Fortescue's ore price peril

PORTFOLIO POINT: Fortescue’s lower profit margin compared with BHP and Rio makes it much more susceptible to a drop in the iron ore price.

Editor's Note: Jim Chanos, the US fund manager, has troubled a number of top Australian companies over the year through his annual publication of his 'top short’. The fund manager came to fame in Australia some years ago when he announced Macquarie Bank was his chosen 'short’. Following that 'call’ from Chanos, Macquarie Bank fell heavily due to a variety of factors surrounding investments banks and the GFC. Now Chanos has announced he has a 'short’ on Fortescue Metals. To some extent these calls by top hedge fund managers are self-fulfilling. The stock may well fall if a major short trade in the market is publicised ... nonetheless, it is essential as a retail investor that you are familiar with these issues in the market. Moves by hedge fund giants such as Chanos can also be picked up by local boutique managers such as Bronte Capital’s John Hempton. Hempton, who has regular short positions in Fortescue, has widely circulated the article below. Anyone with investments in iron ore through Fortescue (which closed at $4.97 today), or indeed in BHP or Rio, will find the piece reprinted below very interesting. James Kirby, Managing Editor.

The Australian boom – the one that leaves foreigners gobsmacked when they see our housing prices, debt levels and general economic cheeriness – has been powered by iron ore and (to a lesser extent) coal.

These are the components of steel, and steel is the foundation metal of infrastructure – bridges, skyscrapers, gas pipelines and rail. Coal and (especially) iron ore are the raw material for the great Chinese construction and infrastructure build-out.

Below I demonstrate just how extreme the iron ore boom is by extracting BHP Billiton revenue and EBIT margin by commodity from BHP's last annual report.

Table 1: BHP Billiton revenue and EBIT

I want to draw attention to the critical lines. Iron ore revenue (in millions of $US) progresses from 10,048 to 11,139, to 20,412, from 2009 to 2011 inclusive.

Underlying EBIT from iron ore was $13.328 billion in 2011.

That is a 65.3% EBIT margin. These margins would make a luxury goods maker salivate. LVMH (the iconic luxury goods powerhouse) had an EBIT margin of about 23%. To make the margin for LVMH equal the margin from BHP’s iron ore operation you need to exclude all selling costs (by far the bulk of costs) from LVMH’s accounts.

You get the idea this is profitable. Breathtakingly profitable.

But it has not always been. Back in 2000, BHP made $2.5 billion EBIT on $21 billion of revenue. BHP only made that because its operations were about the lowest cost in the world.

The numbers above (almost $32 billion of EBIT) reflect the powerful commodities cycle.

For an Australian investor (or an investor in the large Australian mining stocks) the (literally) $64 billion dollar question is: What is the normalised profit of iron ore companies? At the moment (in what might be the tail end of a wild boom) the profit situation reflects two things – an historically very high iron ore price, and historically high costs (especially labour) incurred to get the stuff out of the ground.

The end price of iron ore is going to depend on global cost curves. I do not know the shape of cost curves but it seems unlikely to me that iron ore will remain as profitable on a cost-of-goods-sold basis (and three times as profitable all up) as selling luxury goods.

Whatever happens, BHP Billiton’s mines will remain operational. They are very high grade (mostly over 60% iron content and with acceptable impurities) and with good transport infrastructure in place. The only iron ore operation that is competitive is Rio Tinto, where the grades are a little higher still.

Fortescue: an aggressive miner somewhere in the middle of the cost curve

BHP Billiton and Rio Tinto are the very best iron ore operations in the world. Vale is clearly pretty good too (but further from China, where the demand is strongest).

There are some very marginal iron ore operations getting funding (see Alderon as linked above). Also, there are newly developed large mixed-quality operations (particularly on the West Coast of Africa). The competition is rising.

I don't know (nor does anyone else really) where the cost curve will be, but it is likely that Fortescue Metals Group will be somewhere in the middle. At the moment it is certainly a better-than-average mining operation – it is hemetite (rather than a low-grade iron ore that needs extensive pre-processing before shipping) but the grades are typically about 57%. Fortescue exports some mildly processed ore (fines etc) with higher grades for higher prices.

These are good iron ore properties. They are just not as good as BHP Billiton's and Rio Tinto’s.

You can see this in the accounts too. Here is the last half results:

Table 2: Fortescue Metals half-year results

Gross profit is $1.426 billion on $3.357 billion in sales – an eye-watering 42% margin. After administration costs margins are little thinner.

These margins are still salivatingly good, but they are 20 percentage points worse than BHP. This is a modestly inferior mining operation that is stupendously profitable because iron ore prices are very high.

Fortescue’s vision is to be the “lowest-cost, most-profitable iron ore producer”. And whilst it is frighteningly profitable, Fortescue is a long way from being the lowest-cost producer, and given the difference in grades it is unlikely it can ever close that gap.

Some calculation of profit versus iron ore price

The average price realised during the last half (the half with the P&L above) was $US139 per tonne.

If I take $20 per tonne off that price Fortescue is a darn good business. Better than the P&L above indicates, in fact, because it has mega-large reserves and the volumes are expanding very fast.

But if the iron ore price drops by $50 this is very difficult, and if it drops by $60 this is disastrous.

If you take $60 off the iron ore price from last-half levels, then BHP remains profitable (albeit much less profitable than it is now).

I note that iron ore briefly touched prices in the $60s during the GFC – but prices ramped up with Chinese infrastructure spend almost immediately.

One observation though: at a price in the $110 to $120 range BHP and Rio remain more profitable than Louis Vuitton. This just remains an outrageously attractive business.

Just how big are the expansion plans of Fortescue?

Fortescue might lack 20 points of margin against BHP. But it wants to make that up in volume. Seldom have I seen a company that keen on capital expenditure. It does so much of it that it has wiped its liabilities under Australia’s resource rent tax (at least for next few years).

The capital expenditure is well illustrated in this video from the company.

It can also be seen in the balance sheet – where the company has come through this enormously powerful iron ore boom with ever-increasing volume and ever-increasing debt.

Yes, you do see that balance sheet, right? Exploration, evaluation and development assets of $US5 billion (give or take a little) and debt of $US6 billion.

And it can all be paid if the iron ore price remains high.

But if the commodity cycle goes back to the dark days when BHP’s margin was around 10%, this one is pushing up daisies. It has 20 percentage points less margin than BHP, and with a commodity crunch its margin will go negative and the debt will not be able to be serviced.

Jim Chanos (the noted shortseller best-known for picking on Enron) has publicly stated as much.

Of course, the management don’t see it that way. They have a view of iron ore prices consistent with their business. Indeed, I can’t imagine how long anyone bearish on iron ore prices would remain around Fortescue. Having a less than sanguine view of iron ore prices would be about as sensible at Fortescue as trying to be a proselytising moral conservative working at the bar in a swingers club. You are not going to keep your job.

*Disclosure: I am short less than $10,000 worth of Alderon Iron Ore. I think the project is silly, but the stock is too illiquid and the borrow is too tight to stay short. But it would be a much better short than Fortescue if you could borrow and sell it in quantity. I am also short other marginal iron ore properties. They too are – I think – better shorts than Fortescue.

John Hempton is chief investment officer of Bronte Capital Management and blogs at Bronte Capital. Reproduced with permission.