info on fmg

Huntley's Recommendation: Fortescue Metals Group Ltd

Recommendation: Avoid

FMG is an emerging iron ore player. The company has grown quickly from a concept stock in July 2003 to the third largest iron ore producer in the Pilbara behind BHP and RIO. FMG owns a railway and shiploader with 55Mt annual capacity. Production started mid May 2008 and by end was running at an annualised 24.4Mt. Rapid expansions plans are on hold due to the deterioration in the global economy. The company aims to be a low cost producer with similar or better cash costs than industry leaders BHP and RIO. The balance sheet is weak with $440m cash and $5.3bn debt at end 2008. FMG provides a pure iron ore exposure and upside through exploration and expansions. The weak balance sheet and unproven operations make FMG highly speculative and unsuitable for conservative investors.
Event
16-Feb-2009

In 2Q09, FMG mined 8.46Mt of ore, up 19% on 1Q09 but 40% below budget. Overburden removal was similarly 40% below budget with 10.3Mm3 mined. Only 6.1Mt of ore was processed in 2Q09, down from 6.7Mt in 1Q09 – an annualised rate of just 24.4Mt. Guidance is for 23.8Mt of ore to be mined in 2H09, 18Mt to be processed and 17.6Mt to be shipped. Cash costs in 1H09 were A$38.78/t loaded onto the ship. Excluding corporate administration and government royalties, cash costs were $33.90/t. That puts FMG at the bottom of the highest quartile of the cash cost curve. On a delivered to China basis, FMG does better due to the shipping advantage over Brazilian ore. The mine is still ramping up. The 2Q09 price of A$96.63/t equates to US$64.66/t and a 24% discount. FMG acknowledged “some pricing adjustments” in response to customer demands.

Business Impact: FMG has been operating for nearly a year with production running at about 60% of design. It is somewhat disappointing and more money and time may be needed to reach capacity. The processing plant appears to be the major bottleneck. Shipping guidance in 2H09 is equivalent an annualised 35.2Mt and 64% capacity. Following the 1H09 result, we introduce NPAT forecasts. Our $455m FY09 forecast assumes a 50% decline in the iron ore price from 4Q09, but that FMG recovers price discounts. Our FY10 NPAT forecast assumes 40Mt of iron ore sales, a fines price of US$0.74/dmtu with no discounts, A$/US$ FX of 0.64 and $30/t cash costs.

Forecast Impact: --

Recommendation Impact: No change in view. We maintain our Avoid. The recent rally on apparent early signs of a turnaround in China could be a false start. In our view, Rio Tinto is leveraged enough to the goldilocks quick turnaround scenario without seeking out higher risk plays like FMG.
Event Analysis

At Diggers and Dealers in August 2008, FMG budgeted for just over 14Mt of iron ore to be mined in 2Q09. Capacity of 5Mt of ore mined a month – 60Mt a year – was targeted from November. In 2Q09, FMG mined 8.46Mt of ore, up 19% on 1Q09 but 40% below budget. Overburden removal was similarly 40% below budget with 10.3Mm3 mined, but 32% up on 1Q09. Mine capacity of 60Mt is needed to support rail and shipping of 55Mt as substandard ore is separated as waste during processing. Guidance is for 23.8Mt of ore to be mined in 2H09. Commissioning of the mine was complete in April 2008. First ore was loaded on a train in the first week of April and first ore loaded on ship mid May 2008. FMG has been operating for nearly a year and production is running at approximately 60% of design. It is a somewhat disappointing result and more money and time may be needed to reach capacity. The processing plant appears to be the major bottleneck. Only 6.1Mt of ore was processed in 2Q09, down from 6.7Mt in 1Q09 – an annualised rate of just 24.4Mt. Guidance is for some improvement to 18Mt in 2H09, lower than ore mined due to waste losses and inventory builds. FMG expects to ship 17.6Mt in 2H09, equivalent an annualised 35.2Mt and 64% capacity. Almost all FMG ore is being sold as low grade Rocket Fines with 59% iron. Just over 4% of product shipped was “HG Fines” grading 60.2%. Still no higher value lump product – the explanation cryptic. FMG blamed the commodities market meltdown for customers refusing lump. All ore was crushed, ground and separated into the cheaper fines product, restricting the plant to less than 50% capacity. Why didn’t FMG slash the lump price to avoid the bottleneck and additional processing costs? It cited ore quality issues with high alumina and moisture and more selective Chinese buyers. The mine plan has required “modifications…to accommodate the tighter market”. Additional resources will be directed to overburden removal. Production will be restricted until sufficient quality ore is accessible. Additional ore stocks will be needed at both the mine and port for blending. It all translates to additional working capital and reduced near term free cashflow. Cash costs in 1H09 were A$38.78/t loaded onto the ship. Excluding corporate administration and government royalties, cash costs were $33.90/t. That puts FMG at the bottom of the highest quartile of the cash cost curve. On a delivered to China basis, FMG does better due to the shipping advantage over Brazilian ore. The mine is still ramping up. In 1Q09 FMG’s average price was $88.69/t – US$78.66/t – an 8% discount to the benchmark. The 2Q09 price of A$96.63/t equates to US$64.66/t and a 24% discount. FMG acknowledged “some pricing adjustments” in response to customer demands. We are keenly interested to see if these discounts will be recovered. The company expects further discounts until the new benchmark starts in April 2009. FMG reported a headline 1H09 NPAT of $1.1bn. The result included a $2.04bn pre-tax gain on the Subordinated Loan Note and a pre-tax foreign exchange loss of $808m on borrowings. Outstanding debt was marked to market, reducing the reported liability by over $1bn. Future interest repayments actually rise with the decline in the A$/US$ exchange rate. Adjusted NPAT was just $223.7m. Operating cashflow was $509.8m while $663.3m was invested for negative $153.6m free cashflow. It superficially suggests free cashflow is about to turn positive, but a $322.1m inflow was reported from sale and leaseback of various assets. Cash at end December 2009 stood at $439.5m including $140m from a preference share issue. End December debt was $5.3bn of which $426m is due in a year. FMG has negative net assets of $537.1m – i.e. liabilities are greater than assets despite the favourable $2bn marked to market debt adjustment. Annual interest requirements of $700m could pose a problem. No change in view. To justify its +$7bn market cap – assuming a required 10% annual return – we estimate FMG needs a $49/t cash margin if it produces 40Mt a year falling to $37/t if output hits 55Mtpa.