Income Report / Income Report; A deeper dive into Fortescue + a new income opportunity (FMG, SVWPA)

By Market Matters 22 August 18

Income Report; A deeper dive into Fortescue + a new income opportunity (FMG, SVWPA)

Market Matters Income Report 22th August 2018

Bang! The Telco’s are on fire today with Telstra (TLS) up +5.5% at $3.22, TPG Telecom (TPM) up 15% to $7.25 and Vocus (VOC) is up +5% at $2.70 at time of writing (1pm) against a market that is trading down 17points at 6266 for the ASX 200. The buying stems from news that TPG and Vodafone are thinking about merging signifying; 

1. that consolidation is now a strong possibility in the sector &
2.  A merged Vodafone / TPG would be less aggressive on undermining current prices than a standalone TPG under David Teoh.

That is obviously positive for the sector (TLS and VOC) however TPG would benefit from presumably less spend to develop their own network from scratch. This is a typical example of a sector that was priced to oblivion, a sector the market had given up, fundies were incredibly underweight and we now have forced buying as the industry dynamics change. Go Telstra!

In terms of the MM portfolio for the week, it jumped 1.13%, continuing last week’s strength on the back of double digit performances from Eclipx & Nick Scali. The portfolio is now up 2.50% for the current financial year, and +8.65% from inception vs the benchmark which is tracking at 0.77% & 6.21% respectively. Pleasingly, the portfolio showed strong positive returns during the week despite the market falling -0.24%.

A deeper dive into Fortescue Metals (FMG)

I met with the CFO and COO from Fortescue Metals (FMG) yesterday as they did the rounds following their recent full year results. There were some brief prepared comments that hit the high notes of the result but of more benefit was the discussion thereafter as we shot the breeze about the future of the WA Iron Ore miner. We currently have 3% of the Income Portfolio in FMG sitting on a paper loss of ~10%, not ideal  but it’s important to look forward not back.

My short interpretation of FMG in terms of an income play remain intact, and I think FMG has every chance of delivering a yield of 7-8% inclusive of franking in FY19, which makes it a reasonable income opportunity, albeit a higher risk , more volatile one.

A few key points from their recent result; 

Like many of the miners it was slightly messy, although less so than RIO and BHP given those two had the added complication of asset sales through the period. For FMG, there was the initial view that the result was a miss simply given how they accounted for some aspects of it, however the underlying result was very close to where market expectations were.

Profit was inline and the dividend was a beat relative to the streets expectations, so nothing really new in the result, but that’s not the important thing now. What FMG will likely earn in FY19 and what proportion of those earnings will be passed through as a dividend is key.

It’s always hard to predict what commodity prices will do with certainty however if we assume current conditions remain as they are now, FMG should produce a net profit of $1.2bn in FY19 dropping down to earnings per share (EPS) of about ~33c. They have guided to a payout ratio of 50-80% of NPAT, so at the bottom of the range that would produce a yield of 5.70% grossed for franking, or at the upper end of the range it’s 9.18% grossed for franking. We doubt they’ll pay 80% out in FY 19, instead if we assume 70% payout ratio (market consensus correctly sits at 72%) we get a dividend for the year of 23.76c. Based on $4.10, that equates to 5.79% plus franking, or 8.27% for the year.

The key is clearly around the likely profit for FMG  and there are a few variables here, obviously commodity prices remain key however also the discount FMG is receiving on their lower grade Iron Ore relative to the benchmark. As the below chart shows, there is significant divergence of FMG away from their underlying Iron Ore price proxy. There are a few reasons for this according to FMG and the market more broadly. Tighter environment controls in China means that higher grade Ore is being more highly valued by Steel Mills at a time when Steel prices are very high. If Steel prices are high, margins are usually good and paying up for a higher grade Iron Ore makes sense. The environmental aspect I tend to think is there to stay, however Steel margins will turn at some point, and that should assist the demand for FMG Ore relative to others.

This chart shows that FMG’s iron ore pricing proxy is going up (and the discount reversing as well) but the share price is heading lower. Typically the correlation here is >>90% according to Peter O’Connor at Shaw . The chart links this back through time to when the Iron Ore price was last trading at these levels = share price implied of $5.40/share.

