There is no large cap stock in Australia that generates more...

There is no large cap stock in Australia that generates more polarising views than Fortescue Metals Group (FMG). Today, as one of the very few Australian financial markets commentators who has actually visited FMG's asset base, I am going to give my independent views on the FMG investment case.

When I wrote a week ago that I was attending a FMG site visit I had numerous responses from investors along the lines of "why would you bother doing that?" The simple answer is because this is a A$6bil market capitalisation company, that is included in the benchmark ASX200 index, yet only one mainstream broker writes research on the company and no mainstream Australian institutional investor owns any stock. The company is building the most significant new resource project in Australia, yet nobody in the Australian investment community takes it seriously. Only last week, a major US broker upgraded all their iron ore price assumptions, upgraded BHP and RIO recommendations, and also recommended small caps MGX and MMX. No mention of FMG, and that shows you the discrimination against the stock with the greatest pure leverage to the theme they were broking.

The investment community has made the mistake of playing the "man" and not the "ball". Our view was that it is clearly time to play the "ball", particularly given that it seems a "misinformation" campaign has been run about FMG by vested interests in the iron ore industry. The point is that this is a $6bil company that nobody owns and nobody writes research on, yet when it works it will be the largest pure iron ore company in the world, operating in a politically stable country, with huge barriers to entry and huge free cashflows. While the temptation in FMG is to think "it's moved from 8c to $23.00 and I've missed the opportunity", below we are going to explain why the risk adjusted investment case for FMG is strong and the company is moving from speculative to investment grade.

Our Senior Resource sector analyst David Radclyffe and I went to the FMG trip with an open mind. We wanted to go with no preconceptions and attempt to make an independent assessment of a stock most people are vehement non-believers in. Many people talk about "independent research", but in reality very few people truly practice it. SCE has now had 4 operatives visit FMG's asset base, more than any other broking firm. So lets explore what we saw with our own eyes.

No "one trick pony"

We got an early flight from Perth to Port Hedland. The first thing we noticed was that there were no Australian institutional investors on the trip. The second thing we noticed is that the global brokers who bothered attending, with one exception, did not send their senior resource sector analyst. The fact most global brokers didn't send their senior analyst to visit this company again reaffirms the cynical attitude most have towards this company.

On the flight up I sat next to Graham Rowley (AM), Executive Director of FMG Operations. Graham is a former Rio Tinto operative who held senior positions at Hamersley Iron and Argyle Diamonds. He was previously a Director of the Dampier Port Authority and has extensive experience in operational management of both iron ore shiploading facilities and heavy haul railways.

To me, talking to Graham was the first positive surprise of the trip. I, like everyone else, had previously thought FMG was really the "Andrew Forrest show", but when you delve a little deeper you realise Andrew has assembled a world-class management and operational team below him. The way I see it, Andrew is the financier and largest shareholder in the group. He is the Chief Executive, chief enthusiast, and strategist as such, while below him is a highly experienced team of hardened operational iron ore men, most of who are ex Rio Tinto or BHP Billiton.

Management depth

The depth and quality of FMG's operational team is not widely known, and I am going to spend a little time running through that team and their credentials. I have already mentioned Graham Rowley's credentials, and the other Executive Director is Russell Scrimshaw formerly of the Commonwealth Bank. CFO Chris Catlow is ex Iluka Resources (ILU), CFO of The Pilbara Infrastructure Pty Ltd (100% owned by FMG) Peter Thomas is ex Lehman Brothers, Chief Operating Officer of The Pilbara Infrastructure Pty Ltd Alan Watling has had 25 years in heavy haul management positions with Hamersley Iron (RIO), and was responsible for major new projects at Marandoo, Yandicoogina, and Brockman. Head of Resource Strategy is Dr John Clout who is ex CSIRO, and has previously advised companies such as RIO, BlueScope Steel, One Steel, Robe River, Hanc*ck Prospecting, and Hope Downs. Head of Mining, John Blanning, has over 22 years experience in open cut mining operations, with his previous job being General Manager of BMA Blackwater Mine (BHP), the largest open cut black coal mine in Australia.

