Fortescue Metals Group: Strong operationally while discounts blow out

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
28 January 2022, 12:30 PM
Sectors Covered:
Mining, Energy

  • A good looking quarter, with strong 2Q22 production and shipments.
  • FY22 guidance was unchanged, although FMG did cut FX by 4% (essentially lifting costs). Capex guidance was increased US$200m for the WAE acquisition.
  • We have a divided view on FMG, on one hand liking the earnings power of its core iron ore business, while bearish on its FFI push.
  • FFI’s initial loss-making status has essentially further increased FMG’s dependence on iron ore earnings.
  • We maintain a Hold rating on FMG with a (login to view) target price.

Strong operationally, weaker pricing

Fortescue Metals Group (ASX:FMG) posted 2Q22 shipments of 47.5mt (+4% qoq) vs consensus of 46.4mt according to Visible Alpha data. Realised price continued to weaken in 2Q22, although the achieved average of US$74.36/dmt did beat consensus (discount on FMG product of 32% vs consensus 38%).

C1 costs meanwhile were flat in 2Q22 at US$15.31/wmt (vs MorgansE US$14.99/wmt). 

No change to headline FY22 production (180-185mt) or unit cost guidance (US$15-$15.50/wmt), although FMG did adjust its FX assumption from $0.75 to $0.72 while keeping its cost guidance unchanged (flagging an expectation of inflationary pressures). 

FMG did lift its capex guidance for FY22 to US$3.0-$3.4bn (ex-FFI), for the inclusion of the US$200m Williams Advanced Engineering (WAE) acquisition.

Analysis

A good operational result from FMG’s core iron ore business, while the 3Q22 recovery in iron ore prices has helped to support short-term earnings, FCF generation and dividend potential.

FMG continues to pursue what we see as a very aggressive push into a large number of ESG-themed industries in different geographies.

Our concern here is FMG’s low starting point in each of the new markets it is pursuing, which suggests capital efficiency will be the first victim before getting to any considerations around the possible long-term return profile.

With potential for steel activity to mature in 2022 we are interested to see how FMG’s large ESG-themed investment framework sustains a downcycle in iron ore.

While seeking to diversify outside of iron ore, we would argue that the move into FFI (which could see a long period of losses while FMG gets established), is actually equivalent to increasing FMG’s dependence on iron ore earnings.

Forecast and valuation update

Post the strong 2Q22 result we have upgraded production assumptions, with the largest changes to Chichester production, while leaving discount assumptions unchanged. We have also lifted 2H22 C1 cost assumptions for the currency-adjusted guidance.

Net of these changes our blended (DCF:EBITDA) target price has increased to (login to view).

Investment view

Trading close to our (login to view) target price, and 5.6x FY23F EBITDA, we maintain a Hold rating on FMG. With the recent rise matching the bounce in spot iron ore prices. We are confident that we are now beyond peak iron ore.

Given FMG’s high sensitivity given its position as a mass-scale low-grade iron ore producer it could see added earnings pressure if the current downcycle extends.

Price catalysts

Short-term spot iron ore prices (given sensitivity).

1H22 earnings result and dividend.

Risks

Steel demand drivers particularly in China.

Execution risk in FFI, including R&D risk.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

Solid top-line outcome: BAP’s 1Q22 revenue was flat on the pcp, an extremely resilient result given the extent of lockdowns in the period (~70% of stores impacted) and the strength of the pcp (cycling 27% growth). Composition comprised: Trade +2%; NZ -10%; Retail -12%; and Specialist Wholesale +7%. Overall, BAP stated that non-lockdown areas are outperforming expectations. ▪ 1Q22 trade & retail: Trade/Burson revenue was up +2% on the pcp (LFL sales - 1%; cycling 8% pcp); NZ/BNT revenue was down -10% (LFL sales -15%; cycling +4%); and Retail/Autobarn revenue was down -12% (LFL sales -16%; cycling +36%). Within the Retail segment, online sales were +80% on the pcp. Stores percentages impacted by lockdown were: Trade 70%; NZ 100%; and Retail 50%. ▪ Specialist segment results: Specialist wholesale revenue is up 7% on pcp, with Auto electrical/Truckline divisions ‘performing strongly’; and WANO underperforming. ▪ GM pressure expected to be temporary: BAP stated GM was stable across Wholesale and NZ (45% of FY21 revenue); and down ~50bps Trade and Retail (~55% of FY21 revenue), driven by promotional and online pricing in lockdown areas (we assume no margin pressure witnessed in non-lockdown areas). BAP expect margins to revert once lockdowns ease. ▪ The cost base has increased vs pcp, a function of duplicated DC costs (commencement of new VIC DC), and higher group and team member support (covid related) costs. BAP noted FY22 store rollouts and refurbs are on track.

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