Income Report / Income Report: Fortescue (FMG) – a deeper dive into the numbers (FMG)

By Market Matters 15 May 19

Income Report: Fortescue (FMG) – a deeper dive into the numbers (FMG)

Market Matters Income Report 15th May 2019

Local stocks have opened higher this morning – bouncing back from yesterday’s sell-off as trade tensions peter out – for now. Resource stocks have been in focus – Fortescue Metals (FMG) front and centre after yesterday announcing a big special dividend – we look at the numbers underpinning this today and set out the case for the bulls in FMG from an income perspective.

The ASX 200 is trading up +30points / +0.50% to 6269 at time of writing 

ASX 200 Chart

Over the past week the Income Portfolio fell by -0.25%% with NAB trading ex-dividend for 83cps. In the current financial year, the portfolio is up +4.75% vs the benchmark (RBA + 4%) inline with its benchmark of +4.75%, while the ASX 200 accumulation index is now up ~4.70% FYTD.  The income portfolio has been operational for ~2 years and has delivered in line with its target of cash +4%, but importantly, with substantially less volatility than an equity only portfolio.

In the past week we’ve added CSR and RIO Tinto to the portfolio reducing cash by ~6%.

Fortescue (FMG) – a deeper dive into the numbers

Yesterday, FMG’s board announced another bout of capital management, this time a big special dividend of 60cps which means the total dividends paid by FMG in FY19 will be 90cps fully franked. They call it a special because they have to (ASX rules given no corresponding earnings release) however it looks more like the final dividend brought forward to get in ahead of any change to franking legislation therefore utilising $1.4bn worth of the $1.7bn of franking credits on their balance sheet – so it’ unlikely there will be anything further paid in August.

Based on the share price at the start of the financial year ($4.42), this represents a yield of 20% plus franking, or 29% inclusive of franking. Add to that share price gains of $3.67 to yesterday’s close , the total return for the year is over 100% - Andrew Forrest clearly has reason to smile!  We owned FMG in the Income Portfolio this year and sold for a nice profit, although too early in hindsight  - what now?

To give an idea of the massive shift in market expectations around FMG earnings, the dividends that will be paid by FMG this year are 3 times the size of the average analyst estimates of earnings per share (eps) as recently as January this year +  it seems the market is still ‘cum upgrade’ on eps expectations from here.

FMG guide to a 50-80% payout ratio of earnings which tells us that the dividends paid this FY are somewhere between 3.75x & 6x greater than what the market was expecting in January.  This has clearly been a significant move relative to expectations and that in itself has a big flow on impact to those that don’t own the stock (and need to) but also those trading desks that have derivative positions on FMG - we’ve had a lot discussions with traders about this today.    

FMG eps expectations over time (red) v share price (white)

Obviously the Iron Ore price tailwinds have been significant with the Vale disaster dramatically reducing global supply – the Iron Ore price has moved from $US70 to $US93 in that time period – with FMG and the other miners clearly benefitting, however it shows the huge amount of leverage in these businesses, FMG in particular to higher prices – and the longer prices stay high, the longer the printing press stays open.

Iron Ore Futures Chart

The key now is determining how long the price of ore stays high and what does that mean for FMG’s earnings, dividends and share price gains.

1.    How long can Iron Ore prices stay high?

This is the million / billion dollar question and our best guess is a year or two rather than a month or two. Why? The iron ore supply dynamic whilst not broken will struggle for a while to bridge the demand gap until Vale is fully back on line (perhaps 3-4 years) or price lifts materially to “incentivise” other sources – China domestic, West Africa etc.

Overnight, Vale has talked about expanding the output from its Carajas Serra Sul complex in the Amazon rainforest, as the Brazilian miner seeks to move away from operations that use tailings dams. That mine has the highest grade ore in the world and can be mined without the need for tailings dams which house waste products. They talked overnight about increasing production at that mine however there are operational and regulatory hurdles to overcome, and filling the production that was lost on a best case timeframe would likely be at least 18 months off.

Other miners are fairly well stretched and in any case, increasing production takes time – it can’t simply be switched on overnight. The supply side response (if it comes, is likely to be at least a year off). Prices should therefore stay higher for longer.  

 2.    What does that means for earnings & dividends?

Below is a good chart from Peter O’Connor at Shaw which includes various assumptions about earnings. The orange is Peters expectations based on his forecasts, the blue is the ‘consensus’ expectations from the market, meaning the aggregate of all analyst expectations and the green is earnings based on spot iron ore prices. Given we’re near the end of FY19, the numbers are fairly close although still worth noting that at current spot, there is still the likelihood of a ~10% upgrade from current expectations.

The outer years, FY20 & FY21 shows the big variance. Based on spot prices FMG earnings would double relative to current consensus. The market doesn’t factor in spot prices, and nor should it given spot is volatile however it does show the potential for earnings in the business over the next 12 months assuming no new supply coming on line over that time.  

A lot can happen between now and FY21, however FY20 starts soon. If we put the rose coloured glasses on and assume that prices stay here for the next 12 months, and FMG earnings hit close to $5bn, the earnings per share potential is around ~$1.60. On that number, FMG is still trading on an FY20 P/E of 5x based on spot prices.

In terms of potential dividend and applying a 65% payout ratio (given FMG have some new developments playing out), that’s another $1.04 worth of dividend potential for next year equating a yield of around 13% on current prices.

I appreciate that’s a big call, and not what we’re forecasting, however the potential is there if the Iron Ore price stays high.  Also Interesting to see that FMG’s FY19 and FY20 earnings (Figure 1 above) have already been ratchetted up >>100% and will likely move even higher (>>another 100% based on spot earnings) as the market “begrudgingly” hikes iron ore price forecasts - ever US$10/t higher iron ore price than prior consensus expectations delivers FMG ~US$1- 1.2bn additional EBITDA (~30% hike). Hence, the current year capital management benefits are likely to continue for another year.

3.    What does that mean for share prices?

Share prices follow earnings and there is a clear road to $10 per share for FMG if Iron Ore stays at current prices. As mentioned above, a US$10/t higher iron ore price more than prior consensus expectations delivers FMG ~US$1- 1.2bn additional EBITDA. The key here is that the latest capital management windfall is not likely to be the last and that will be supportive of the share price over time.

Fortescue Metals (FMG) Chart

Conclusion (s)

While buying resource stocks for dividends should always be done with caution, there is clear commodity price tailwinds currently in Iron Ore, Yesterday we added Rio Tinto (RIO) to the income portfolio for that reason, and its why we remain  keen buyers of dips in the sector.  

We like Fortescue (FMG) and would be keen buyers of any news driven dips.

Have a great day!

James & the Market Matters Team


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.


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 15/05/2019

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