Monday, June 4, 2012

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.
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...)


*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.


CurmudgeonlyTroll said...

Meanwhile, in China...

Ore pile mounts as demand falls

John said...

I'm bearish on iron price, Aussie dollar and the Australian economy in general. However, it looks like the policy makers in China are prepared to kick the can further down the road with more rounds of stimulus package.

Btw, I'd rather buy msft at ~10x FCF for a similar 40% operating margin. We are at the point of the upgrade cycles that there will more tailwind than headwind. I just find msft's price silly... Sorry, I digress...

ermen said...

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

Hi John, sorry if this is a repeat (computer issues) but I had 2 comments:

1/ How would you be able to say definitely the US$110 that FMG say the LT price should be is unreasonable without knowing the cost curve? Maybe it is US$140 for all we know (and I don't)

2/ Don't think it is fair to compare BHP's margins with LVMH as the latter's business can be competed away by free enterprise (e.g. a competitor can come up with better branding, design etc). In BHP's case though, it is really who sought out and monopolised the best tenements first. It is highly unlikely that US$20 - US$30 / tonne cost iron ore is likely to be easily found (case in point, people are financing marginal projects like Alderon). Hence, the margins that BHP enjoy are were more a function of them being lucky enough to be one of the first to the party (some parallels with the lucky sperm club actually).

Joshua Wallis said...

All this talk about the iron price and no Game of Thrones reference? You are losing nerd points John.

Interesting take on ebit margins and how they show possible signs of excessive ore prices. I have no idea how to properly value commodity prices...wonder if there is a way to guesstimate the price if demand falls greatly...

Nev Power interview was hard to watch. He seemed a bit too uncomfortable talking about low iron ore prices. Alan Kohler did a great job.

Construction in Taiwan seems to slowing down a bit. News here is predicting a slow down in housing prices which is also reinforcing the lack of demand. I'd imagine Fortescue is a short Chanos has in his overall China short.

Are you shorting Fortescue via US pinks so you short with the USD? (not sure if this even possible) or do you short in the ASX and convert currency? You said you are down the AUD so I imagine you are doing something like this.

Good luck on the trade.

Anonymous said...

Hi John. Long time blog subscriber, my first (somewhat random) comments.

1/ Here is a cost curve constructed by Citi group in a recent 140 page report they released. Citi purport to cover 80% of current supply and 90% of new projects under their coverage / in their cost curve.

The consensus analysis of the iron ore cost curve is that the marginal producers are expensive Chinese mines where iron ore grades have been declining for some time now. Citi have Chinese domestic head grades at 19% Fe. I recall other charts which show lower.

2/ In analysis of iron ore operating costs, it is common to overlook sustaining capex. For FMG, this adds up to ~$6/t in cash costs. FMG also frequently quote in wet metric tonne. I recall they have a moisture of around 10% which is why (along with lower grade) their revenue / t always seems lower than BHP / RIO. High FMG opex vs BHP/Rio is predominantly from high strip ratios (rising recently) and that their ore is below the water table. On expansion, FMG say their opex / t will go down from current levels.

3/ It is worth nothing that FMG in their ~100Mtpa expansion are doing it on a capex intensity of approximately $100/t annual capacity (after inclusion of finance lease items into capital costs). BHP's Port Hedland Outer Harbour expansion (if approved) will be around $200/t annual capacity all-in for capex intensity.

- P Time

Anonymous said...

The iron ore prices recovered quickly to above $100 because that is supposedly where the marginal cost of Chinese domestic production is. Domestic Chinese production costs are v opaque for all commodities so not sure how accurate that is.

I think what is missing is a look at the cost curve rather than margin comparisons between sectors.

Robert in Chicago said...

Make hay while the sun shines. Lots and lots of hay.

It is amazing how many businesses I look at these days and conclude, "it's probably going to near-zero, but slowly enough that you'll pull 2x your investment out of it before it gets there."

But those are usually businesses whose costs are already sunk and whose balance sheet is a given, not ones who are newly deciding to raise $5b and go to Macau and put it all on "black." If I were running Fortescue I would never take on the risk they have.

The question remains: If you assume iron ore prices over the next 5 years go $110 $100 $90 $80 $70 and they hit their production targets, (or choose your own different decline curve), how much debt have they paid off by then? Might not whatever realistic base case you assume be a decent bet, even if the price-collapse scenario is disasterous?

Anonymous said...

How much capital does Bronte Capital actually manage? Liberty Metals & Mining is the investment arm of a Fortune 100 company, and Hebei Iron and Steel is the world's 2nd largest steelmaker. Both Liberty and Hebei are investing about $450 million in ADV. Let's see how that short looks a year from now.

John Allen said...

The biggest reason I've stayed not bearish on iron ore is the simple fact that the people that know their country/economy best, the Chinese govt., continue to pour money into iron ore projects (eg. the recent Alderon agreement). Are they just thinking long-term, 5+ years, and we're thinking 1-3? You'd think that they would be studying the global iron market at least as much as anyone and they obviously have the best information about the demand side. You'd also think they could set up a massive, concerted, one year or so iron price decline and pick up the Canadian projects and Fortescue for nothing, essentially. Why don't they do that if the market is so weak (or will be weak)? You're essentially betting against the Chinese here, the market participant that has an extremely asymmetric information advantage, which in the short-term, I'm inclined to do as well, but definitely not 3+ years out.