Source; Shaw & Partners

FMG are taking steps to address the discounting issues in two ways;

1.       New 60% product details - Fortescue to produce 60% iron content product, named West Pilbara fines, in 2H19 from existing operations. This puts a higher grade product into the market and gives FMG more flexibility in their deliverables.

2.       Eliwana Development - FMG have committed to develop the Eliwana mine and rail project to produce a product made from blending Firetail mine with the high grade product that will come out of Eliwana. This will again put a higher grade product into the market

Both of these approaches are obviously reactionary as a result of the ongoing discount applied to FMG ore, however it does show FMG has scope / capacity to react to market forces, and importantly, given their low levels of debt, they have flexibility which was not necessarily the case in the past.

All in all, FMG looks a good risk v reward play below $4.00. however if we’re correct on BHP and see that trade sub $30, as we expected, FMG would be around ~$3.75, so patience prudent just here.

Fortescue Metals (FMG) Chart

Seven Group Hybrid (SVWPA) – rockets!

It’s rare to see a hybrid up by 12% however today we have the SVWPA’s surging higher. Seven Group Holdings (SGH) have announced an offer for TELYS4 shareholders to convert at a premium into  ordinary shares. TELYS4 holders are being offered a number of options including converting to ordinary shares or receiving a partial cash exit at an 8.5% premium to market value (before the deal was announced).  

In short, the Conversion Proposal offers SVWPA holders the opportunity to receive 4.60645 ordinary shares for each TELYS4 (SVWPA). (Based on close price = $20.29*4.60645 = $93.4648) 

If the vote is passed, holders will have the option of selling up to 50 per cent of the TELYS4 for cash, at a price of at least $88.00 per TELYS4. “This conversion ratio represents a 15 per cent premium to the current trading price and the proposal also enables holders to receive cash for up to 50 per cent of their TELYS4 at a minimum price which is an 8.5 per cent premium to the current trading price of the TELYS4.“

This is clearly an interesting move from SGH on one of the older style perpetual hybrid securities. It’s expensive debt and they can tidy up their capital structure by converting these to equity.

Seven Group Hybrid (SVWPA) Chart

Income Investment opportunity – International Bond Fund – ASX Listed

**MM plans to add the Neuberger Berman International Bond Fund to the Market Matters Income Portfolio with a 5% weighting, funded by reducing our weighting to financial hybrids. The chance of a Labor victory and the removal of cash refunds for franking credits has increased, and therefore we are reducing our weighting to hybrids that may be impacted by 5% to take up the new offer – watch for alerts**

Key Dates

Offer Open

20 August 2018

Broker firm Offer close

31 August 2018

General Offer close

7 September 2018

Expected holding statement dispatch

19 September 2018

Expected ASX listing

26 September 2018

 






We covered this investment opportunity last week and since then, we’ve met the portfolio managers and believe the offer is suitable for the Income Portfolio. The key dates are outlined above. As a recap, the Trust will invest in the high yield bonds of large and liquid companies around the world, with the aim of delivering stable monthly income. Its well-diversified portfolio consists of around 300 large, global companies, with a strong emphasis on capital preservation. The Trust will be targeting a net distribution of 5.25% per annum (“Target Distribution”), paid monthly.

More information is available in last week’s Income Report;  https://www.marketmatters.com.au/blog/post/income-report-dividends-a-plenty-tls-iag-sun-nck/

They have already surpassed the minimum raise of $150m. Subscribers can bid into the IPO through Shaw and Partners, however an account will need to be established with Shaw to facilitate this (no charge). Email [email protected] should you wish to participate

**Please note; Shaw and Partners, a shareholder of Market Matters has been appointed Co-Manager to the offer**

Conclusion (s)

Fortescue (FMG) is not your typical income stock and it is higher risk, however at depressed levels it looks attractive. We expect to average FMG ~$3.75

We are adding an international bond fund to the MM Income Portfolio with a 5% weighting, reducing exposure to financial hybrids – watch for alerts

Have a great day

James / Harry &  the Market Matters Team

Disclosure

Market Matters may hold stocks mentioned in this report. Subscribers can view a full list of holdings on the website by clicking here. Positions are updated each Friday, or after the session when positions are traded.

Disclaimer

All figures contained from sources believed to be accurate.  Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy.  Prices as at 22/08/2018

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