The point I am making is that the management team is serious, credentialed, and experienced in large-scale mining, financing, and heavy haul logistics . I think very few people realise the depth and quality of FMG's operational management team. Meeting these guys was a very interesting development. They are all passionate about the project, and they all have significant shareholdings in FMG.

I was very impressed by Alan Watling. This bloke breathes, eats, and sleeps iron ore. I sat next to Alan at dinner that night, and I put to him that most people on the East Coast didn't believe FMG would ever have a train line that works, never have a port that works, and never have a business that works. That was red rag to a bull, and he was absolutely adamant that FMG's infrastructure would be the most efficient in the Pilbara, with the advantage of being developed from scratch.

The dinner was after a full day of inspecting the Port of Port Hedland and FMG's new port, train unloading, and stockpiling facilities at Anderson Point. I was shocked at both the scale of the Anderson Point development, and how far advanced its construction was. First Iron ore on ship is scheduled for May 2008, and after speaking to the contractors, I believe that target date will be met.

FMG has employed blue chip contractors for the project. Laing O'Rourke are doing the rail construction, Roche Mining are doing the outsourced mining operations, BGC the rail earthworks, General Electric the locomotives, McConnell Dowell the marine structures, and Thyssen Krupp the design of iron ore stackers, reclaimers, and ship loaders. They are all incentivised to deliver the project on time and on budget. Infrastructure is key to any bulk mining business, and I want to show you some photos of FMG's $2bil+ of infrastructure under construction. Remember, a lot of people don't even think this infrastructure exists, let alone is this developed.

Anderson Point; well advanced, huge scale 200mtpa potential capacity



Day 2; small planes and big mines

We were the first people to land at the new airstrip at FMG's Cloud Break mine 300kms inland from Port Hedland. The airstrip is 2300m long, and will cater for commercial jet flights from Perth (or anywhere). The strip will be bitumen and all-weather, which is crucial given the wet season. From the airstrip it's a short hop to the camp, and construction is moving along on the permanent camp. As I mentioned on Monday, "camp" is an inaccurate description of the facilities.

Heavy earthworks at Cloud Break





The topography at Cloud Break is much flatter than the other existing iron ore mines we saw. This is an interesting point as the topography and positioning of the ore body close to the surface should reduce mining costs and increase sustainable margins. Some of the other existing iron ore mines we saw are so deep it takes the trucks 40 mins to reach the top, and one can only guess how many hundreds of litres of diesel that takes. FMG's trucks should only take 5 mins across flat country to reach the crushing and screening plants. That is a big sustainable advantage in diesel costs, as is the continuous mining strategy that FMG are employing.

The nature and structure of the ore body make continuous mining necessary. The market has huge doubts about continuous mining of iron ore, yet the technology is widely used around the world in the coal industry. FMG have ordered 16 continuous miners from Germany's Wirtgen, and have people on site at the manufacturing plant making sure the technical specifications are met. The test pit FMG mined was using a single 17 year-old continuous miner, and that worked well. The new models have significantly better operating features, and are dramatically more efficient in terms of operating costs. The market will only believe that continuous mining of iron ore works when they see the first train loaded with ore from the mining technique, but after seeing the test pit with my own eyes I would be certain that continuos mining works on an iron ore body of this style and that will keep FMG right down the cost curve.

This is a key point, and should ensure that FMG's lower iron content ore is offset by lower mining costs, seeing margins similar to existing operators. The other factor that should increase operating margins is FMG's project "rocket", which is designed to increase the average iron content of shipments, which should eliminate the discount FMG receives for its product.

In the few broker models I have seen for FMG, all assume higher cash costs, lower through put, and significantly discounted final prices. The conclusion is margins significantly below what will be achieved.

Volume x margin

Iron ore is basically a logistics business. It's all about moving as much high iron content volume as possible, doing it 24/7, and doing it for the lowest cash cost you can. FMG's initial target is to move 45mtpa of iron ore. That annualised rate will be achieved in the 2nd half of 2008.

