How business decisions are made in a boom: Fortescue Metals edition

The Australian boom - the one that leaves foreigners gobsmacked when 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 revenue and EBIT margin by commodity from BHP's last annual report:

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

Underlying EBIT from iron ore was 13,328 million in 2011.

That is a 65.3 percent EBIT margin. These margins would make a luxury goods maker salivate. LVMH (the iconic luxury goods powerhouse) had an EBIT margin of about 23 percent. 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) sixty four billion dollar question is what is the normalized 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 (i) an historically very high iron ore price and (ii) 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. Some very dicey mines are getting funding (for example Alderon financed by Liberty Mutual who are going to waste their policy-holder funds)*. 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's mines will remain operational though. They are very high grade (mostly over 60 percent iron content and with acceptable impurities) and with good transport infrastructure in place. The only iron ore operation that is competitive is RIO - where the grades are a little higher still.

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

BHP and RIO 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 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 percent. 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 the BHP and RIO ones.

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

Gross profit is 1426 million on 3357 million in sales - an eye-watering 42 percent margin. After administration costs margins are little thinner.

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

Fortescue tell us their vision:

They want to be the "lowest cost, most profitable iron ore producer". And whilst they are frighteningly profitable they are a long way from being the lowest cost producer and given the difference in grades it is unlikely they can ever close that gap.

Some calculation of profit versus iron ore price

The average price realized during the last half (the half with the P&L above) was USD139 per tonne.

If I take $20 per tonne off that price Fortescue is a darn good business. Better than the P&L above indicates because they have 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 they want to make that up in volume. Seldom have I seen a company that keen on capital expenditure. They do so much of it that they have wiped their 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 USD5 billion (give or take a little) and debt of USD6 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 percent this one is pushing up daisies. They have 20 percentage points less margin than BHP and with a commodity crunch like their 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 proselytizing moral conservative working at the bar in a swingers club. You are not going to keep your job.

Still iron ore prices were covered in this amazing interview of Nev Power (Fortescue CEO) by Alan Kohler:

ALAN KOHLER: Now, you must be feeling a bit nervous about what's going on in Europe at the moment. About a week ago your chairman Andrew Forrest said it's all a storm in a teacup beaten up by the media. Do you still think that?

NEV POWER: I think the issues in Europe have had a very strong effect around the global economies, and probably far more than what you would expect, so the difficulty there is that yes, they are in trouble over there in those economies, but if you take the sum total of the impact of those economies, say, on China and Australia, they're relatively small.

But the equity markets have been hit very, very hard in comparison to that effect, so what Andrew was talking about was the fact the equity markets have been spooked by Europe far greater than the actual physical impact.

ALAN KOHLER: But what matters to you of course is the iron ore price.

NEV POWER: Yes.

ALAN KOHLER: What price have you got in your forward planning, in your budgeting?

NEV POWER: Well, we see in the short term that it'll trade in that range of $130-$150 a tonne and it has been very resilient over the last 12 months or so trading around that range. But looking forward we've allowed the forecast to drop down to around $110 a tonne and done all our modelling around that, so we see that long term that'll be the sustainable price.

ALAN KOHLER: But in the 2008 crisis it got down to as low as $55 a tonne, so if there's another crisis - this is what I'm talking about you feeling a bit nervous - if there's another crisis, Spain collapsing, Greece or whatever, you could see the price go down to that level again.

NEV POWER: Well, Alan, it did go down to around a little under $60 a tonne but that was for a fleeting moment and it recovered to over $100 a tonne within weeks - and that was a global financial crisis, that was a real global crisis.

ALAN KOHLER: But the reason it recovered so quickly the Chinese economy recovered so quickly and right now it's slowing.

NEV POWER: Well Alan, the Chinese economy is going through a short-term fluctuation, but overall it's growing very strongly. It's growing in that 7 to 8 per cent range which reflects back to a 4 to 5 per cent growth in steel which we see as a really strong growth and something I think a lot of countries would aspire to.

ALAN KOHLER: Thanks very much for joining us, Nev Power.

NEV POWER: Thank you, Alan. It's good to be here.

Get this: they have modelled around a price ($110 per tonne) which is high enough to keep BHP earning far better margins than Louis Vuitton. As if BHP has a god-given right to make Louis Vuitton look marginally profitable.

Those are prices that might even make the Alderon project cited above borderline viable.

Whatever: Nev Power is sure - simply sure - that the price registered in the GFC was an aberration. To view it otherwise means that he could not possibly hold a senior position at Fortescue.

And I am sure Nev Power is a rational man - but I methinks he has succumbed to the capitalist version of rationality. Whatever makes you a dollar (or in this case for the senior people at Fortescue a few billion dollars) is what is rational (and moral too).

If I were not short this I would wish them good luck with that. As it is I have a small bet against Mr Power and Fortescue. (But then maybe I am just hedging my Australia risk...)


John

*Disclosure: I am short less than 10 thousand dollars worth of Alderon Iron Ore. 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.