With iron ore price approaching levels not seen since the last great commodities boom, up nearly 200% over three years, many investors are understandably skeptical about how long the party can last. Perhaps that’s the reason for Fortescue Metals Group’s single-digit PE ratio, and a double-digit trailing yield. But Peter Gardner from Plato Investment Management thinks that markets are underestimating how long prices can remain elevated.

“It takes longer to increase the supply, so prices stay higher. We don't expect them to stay this high in the medium to long-term, but we think the market’s probably underappreciating just how strong the iron ore price can stay.”

Following their recent half-year results, I spoke with Peter about the outlook for iron ore, how Fortescue aims to reduce the discount on their lower quality ore, and we discuss the ‘blue sky’ opportunity that could present risks for the company.

How long have you held Fortescue? And what initially attracted you to the company in the first place?

We have held Fortescue for the last three years or so. Fortescue is a play on the iron ore price mostly. Everyone's pretty confident generally in Fortescue's production. When the iron ore price was doing poorly a number of years ago, then Fortescue wasn't a great exposure. Then once the iron ore price started turning around, it looked very cheap and it's just continued to get cheaper as the iron ore prices continue to go up.

What do you think are the most important factors to focus on with the iron ore price?

It's fairly simple. It's world steel production, particularly that coming out of China given they're our biggest importer of iron ore. It’s also important to consider steel margins for Chinese steel mills. If those margins go negative, it then reduces the incentive for steel mills to continue to produce. They're the basics.

What drives the steel production higher is infrastructure development around the world, and once again, particularly in China. During the pandemic, we saw China increase their production significantly and the rest of the world's production went down significantly. But now has bounced back to normal levels for the rest of the world, and then may even go higher as you see a bigger focus on infrastructure spending.

We're fairly positive about the iron ore price in the short to medium-term. Over the longer term, we don't expect it to stay at these levels. I don't think anyone really does as you'll see production increase to catch up with demand. But the thing about production is that it takes a long time to build new iron ore mines. So we don't see a huge amount of production coming online. If you look at the major Australian producers, Fortescue is keeping production fairly flat apart from this new Iron Bridge project, which again will take a few years to come on board. BHP and Rio, there's no significant increase in production there. There's a little increase from Mineral Resources, one of the smaller players, but generally, the production is being kept quite tight at the moment.

There were some fairly significant announcements about Iron Bridge today attached to the report. Could you maybe outline them and explain the significance for Fortescue?

The significance for Iron Bridge is greater iron ore production. It's a magnetite project, which is higher grade ore. Fortescue usually sells iron ore at around 58% iron. Whereas BHP and Rio are generally up around the 62% level. Because this magnetite project is above 62%, Fortescue can potentially bring the two ores together and increase the grade of their underlying iron ore, which will reduce the discount. Over the last six months, the discount was around 10% for their 58% product versus the normal 62% benchmark. They'd like to get rid of that discount.

The disappointing thing is that the cost required to build it has increased by US$400 million to $3 billion. So that's obviously disappointing. But given Fortescue earned $4 billion during the half, then it's not sheep stations in our view. But it's good that management has got a strong focus on it.

There's obviously been something going on behind the scenes that they haven't fully made the market aware of with what's happened at the senior management levels. They're talking about communication. So I think there's probably a lack of communication between the people running that project and the CEO. Fortescue is looking to get back control of that and keep their strong culture intact.

Iron Bridge project is a concentrated project. So they'll be processing the ore before it's shipped. But all their other projects to date have all been direct shipping ore. Do you think the fact that it is the first time that Fortescue has had to process their ore before shipping adds additional risk?

It's definitely a risk. There's no doubt about that, but we're fairly confident that management will be able to manage it well. We don't have too many worries in that regard.

What were the key things that stood out about the result?

Overall, it was a good result. Profit was $4.1 billion, which was 67% above this time last year. Ore shipments were up just 2% in the last year and the costs were flat. So that increase in profit was all due to the price increasing. The average price that they're able to realise over the half was $114 US a tonne. That was up 42% over last year. And margins are now 71%. And they've got a 47% return on equity. So you can see how much money these guys are making.

They take it out of the ground at about $12 US a tonne, obviously, there's shipping and transport costs on top of that and all the taxes they have to pay. But they're making huge amounts of money with the price where it is at the moment.

They made AU$1.84 earnings per share, and they've paid out 80% of it, which is the top of their guidance range. They aim to pay out 50 to 80% of their EPS as dividends, and this half’s dividend was $1.47. Their net debt is basically zero at $100 million dollars. So it was a good result.

A slight upgrade to their iron ore shipment guidance going forward. So that's a positive, but that's pretty minor. And obviously, the disappointing thing is the increasing CAPEX at Iron Bridge.

So the result was pretty much in line with expectations then?

Yeah. It's a fairly simple business. Their costs are generally pretty well guided or well known. So it's really all about the iron ore price for them, as long as they don't make any mistakes on the production or cost side.

Was there anything else at all that kind of popped out regarding their outlook that they shared?

The other real danger or risk for Fortescue is that they're looking to move into hydrogen projects and looking to become more carbon neutral. That's a big risk for the business. You mentioned before about the increased risk of them now processing their ore. That's an incremental risk. But going out and doing a new hydrogen project is completely different to what they're used to. It’s a much bigger risk in that regard.

Management is still going through the process of working out whether that's feasible. We hope that they don't have too much hubris in that and that they can be rational about that decision. Our mind's open. Hydrogen could be very important in the mix in terms of reducing carbon pollution around the world. So it's got the potential out there, but it's a big risk for the iron ore business.

Is there anything that you think the market is missing about this result?

The one thing that the market has this big disagreement about is the future for the iron ore price and how long it's going to take for that to come back to more normal levels. Our view is that these cycles take longer to go through when the demand increases. It takes longer to increase the supply again, so the prices stay higher. We don't expect them to stay this high in the medium to long-term, but we think that the market’s probably underappreciating the strength of these iron ore miners and just how strong the iron ore price can stay.

Would you consider yourself a buyer, a seller or a holder?

We’re a holder. We're at the higher end of our maximum position.

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