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Fortescue

Fortescue Metals Group (FMG) 31s (BUY)

IAM Capital Markets View

The Fortescue Metals Group (FMG) share price has always correlated strongly with iron ore prices. Since the end of July 2021, iron ore has dropped over 50% from around USD220/t to around USD100/t, with the share price falling by nearly 50%. FMG’s 31 bond valuation has also cheapened up, with the bonds now trading with a yield to maturity (YTM) of around 4%.

For reference, the FMG 31’s have dropped by around 6% in price terms. At these YTM levels, it’s now looking increasingly good relative value versus other BB assets, even if FMG were to stay a high-yield credit for the near term. Versus the AUD IG BBB corporate curve, the FMG 31’s offer almost a 1% pickup — which is quite attractive. FMG continues to offer exposure to long life operations, with attractive margins and expansion optionality over the long term.

Even though iron ore prices have fallen significantly, FMG still generates around USD26/t margin at spot prices. Assuming a spot price of USD95/t, JPM estimates a margin of USD26/t, which translates into healthy free cash flow (FCF) generation and is more than sufficient to service their outstanding debt stack comfortably.

Barring a total collapse in the Chinese economy, this credit is still in good shape. One can look at the iron ore futures market to see that the 1 year forward contract is only priced at USD105/t (not USD50-60/t). So, while FCF generation may be lower, we expect FMG to manage capex and shareholder returns in the current environment.

Table 1. Margin Analysis at Spot

Margin analysis MIN FMG RIO
C1 unit costs (US$/wt) 48 15 18
Royalties (US$/t) – notional 7.5% 5 5 7
Freight (US$/t) 16 16 16
Total EBITDA costs (US$/t) 69 36 41
Sustaining capex (US$/t) 4 5 5
All-in cost (US$/wet t) 73 41 46
All-in cost (US$/dry t) 79 45 50
Price discount @ 25% of spot 24 24 0
All-in cost + discount (USD$/dmt) 103 69 50
Iron ore price 62% Fe (US$/dt) 95 95 95
Margin (US$/dt) -8 26 45

Source: Bloomberg Finance L.P., J.P. Morgan estimates

Iron ore prices have fallen in recent months due to the Chinese government focusing on reducing pollution ahead of the Winter Olympics in Beijing, which has resulted in a drop in Chinese steel production and iron ore imports in July and August 2021. However, commodity prices including Chinese steel have held up well despite the collapse in iron ore and even the debt crisis at China Evergrande.

This points towards the Chinese economic engine being in generally sound shape (albeit slowing) and the drop in iron ore being largely driven by idiosyncratic (rather than structural) factors. Beijing will want to balance the country’s climate goals against economic stability — particularly if growth starts to wane with COVID-19 counts ticking higher.

Furthermore, FMG’s FY21 results were incredibly strong, hitting an EBITDA margin of 74%. FMG is sitting on a net cash position of around USD2.7bn, and adjusted EBITDA was at USD16.4bn (a record for the group, and no doubt pleasing for CEO Twiggy Forest’s paycheque). The company also has limited debt maturities until 2024. A USD1.5bn bond issued in March 2021 and early repayment of 2022 and 2023 debt maturities has reduced any refinancing risk.

Table 2. Financial Metrics

$ in millions
Source: Company Filings, FactSet & CreditSights

Table 3. Iron Ore FE, CFR China Futures (Quotes)

Data as of 5 October 2021
Source: CME Group Futures Pricing

FMG’s 31 bond valuation has also cheapened up with the bonds now trading with a yield to maturity (YTM) of around 4%. For reference, the FMG 31’s dropped by around 6% in price terms. At these YTM levels, it’s now looking increasingly good relative value versus other BB assets, even if FMG were stay a high-yield credit for the near term.

Versus the AUD IG BBB corporate curve, the FMG 31’s offer almost a 1% pickup, which is quite attractive given it offers exposure to long life operations, with attractive margins and expansion optionality over the long term.

Chart 1. Relative Value for FMG USD Secondary Curve

Source: Bloomberg

Chart 2. Relative Value for AUD IG BBB Corporates

Source: Bloomberg

Chart 3.FMG Equity vs Iron Ore Price (USD/t)

Source: Bloomberg

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