prudence I would never reference commodity prices that are at unprecedented levels as the basis for assessing fundamental value. Because doing so simply ensnares one in the trap of narrative bias.
Instead, what I do is take a Free Cash Flow (FCF) yield approach
[*], using mid-cycle commodity prices.
So, in FMG's case, to derive
mid-cycle FCF, I make use of the following assumptions in my modelling:
1. Annual sales of 165mtpa,
2. Mid-cycle benchmark 62% Fe iron ore price of US$60/t,
3. FMG price discount to benchmark price = 15%
4. Unit Cash Operating Costs of US$25/t,
5. Effective Royalty of 6%
6. Long-run A$:US$ exchange rate of 0.72
7. Capex, mine development and exploration expenditure of US$1.2bn pa
8. Valuation: Fundamental Value-to-FCF = 8.0x (base case) to 10x (bull case upside "flex")
Using the above parameters, the salient elements of the FCF calculation are as follows:
Unit Cash Margin = US$60* (1-15%) - US$25/t = US$26/t
Net Cash Receipts = US$26/t * 165mt = US$4.3bn
Now Operating Cash Flow (OCF):
= Net Cash Receipts - (Interest Payments + Royalties + Tax)
= US$4.3bn - (US$0.2m + US$0.4m + US$0.7bn)
= US$3.0bn
Therefore,
FCF= OCF - (Capex + Development + Exploration)
= $US$3.0bn - US$1.2bn
= US$1.8bnNow, deriving Fundamental Value:
Valuation @8.0x FCF:
= 8.0 * US$1.75bn = US$14.3bn
= A$20.4bn (@ A$:US$ = 0.70)
=
~A$6.60/share (3.1bn shares on issue)
Valuation @10.0x FCF (corresponds to bullish, "upside flex" case):
= 10.0 * US$1.8bn = US$18.0bn
= A$25.6bn (@ A$:US$ = 0.70)
=
~A$8.20/share (3.1bn shares on issue)
Some qualifying comments are probably warranted:
1. One can debate until the cows come home about the merits and demerits of the assumptions used in this exercise, and everyone will have a different view depending on their personal circumstances, risk tolerance and general approach to investing. The above parameters are what I am personally comfortable with and which I therefore deem to be fair and reasonable given my investing process and philosophy and the nature of the company in question.
2. Clearly, the variable that matters most in such analysis is the assumed mid-cycle benchmark iron ore price. I do not keep a close track on what analysts use as long-term prices these days for their discounted cash flow valuations but when I last looked (about 6 months ago), it varied between US$40/t and US$50/t (real). While these figures - because they are long-term assumptions - should not vary much over time, analysts might have been edging them up to account for the current supply-side shock. Which is why I have used a figure well above the prevailing long-term prices; to preempt the "creep" in long-term assumptions.
3. As a reasonableness check, I compare my US$60/t long-term price to the long-run price required to induce induce incremental supply which I assume would correspond to an Internal Rate of Return on Incremental Capital in excess of 20%. To that end, investing in the average 10m tpa brownfield operation, based on a capital-intensity of US$100/annual tonne of capacity, and at a cost structure in the middle of the global cost curve, will yield an IRR of somewhere between 25% and 30% based on a US$60/t long-term price, by my calcs. So, a US$60/t long-term price is self-evidently quite generous in the context of industry economics.
4. Probably the most relevant observation I think I am able to make on this subject relates not to fundamental value
per se (which, as we know is always subject to one's chosen input assumptions), but to share price versus commodity price momentum.
In that light, I think that the biggest risk to the stock price is if the spot iron ore price eases from its current level (stating the obvious, I know).
And even if it falls from its current level of ~US$120/t to a still-elevated US$90/t or US$100/t (which are still well above any semblance of long-term price expectations), I am quite certain that FMG's share price will also ease under such a scenario.
Conversely, should benchmark iron ore prices rise even further than their current parabolic levels, there is a real risk that investors question the sustainability of such further price rises, and therefore choose not to buy more shares in iron ore producers. In fact, there seems to be some early evidence of this market psychology in the past two weeks or so, during which the iron ore price has continued to strengthen, yet the share prices of iron ore stocks have not followed (in fact, they've eased back a bit).
So, in terms of the momentum side of the equation and potential buyer fatigue, I struggle to see where can see where the marginal buyer of FMG comes from, but I can see where potential sellers might materialise.
[*] The reason I ignore conventional valuation methodologies such as P/E multiple, is that because the capital cycle in a resources company is mostly front-loaded (during the exploration, development and construction of the project), the subsequent accounting treatment of the sunk capital via an amortisation charge, is not relevant to the discounted cash flows once the mine is up and running.
(By inference, using P/E multiples risks actually
understating the intrinsic value of a resources company, because the "E" includes accounting charges of a non-cash nature which bear no relevance to the continuation of the business as a going concern... well, until the mineral resource in question is depleted, but that forms a topic for a different discussion.)
(20min delay)