Aharon L said...

Somewhat less than my two cents' worth below, but the internet gives everyone a voice, so...

Timing a cyclical turn is almost impossible, but escaping cyclicality removes the "almost" from the phrase. High margins beget new entrants, which begets overproduction, which begets a price crash. This is the internal dynamic, quite separate from the external dynamic of demand, which also seems to be heading toward a turn (but has seemed so for a while and may well persist longer than seems remotely rational).

The notion that iron ore is rare and thus we're in a "new era" elides the fact that what's really rare are massive deposits of 65% purity in fairly convenient geologies and locations with established infrastructure. And the idea that higher costs for most/all will keep high-cost producers afloat strikes me as bizarre and backwards. Since so much is sunk into a mine upfront (at least a mine like Northern Millennium's, or Alderon's, or even Northland's), even if ore can be produced at a profit that "profit" goes to service debt. Either things get so bad that this is no longer the case--in which case big marginal mines shut down--or else the marginal mines stay open and prolong all miners' misery.

One final note on the demand side: steel gets recycled. Initial massive demand for ore accompanies urbanization, but once infrastructure's in place a fair amount gets melted down and reformed, which also reduces demand for ore. Of course, we can say that India is ramping, and behind it Africa, along with healthy growth in mid-income countries/continents. They probably will provide the next booms.

But without bust, there's no boom (which only sounds like a strip club tagline).

David said...

From Andy Xie's latest:

"Properties under construction, sold vacant properties and the inventories of commodities like steel and non-ferrous metals may exceed 100 percent of GDP at current market value. The rising inventories have exaggerated the country's economic growth in the past five years."

Michael Petis wrote a few months ago that the Chinese government could keep this going for another 2 or 3 years. Who knows. In any case with the political fallout the limits are now visible to all.

John: Have you any new thoughts on the Chinese solar PV industry? Do you think they have the time or capacity to decrease prices sufficiently for demand to takeoff without government subsidies for purchasers of energy? Is 2 or 3 years enough or are the walls all closing in?

Anonymous said...

You state:

"Some very dicey mines are getting funding (for example Alderon financed by Liberty Mutual who are going to waste their policy-holder funds)*."

1) Liberty Mutual is a Fortune 100 company with over $100b in assets. Their total investment in Alderon is around $53 million. I wouldnt be too critical of that investment in the context of their overall portfolio. If you believe that was a bad investment, then what did you think when Cliffs paid $4.9 billion for Consolidated Thompson? (Cliffs has total assets of ~$14b.) Consolidated Thompson is right next door to Alderon and has a very similar cost structure/development schedule. Why wouldn't you prefer to short Cliffs? (In fact there are operational issues right now that are keeping costs well above $60/ton).

2) But, if Consolidated Thompson was able to be developed into an operating mine (in the middle of the 08-09 crisis no less), what is it about Alderon that is different? What specific factor(s) would distinguish Alderon from Consolidated Thompson and lead you to believe that it is "silly?" The Consolidated Thompson mine does have its cost/operational problems, but it is producing iron ore, and someone did pay $4.9b for it.

I would estimate the probability that Alderon becomes an operating mine as significantly above 0.

Barak said...


First time on this blog, great information.

A question to the Anonymous commentator "Long time blog subscriber".

Where can I get the report Citi Group report you referred to:

"constructed by Citi group in a recent 140 page report they released."

Many thanks,

Eric Titus said...

Would iron prices decline if there started to be a strong global economic recovery? My own outlook is that the world economy won't change much over the next few years (or change for the worse, even), so this logic makes sense to me. But if the economy were to improve, wouldn't Fortescue be very reasonable in assuming constant iron prices? Or at least prices above $100?
A more likely reason for iron prices to drop, as I see it, is that the new production/mining that everyone is building comes online at the same time.

Anonymous said...

Amazing BHP figures you point out yes, and yet the stock has STILL not done anything for 6 years!! Great if you picked the peaks and troughs, but any long term investor in 'The Big Australian' should be taking Kloppers out into the street and 'you know what'. The dividend is rubbish as well. In comparison, I see LMVH stock has appreciated 50% since mid-2006. Why do analysts still slap a buy on BHP. Why?

Anonymous said...

You forgot Vale, the Brazilian giant who completes the iron ore control party. Iron ore is a very profitable commodity, and has been for many years before china demand erupted, because the 3 of them (BHP, Rio, Vale) control ~70% of the traded iron ore market. LVMH does not share joint control the luxury goods market to anything like a similar extent.

Iron ore was a great business turned into a fantastic one by Chinese demand. Steel, on the other hand, has been a lousy business temporarily turned into a good one by the same.

Nonetheless, the concerns on China fixed asset investment excesses are legit.

When steel turns down, the big 3 will reduce output, and earn [much] less. When steel turns down, a lot of steel capacity will simply go bankrupt.

Big difference.

Anonymous said...

Grandich throws down the gauntlet..

Anonymous said...

Time to revisit this one? Iron ore price now US~$90 and Mr. F is buying his own shares hand over fist....

Brooks said...

So I see this graph....

Basically looks like a bubble. $50 per ton?

Anonymous said...

Guess that Alderon short worked out ok

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