Thursday, July 17: The cartoon below appeared in the West Australian earlier this week and many investors have asked me whether the character in it is meant to be me.
I am pretty certain I never wrote anything about carrying a cross down Oxford Street if Fortescue (FMG) shares dipped below $9.50, but I have to admit the recent shorting attack in FMG shares by global hedge funds has made me feel a little like the bloke in the cartoon being whipped by investors.
Fortescue shares have been subject to an aggressive and coordinated shorting campaign from a high of $13.15 to an intraday low of $8.59 on Wednesday. That is a reduction in market capitalisation of $12.7 billion in a little under three weeks to a current capitalisation of about $25 billion.
During the period absolutely nothing changed fundamentally for Fortescue. If anything, the fundamentals got stronger, with the Chinese steel mills agreeing to pay a partial freight rate differential for Australian iron ore, which Fortescue will receive. The commissioning process is going extremely well according to my spies on the ground in Port Hedland, but it seems the mean reversionist shorters have simply picked it as an easy target to short. Fortescue was the best performing large-cap stock in Australia in 2007-08 and it seems to have become a victim of its own success in the short term. I don't think that will be the case over the medium term.
The key reason given for the shorting of Fortescue is an unfounded market rumour that initial cargoes of its ore have not been up to the specification standard expected by the Chinese mills. That is absolute rubbish, in my opinion, with all the ore checked and graded at a variety of points along the production process. This unfounded rumour has all the hallmarks of being made up and spread by vested interest shorts, based on absolutely nothing factual.
Another vaguely plausible reason I have heard for the short attack was some people believed Fortescue's expansion plans would be delayed by turmoil in credit markets considering the company's preference for debt funding the project. I don't believe the credit markets are closed for Fortescue at all. I think the company would find any new form of project finance cheaper than previous finance, particularly once it hits official project completion. The cost of funding for companies with cash flow is lower than for those that don't. Those people who believe the debt markets are closed for Fortescue have been shorting its shares in the belief the company would have to tap the equity market for expansion capital. I don't see that as a likely outcome at all at these low share prices, or potentially at any share price, because I think the next stage of the project will be easily and readily debt funded.
Below is a chart of Fortescue's US listed bonds. This is the biggest of the bonds at $10.8 billion issued. These bonds were originally issued at a yield of 10.625%. Today the yield is 7.66%, which shows bond investors are happy to buy Fortescue debt at a 300 basis point "premium" to where it was originally issued. There is no way the value of these bonds would have rallied so sharply if bond investors had question marks over Fortescue's cash flow or expansion plans. If anything, the bonds are showing you how confident credit investors have become in Fortescue. This is telling me the company would have no problem raising fresh debt capital funding at a LOWER rate than the original bond issue. The bond market is now pricing Fortescue debt as low-risk, yet the equity market still naively believes the company is a high-risk investment proposition.
The final, vaguely plausible reason I have heard for the shorting attack is based on the view of another broking firm that there is going to be a global iron ore surplus in 2009-10, which will lead to prices falling 30%. That is completely contrary to independent experts Metalytics view on the global iron ore market supply/demand fundamentals for the next four years. It is also completely contrary to the views of the world's major iron ore suppliers. Even as recently as yesterday Rio Tinto said "Chinese GDP is continuing to grow at around 10% per annum, demand is strong while supply remains constrained. Fundamentals, not financial speculation, are driving the record prices we are realising across aluminium, copper, iron ore and coal and we see the same trends continuing into the future." Yet again, the market is backing a macro view and not listening to the biggest industry insiders.
Iron Ore supply/demand outlook
Source: Metalytics
The only thing to look at here is the "net surplus/deficit" line. You can see Metalytics' forecast deficits in the global seaborne iron ore market out to 2012. In an equity market that can hardly see past tomorrow that forecast deficit gives me continued faith in the iron ore sector. The deficit increases in 2009-10 and Metalytics forecasts iron ore prices will rise another 22% in Japan's 2009-10 financial year. That makes our forecast 52% increase different from the bears and of course that makes a huge difference to Fortescue's earnings forecasts as it remains the largest pure play iron ore stock in the world.
Fortescue, the listed iron ore derivative
Fortescue is basically a derivative over the iron ore price. Very small changes to iron ore price assumptions have huge ramifications for valuations and earnings estimates. The reason there is such a wide range of valuations and earnings forecasts for Fortescue simply comes down to differing long-term and short-term iron ore price assumptions. Most analysts have similar cost and production assumptions, but the real differences come down to iron ore price assumptions. All the analysts with $5 net present values assume mean reversion in long-term iron ore prices.
The forecasts I use see Fortescue generating net profit after tax of $1.3 billion (earnings per share of 45.4¢) in 2008-09 and $2.9 billion (EPS 104.4¢) in 2009-10. On a 120 million tonnes per annum production case, I calculate an net present value of $14.84 (NPV), while on the 180 million tonne pa expansion case I calculate NPV of $18.07. You can see the share price is significantly below both those NPVs.
The Fortescue non-believers will question the margin assumptions and production assumptions in our earnings models, but both are conservative. The year to June 2010 is the area of debate on Fortescue, yet on my numbers the stock is trading on a price/earnings multiple (P/E) of 8.4 times and an return on equity of 70%. Earnings per share growth in 2009-10 over 2008-09 will be 130%. That appears very cheap for the only large-cap pure play way of buying iron ore leverage in the listed universe, let alone on price to growth metrics.
Fortescue will achieve "project completion" at some stage this month. That target is production of two million tonnes per month. Reaching that milestone triggers the ability to renegotiate with bond holders and move forward with the next leg of the expansion. Again, our spies on the ground at Port Hedland who count train carriages, ships, etc, believe Fortescue is potentially running at a rate well ahead of the two million tonne per month "project completion" rate.
Bottom up vs top down
Shorting is a part of today's markets and I don't want anyone to mistakenly believe I am anti-shorting. I am pro free markets.
Buy the fact
We are seeing many "buy the fact" responses in leading Australian stocks that have been subject to persistent shorting campaigns on global top-down themes once the company in question addresses the market. Woolworths (WOW) was another classic example yesterday, when it cleared the air about its recent trading performance and actually made some optimistic comments about current trading conditions.
This is why I remain hopeful that the pending 2008-09 reporting season, while clearly backward looking, will be the trigger for shorting pressure easing on leading Australian stocks. I simply believe corporate Australia will prove itself to be broadly innocent of the global crime for which it has been charged and sentenced in terms of share prices. Perhaps we won't see a complete "acquittal"; we will see the sentence reduced to weekend detention.
Either way, the trend is becoming clearer where large-cap Australian corporates either react by recapitalising their balance sheet or some form of restructuring of the business, or simply allaying market fears by confirming their earnings outlook. Expectations, in the form of share prices, are so low that simply confirming no new bad news sees the market "buy the fact".
In the case of Fortescue, I expect the "trigger" event to be the announcement of "project completion" this month. That announcement should also be accompanied by a statement about Fortescue's expansion plans and product shipments to date. In my view that should lead to the "buy the fact" trading response we are seeing in large-cap Australia
Fortescue has an extremely low free float of about 11%, so I would expect the short squeeze to be violent when it starts. It also surprises me that local institutions, who are structurally underweight Fortescue, are not using this period of price weakness to accumulate stock. Fortescue is the stock local institutions always forget to buy into weakness.
FMG Price at posting:
0.0¢ Sentiment: LT Buy Disclosure: Held
(20min delay)