Fortescue scores higher grades

An iron ore miner moving its main product wouldn't ordinarily attract attention, but a recent cargo of iron ore shipped by Fortescue Metals was closely watched. 

Fortescue has shipped its first batch of higher-grade iron ore from the Pilbara. Average grades of 58% will be bolstered by new production at 60% iron ore.  

Beginning with just a few million tonnes this year, production should lift quickly and, by 2020, the company aims to produce 40mtpa of this higher-grade ore. The company appears to be on track to start lifting its often maligned iron ore grade.

Grade concerns

Grade has been a contentious issue for Fortescue and a key reason why the market has discounted the stock. At the time of our upgrade in Fortescue: options and opportunity, it was trading at a healthy discount to tangible assets, a humble PER of 9 and a yield of more than 6%.

Extreme, visible cheapness was on offer because there was plenty of bad news. As we explained, regulatory changes in China caused the price discount for lower grade ores to widen. 

A historical price difference of 10% had blown out to 40% and most of the market was convinced this move was permanent. 

We argued it was a mistake to price a variable outcome with dead certainty. Maybe the discount had permanently widened but maybe not. In any case, Fortescue had plenty of options for tweaking its own operations to respond to changing prices. We suggested the price discount embedded in the stock presented a prime opportunity.

So far, that thesis appears to be playing out. In otherwise rocky markets, Fortescue has been an unlikely star, rising 20% since October. 

Closing the gap

Iron ore prices haven't played a large role in that move. A fall in November was quickly reversed and benchmark prices are now back to where they were in October. Yet prices for 58% iron ore - the lower grade mined by Fortescue - have risen considerably. The price gap between high and low-grade ore has narrowed.

One reason for that has been a significant fall in steel prices. Record steel margins have subsided and producers have responded by using cheaper inputs for steel production, among them, lower grade ore. If steel prices continue to fall, that substitution, which is still in its early stages, could hasten. 

A cyclical recovery in low-grade iron ore prices is now a greater possibility than it was a year ago and, combined with strong action from Fortesue itself, have helped restore the belief that the dreaded grade discount might not be permanent after all.

The company's swift pursuit of higher grades has been impressive and, although costs are expected to gently increase, they remain world-beating. Fortescue is aggressively repaying debt and is on track to be debt free within a few years.

Still cheap?

Having cheekily bought back shares as they fell below asset value, Fortescue will, in our view, also pay a dividend of 18-19 cents per share this year. Mining dividends are far from annuity streams but with more than US$2bn in operating cash flow and close to US$1bn in free cash flow expected for the full year, chunky dividends alongside debt repayments seem likely.

Trading at net tangible asset backing with a high quality, long life asset base, Fortescue remains cheap, but the extreme value has gone. For some, this might still be a buying opportunity, but commodity price risk remains high. With the share price rising, we're downgrading to HOLD.

Disclosure: The author owns shares in Fortescue Metals.