By the rivers of Fortescue

Tuesday, June 24: What is the perfect business model for the current macroeconomic and market environment?
In my view it is a very simplistic business, with scalability, pricing power, expanding margins, high free cashflow generation, and high interest cover. The business will be highly understandable and highly transparent, with low leverage to the first world consumer. Right now, among all this turmoil, more than ever I can see no better business to be in than bulk commodities.

Bulk commodities will prove the most defensive and offensive sector over the medium term. Not only will the sector’s earnings prove robust, the combination of volume growth and rising prices will see earnings and dividend growth beyond all current expectations. As you know, I think earnings and dividend growth is actually going to prove the rarest "commodity" of all over the next few years.

This week the Chinese settled with Rio Tinto up 97% for lump iron ore and up 80% for fines iron ore. I don't see any industrial industries achieving that scale of product price rise for 2008-09.

My core strategy remains that we are going to experience a "two-tiered" economy and a "two-tiered" equity market over the medium term. More accurately, it seems the right description is "three-tiered": the "haves", the "have nots", and the "completely gone".

Management depth

One of the points I have consistently tried to make in support of the Fortescue Metals (FMG) investment case was the depth and breadth of management experience below Andrew Forrest. In fact, one of the first things that attracted me to Fortescue was being somewhat stunned at the experienced team Forrest had assembled to deliver the project. All of the divisional heads were formerly with BHP or Rio Iron Ore and all had decades of experience. They were passionate iron ore or bulk commodity men and highly leveraged personally to delivering outcomes for all shareholders, including themselves.

I think Forrest’s absence from last week's site visit of brokers reinforced this point about management depth to those who attended. Numerous people said to me, 'I never knew the guys below him were so high quality’. That is a point that needs to be driven home because it remains underappreciated by most investors and commentators.

I continue to regard Forrest as "chief enthusiast", "financial arranger", "largest shareholder" and "front man" of the Fortescue "band". But as we all know the best "front man" needs a great band behind him if he is going to deliver the "music" the market wants to hear in the form of earnings and dividends. Forrest has a great "management band" behind him and it remains an underappreciated fact of the Fortescue investment case.

After getting over the shock that $11 billion didn't buy you immunity from the flu, we made our way to the Fortescue train unloading facility to watch a 240-carriage train be unloaded by an amazing, fully automated process. No locomotives or train engineers are involved, with the train being moved precisely by hydraulic systems just outside the car dumper house. Watching a 240-carriage train being moved by fixed hydraulics on the ground is amazing enough; then to watch two 120-tonne cars be flipped upside down effortlessly, while still coupled together, and the whole process taking just 86 seconds, does impress you.

Train Unloader

The point about the car dumper is that it is state of the art. No expense has been spared and no corners cut. This is a feature of all Fortescue's infrastructure, which has been engineered and delivered by WorleyParsons. Seeing all this reinforces my positive opinion on Worley.

Automated reclaimer

I was very impressed by the changes I noticed at the port since I was last up there a month ago, and you get the feeling that the decision to move to the second stage of the port and rail capacity expansion can't be too far away. Remember, Fortescue has designed the port and rail so that expansions don't interfere with existing production. Fortescue has already loaded more than a million tonnes of ore from the port in this ramp-up stage. The ramp-up accelerates sharply over the next few months with the two million tonnes per month "project completion" benchmark to be hit next month. This is important in terms of bond holder negotiations.

Shiploading

We then made the 30-minute flight to Fortescue's Cloud Break mine and processing facility. As you can see in the photo below, the Cloud Break airport would put most regional airports to shame, with a 2300-metre runway capable of the handling 737s that transport the fly in/fly out workforce.

Cloud Break Airport

The last time I was at Cloud Break was on Anzac Day in 2007. In just 14 months the development progress achieved is incomprehensible. Below are two photos taken from Strawberry Hill at Cloud Break. The first was taken on May 23, 2007, and the second on June 20 this year. Just have a look at these before and after shots. I can still remember Forrest pointing to different patches of dirt telling the small crew on the first trip where things would be built. Today they are built and operating.

View from Strawberry Hill, May 23, 2007

View from Strawberry Hill, June 20, 2008

The photo above does not do justice to the scale of assets that have been constructed. For example, the conveyor dumping crushed and screen iron ore is the world's largest radial stacker. You can only truly comprehend the scale of these assets by seeing them with your own eyes. Just 14 months ago only basic site levelling had been completed for these ore processing facilities; today they are operational and being ramped up to the 55 million tonnes a year production target.

In all my conversations with investors, the biggest debate about the Fortescue investment case has been the mining method. In my view, the consensus view of fund managers remains that the surface mining method won't be able to meet production targets. Well, as the photo below shows, surface mining works on the type of flat ore bodies Fortescue controls. To watch 100-tonne capacity trucks being filled by a surface miner that is chewing through the iron ore like it is chalk surely and finally puts to rest the notion this mining method won't work. The fact is that it is working better than expected. The fact is there is no lower-cost mining method.

