Green transition spells a tough time for dividend darling Fortescue
The last six months have been a rollercoaster ride for iron ore prices – plummeting to near four-year lows of US$75 a tonne last October and then rallying 75% off lows to almost US$130 a tonne by late January. Thanks, China.
In parallel, the Chinese reopening rally inspired a more than 50% rally for Fortescue Metals Group (ASX: FMG) shares. But after such an outsized move, has the hype outrun the fundamentals?
Mark Gardner, Head of the Investment Committee and Senior Private Clients Adviser at Maqro Capital says the stock is a Sell as the rally leaves very little wiggle room for error. That said, he views quality businesses like Fortescue as a staple among his fund. So he’ll be back should valuations ease from current levels.
In the company‘s half-year results on Wednesday, key financial metrics weakened across the board, reflecting persistent headwinds such as labour shortages, high input costs and lower iron ore prices.
As Gardner points out, the most intriguing part of the result was not the earnings but the company’s transition from an iron ore pure play (with a reliable dividend) to something of a more CAPEX-heavy and green-oriented business.
Fortescue’s first-half FY23 highlights
- Revenue of US$7,835 million, down 4% on pcp (1H22)
- Net profit of US$2,368 million, down 15% on pcp
- Interim dividend of $0.75 per share, down -12.8% on pcp
- Dividend payout ratio of 65% compared to 70% a year ago
- Record iron ore shipments of 96.9 million tonnes, up 4% on pcp
- Average revenue of US$87.2 per dry metric tonne, down -8.8% on pcp
- C1 cost of US$17.43 per dry metric tonne, up 13.7% on pcp
- Net debt of US$2,076 million from US$879 million a year ago
- Reaffirmed FY23 guidance for shipments, C1 cost and capital expenditure
Note: This interview took place on Wednesday 15 February 2023.
Key company data for Fortescue
In one sentence, what was the key takeaway from this result?
It’s an insight into the complicated future of Fortescue, which has been a pretty simple business historically.
What was the market’s reaction to this result? In your view, was it an overreaction, an under-reaction or appropriate?
I think it’s fairly appropriate. Analysts' price targets are well-below where Fortescue is trading at the moment. We saw some initial strength, but as we dived into the result, there were more reasons to be looking to sell it.
Margins dropped for Fortescue Future Industries' costs by about $300 million and they’ve increased their debt by 120%, which is not that great in a rising interest rate environment.
Historically, Fortescue has been a really simple business. They were one of the lowest-cost producers of iron ore, shipping it and paying big dividends.
Now, the Chairman is essentially going down the route of a growth business rather than an established dividend-paying business. A lot of shareholders probably held this stock for that simplicity.
They also reduced their dividend payout ratio to 65%. So it's a very different company from what it was even 12 to 18 months ago. From a moral standpoint, I applaud Andrew Forrest for the initiative of going down the hydrogen route. But in terms of what it means for shareholders, it’s a long road. If they get it right, it’ll be fantastic. However, the technology is nowhere near that yet. You might see the dividend payout ratio struggle to hold up and an extra $1.2 billion in debt with interest rates at their highest point in a while isn’t going to help things either.
Overall, Fortescue has always had a premium skew to analyst consensus, expectations and price targets. You’ll start to see that premium be removed due to the fact that the business is not a simple dividend bonanza like it used to be.
Were there any major surprises in this result that you think investors should be aware of?
The deeper you dig, the more it becomes apparent that Fortescue is shifting from the value end of the investing curve to the more growth end of the investing curve. I certainly would not call it a growth company by any stretch of the imagination, but previously it was very firmly in the value side.
Given the new strategy, Fortescue executives are now incentivised in raising the green footprint rather than profitability, which may or may not work out. At these prices and very stretched valuations, I’m very cautious about how this will go moving forward.
Would you buy, hold or sell Fortescue on the back of these results?
Definitely a seller. The current price, even among the big three BHP (ASX: BHP), Rio Tinto (ASX: RIO) and Fortescue, reflects everything going well with the China recovery, but what investors are ignoring is that these are cyclical businesses, facing higher interest rates and a global slowdown. Whether it be a soft landing or a hard landing, there is some form of a slowdown coming.
There’s very little wiggle room at these prices for any sort of hiccup to happen. China’s got to go absolutely bang to plan and probably even better.
There’s also margin compression as inflation is affecting all these companies. Fortescue’s EBITDA margins were over US$58 a tonne, now it's only US$52 a tonne. That’s a fairly significant drop in their margins. I would like to wait to see how they report later in the year and how higher interest rates are going to affect the global economy.
What’s your outlook on Fortescue and its sector over the year ahead? Are there any risks to this company and its sector that investors should be aware of?
These are very high-quality companies and generally staples in our portfolios here at Maqro Capital.
But for the first time ever since I’ve been here, the price doesn’t justify having them around any longer because we see too much downside risk. We’re very much looking to buy them back at cheaper prices.
Overall, commodities and energy will do fairly well over the course of the year but there’s a little bit too much good news priced in at the moment. Fortescue is one of the first shocks that are going to come to investors. Analyst expectations for BHP and Rio Tinto aren’t particularly rosy either - in terms of earnings per share and dividend per share - which may make people re-evaluate a little bit.
From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious about the market in general?
At the moment, we’ve got approximately 20% of companies in the ASX 200 having never operated outside of a zero interest rate environment. Approximately 18% of them are unprofitable. Then there are the Big Four Banks, which generally only grow when credit is expanding and new home loans are being issued. That’s a big chunk of the index that’s potentially facing fairly stiff headwinds over the next six to twelve months. The next few months might be a struggle, but I also don’t see us going back down to last year’s lows - that was very much panic.
Energy and Commodities will continue to do well, as well as Consumer Staples, particularly food. Most of the world has largely forgotten about how much food Ukraine used to produce – they were effectively Europe’s food basket. I’m approaching this year with a cautious and patient view but happy to have bigger weightings or a larger swing at more sure things.
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Kerry is a content strategist at Market Index. He writes the Morning and Evening Wraps. He is an avid swing trader, drawn to technical set ups and breakouts.
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