However, the limited broker research doesn't see 45mtpa until fy10 at the earliest, and as I mention above, they see cash costs closer to $25t and selling prices heavily discounted to RIO and BHP. Even with these very pessimistic assumptions, the company generates forecast revenue of $2bil+, a net profit of $700m, and EPS around $2.40 per share. Even on very pessimistic assumptions, FMG is trading on 9.5x fy10. That's the worst-case scenario, and lets look at some more realistic "back of the envelope" earnings scenarios for the years beyond FY10.

Lets assume FMG make the decision to go straight to 120mtpa production. That decision needs to be made by August this year. That would require bondholder approval, which I suspect would occur. FMG keep all the contractors on site, and they go for it. The 120mtpa scenario sees 4 berths, 3 shiploaders, 10mt of stockpiles at the port, a double train loop with 1x2 car unloader, and 1x4 car unloader. It's all additions to what will be existing infrastructure, and I think it's unrealistic to consider FMG as a 45mtpa producer. Under the expanded production scenario, FMG would be producing 120mt in FY12.

120mt x A$ margin of $40t = EBIT of $4.8bil. Interest costs will be $300m (ish) assuming stage 2 is debt funded, corporate tax of 30% comes out leaving a NPAT of A$3.15bil, EPS on the current capital base (264m shares) of $11.90 per share.

Yes, that is not a typo. The scenario above sees FMG earning FY12 EPS of $11.90 per share, which puts the stock on a prospective FY12 P/E today of 1.87x. The stock will have a tonne of free cashflow, and should be able to maintain a 50% payout ratio. The dividend yield is potentially extremely attractive.

Lets just say FMG do generate EPS of $11.90 in FY12. The world will pay 10-12x earnings for that annuity stream, which gives you a FY12 price target of $119.00 to $142.00. The FY12 market capitalisation could be between $31bil and $37bil, placing FMG in the top 10 stocks in Australia by market capitalisation. This could all happen in the next 4 financial years.

Who dares wins

No analyst will ever dare write what I speculate about above, but this is how you make money in company's nobody believes in. You have to take a view, and run "what if" scenarios. Even if the scenario is even half right, FMG will earn $6.00 of EPS in FY12, put that on 10x, and you still get a share price target of $60.00.

The point I am making is even doing rough back of the envelope mathematics, you can see this company at $6bil current market could easily prove to be a tremendous bargain. Yes, we are a long way from FMG shipping 120mtpa at a $40 margin, but we aren't as far away as the market believes. I think you can justify the current FMG share price on a worst-case scenario, because I believe the mining and logistics process will work, and the initial 45mtpa target will be met.

Yet, when you do "what if" scenarios you can see the leverage in this stock is potentially enormous. There is no way of buying such pure, large scale, leverage to the sustainability of iron ore contract prices. If we are right about our stated view about the sustainability of iron ore prices, and if we are right about FMG's production growth and selling price assumptions, then in medium-term (3 to 5 years), FMG could easily be a $100 stock and a significant weighting in the ASX200 index. The great disappointment is that no Australian institution will own it, and retail investors will not know about it because mainstream brokers won't write research on it.

I am one of only a handful of Australian's outside of FMG's employment who has visited their project. Unlike the vast bulk of East Coast cynics who have never been to site, I believe this project of National significance will work, and work to a scale both operationally and financially that nobody currently believes possible . The biggest risk is that this project is a genuine success, not the genuine failure that most people expect. On that basis, the real investing risk in FMG is low, and the potential upside leverage high.

The FMG ride won't be without volatility (like all resource stocks), yet the tight register means it will be very hard to get set if the scenario I believe in unfolds. Start playing the ball (assets) and you will see the upside opportunity in FMG. All we are playing is the long-term trade in FMG doubters becoming believers, and that will be one rewarding process for existing shareholders. Corporate Australia is littered with stories of doubters becoming believers, and then the company becoming a mainstream investment. ( MBL, SGB, HVN, WPL, TOL etc)

I 'd be buying/accumulating FMG anywhere under $30.00 and putting them in the bottom draw. This will work, and FMG will become one of Australia's largest companies. We back people and assets, and FMG has both. If you build it, they will come.