Continuous mining: $8700 per truck load of ore

In my observation, the production ramp-up was progressing solidly at Cloud Break. The fleet of surface miners and trucks was working efficiently to deliver a continuous stream of ore to the ore processing facility. Each 100-tonne truck is carrying $8700 of iron ore under the new contract prices (60� x $144.66 per metal unit)

Show me the money

For a couple of years Fortescue’s supporters had to put up with comments about the market cap of a company "that has never produced a tonne of iron ore"; now we have to put up with comments about the market cap of a company "that has never made a profit". These comments clearly come from people who have no idea how equity markets work. The equity market discounts the future and they are clearly discounting that Fortescue will be a highly profitable company as cash flow commences.

Let's assume Fortescue produces 45 million tonnes of "fines" ore in 2008-09 as the ramp-up gathers pace. It will get $US87 a tonne for that ore (average 60�). That equates to raw revenue of $3.9 billion. Fortescue would generate a $US65 a tonne margin on that ore, creating an EBIT of about $2.95 billion (pre royalties and interest) That puts Fortescue on roughly 14 times earnings, yet with a production growth profile that should see the company producing at four times that rate in five years time. Fortescue will be a 200 million tonne per annum (mtpa) producer and I reckon there is some chance it will do so before some of its larger competitors. Just for the exercise, 200 million tonnes, with a margin of $US65 a tonne, equals EBIT pre royalties and interest of $13 billion. There's something to think about.

The Fortescue infrastructure had been designed for scaleability. Make no mistake: Fortescue is the most leveraged exposure to the Chinese paying up for our iron ore. It is 100% iron ore; Rio is 30% and BHP 15%. Fortescue is the pure play, the pure leverage.

No more equity will be issued

With the Fortescue cash flow tap now turned on, my view remains that it the company will not need to issue any new equity to fund further expansions. There is no doubt that rapid production expansion is the way to generate the highest return on capital and bring forward profitability. With cash flow commencing, Fortescue will have debt financing options for production expansions and I believe it will prove to be exactly like Woodside Petroleum, where issued equity capital has remained unchanged for 20 years. The point is that if you are going to buy Fortescue shares, you are going to have to buy existing equity. This is in a stock where the "free float" is effectively 11%. Seventy percent of Fortescue's register is owned by just five parties. I think you can happily forecast the company’s earnings per share for the next 20 years using the 2,803,832,520 shares on issue as the denominator.

Everyone who doesn't know him keeps telling me that Forrest will sell down some of this holding. My view is that there is absolutely no chance of that occurring. Those waiting for him to sell them stock will remain sorely disappointed. In fact, I don't think Fortescue staff will be the source of any selling.

Moving into a new higher trading range

Clearly, Fortescue shares have moved into a new higher trading range to acknowledge the company's evolution from explorer to producer last month.

I believe that as the market then comes around to focusing on Fortescue as a 100 mtpa producer, the stock will trade between $12.40 and $15. That also hasn't assumed Fortescue pays any dividends, which they are likely to do (in a small way)

While many investors will naturally think "I've missed the Fortescue boat", I believe that certainly isn't the case. You have missed the share price all but discount a 55 mtpa producer, but you are still buying a 100 mtpa, 200 mtpa or eventually a 400 mtpa producer very, very cheaply.

Fortescue remains a strong buy and is the great "pure play" winner of structural change in iron ore pricing. Forrest and his team have done such an admirable job against enormous odds and enormous scepticism. To deliver this project on time and within budget in a period of "hyperinflation" in engineering and materials costs is an outstanding effort. Fortescue is now a physical "producer" and from this point domestic investors who need to see cash flow before they buy, can buy the stock.

I have seen the Fortescue production process working with my own eyes. It works, it works well, and it is clearly scaleable. Fortescue remains the only new, real, large-scale supply response I can identify. Everyone talks about a supply response, but Fortescue is physically delivering one.

Stockpiling cash

Have a look over my right shoulder. That is a sweet sight for Fortescue shareholders. That is a river of cashflow. You can't help but be impressed by what Fortescue has created in such a short period. But this is only the beginning of a long march to be a top-tier global iron ore producer, yet one that resides right down the cost curve.

While there were more analysts and investors on last week's site visit than previously, the fact remains that Fortescue remains the most under-owned large cap stock in Australia. This is despite it being the best-performing stock (up 256%) in the ASX100 this financial year. Everyone owns Rio, but even with Rio (up 50%) under takeover you would have done five times better owning Fortescue this year.

The top 10 performers are all resource stocks and I remain absolutely convinced that resources are taking over leadership of the Australian equity market for the foreseeable future. I am happy to say I never recommended any of the bottom 10 in this list. Look at the performance numbers delivered by the top 10 and they tell me this is a bear market. It isn't in resources, it is in gearing.

When I am in Port Hedland I see non-stop activity and demand for product. This resource cycle is in its infancy and the great winners will be those who can deliver production growth into structurally higher commodity prices. Fortescue is clearly one of the great winners and is seizing the opportunity for Australia and its shareholders. It remains the biggest new story in Australian resources and the doubters will remain wrong.