Fortescue (FSUMF) Stock: Fortunes Still Tied To Iron Ore

Fortescue Ltd (OTCQX:FSUMF) may have recently changed its name from Fortescue Metals Group, but it is still an iron ore company.

As it stands, Fortescue is the fourth-largest iron ore miner in the world, and the company gets most of its revenue and EBITDA from iron ore.

Fortescue is, however, diversifying into trying to become more of a green energy and green steel company.

Although iron ore prices have strengthened in recent weeks, the medium-term demand for iron ore is less known, given potentially peaking demand from China and more uncertain demand from India and Southeastern Asian countries.

Still an Iron Ore Company

As of FY2023, iron ore is the dominant contributor to Fortescue’s revenues and profits.

In terms of segments, Fortescue’s metals division (which primarily makes iron ore) accounted for US$16.764 billion in revenue and US$10.545 billion in underlying EBITDA. The company’s energy business, which includes renewable energy and producing green hydrogen, meanwhile, had US$107 million in revenue and a loss of US$617 million in underlying EBITDA. Overall, the company had consolidated revenue of US$16.871 billion and underlying EBITDA of US$9.963 billion.

Fortescue has a low cost of production of iron ore given its reserves. The company’s underlying EBITDA margin for 2023 was 60% US$/dry metric ton when excluding Fortescue Energy. That’s down from 63% for 2022, but nevertheless very good. Overall, Fortescue had an underlying EBITDA margin of 59% for 2023, down slightly from 61% for 2022.

Given where iron ore prices have been, Fortescue has been fairly profitable.

For the year ended June 30, 2023, Fortescue had revenue of US$16.871 billion, underlying EBITDA of US$9.963 billion, and net profit after tax of US$4.796 billion. Earnings per share were US$1.56. Underlying net profit after tax was US$5.522 billion and underlying earnings per share was US$1.8.

Green Hydrogen

Fortescue’s other business, Fortescue Energy, is focused primarily on producing commercial scale of green hydrogen and green energy.

Green hydrogen, which is hydrogen created by renewable energy, can help decarbonize industries like steel production. With environmentally friendly techniques, steel mills can directly reduce iron ore with green hydrogen and lower their emissions substantially before processing the material further to produce ‘green’ steel.

Strong demand for green steel is expected in the future as steel production currently accounts for around 7% of global carbon emissions and is challenging to decarbonize. There are other ways of producing green steel that do not involve green hydrogen as well.

In terms of goals, Fortescue hopes to produce 15 million tons of green hydrogen annually by 2030. With a substantial portion of the green hydrogen, Fortescue hopes to produce green steel. By producing green steel, Fortescue hopes to be an integrated green steel producer, given its hydrogen and iron ore production capabilities. By producing green steel in Australia, the company also doesn’t have to ship hydrogen, which is expensive.

If the economics work out, Fortescue could also one day be an exporter of green hydrogen. According to Deloitte, the green hydrogen market is expected to surpass the value of liquid natural gas by 2030.

According to a McKinsey report in November 2022, McKinsey research estimates that total hydrogen demand could increase to 600 to 660 million tons by 2050, helping reduce over 20% of global emissions.

With countries like Japan and South Korea with larger populations and less renewable energy generation resources accessible by sea, Australia would have a readily available market.

In addition to Australia, Fortescue is also developing green hydrogen projects in areas such as Phoenix in the United States.

While there is expected to be substantial demand for green hydrogen and green steel, the spending on green hydrogen and producing green steel will take a lot of capital expenditures in the near term and the return on equity of the business will likely not be high given the capital-intensive nature. It is unlikely to be anywhere near the 31% return on equity on underlying earnings as Fortescue realized in 2023.

Quarter Ended September 30

For the quarter ended September 30, Fortescue shipped 45.9 million metric tons of iron ore, 3% lower than the corresponding period of the previous year.

The company’s Pilbara Hematite C1 cost was US$17.93/wet metric tonnes, or up 1% year over year.

The company had a net debt of US$2.2 billion as of September 30, 2023, which means the company’s balance sheet is very strong given its underlying EBITDA of US$9.963 billion for the year ended June 30, 2023.

For FY2024, management sees iron ore shipments of 192-197 million metric tons.

For the period, management expects C1 cost of Pilbara Hematite to be from US$18-US$19/wet metric tonnes.

Valuation

Given it is still predominantly an iron ore company, Fortescue’s profits depend on how strong iron ore prices are.

If the price of iron ore is strong in the next 10 years, Fortescue will likely be a good investment.

If the price of iron ore decreases, the company could face headwinds.

I think there will be a lot more infrastructure built in the next ten years as governments spend more to improve living standards and promote economic growth. Nevertheless, I also think there will be more iron ore supply as well. Steel recycling could be cheaper and more effective and more iron ore mines will come online in the next few years. Likewise, steel recycling and other technologies could also compete against the green steel Fortescue plans to make.

In the long term, technology could reduce the cost of producing iron ore. It can also increase iron ore demand substantially. I am not really sure how the two will affect Fortescue’s long-term profits given the uncertainty.

In the medium term, how well Fortescue does depend on how strong the demand in China is and how strong the demand from other emerging markets is.

Given China imports around 70% of the world’s global seaborne iron ore, the company’s EBITDA is heavily affected by how much the country imports.

In terms of China according to Rio Tinto iron ore CEO Simon Trott, “China is nearing a structural peak in terms of its demand.“

China is less concerned about their economic growth rate than before as the country has already developed substantially. China’s leadership seems more concerned about the quality of growth rather than GDP growth at all costs. As such, the government might not spend as much on infrastructure as it did before to help rebound economic conditions.

In terms of other developing countries in Asia that could import iron ore, demand is expected to increase, but it isn’t certain that demand could offset any decrease in China’s demand.

According to mining analyst Lachlan Shaw of UBS:

“We need to do more to understand what the demand growth profile looks like coming out of South-East Asia and India, to get more comfort in how that supply and demand balance will come together.”

Although India is a developing country with a larger population than China, the country has its own iron ore reserves.

Given the uncertainty in the medium term, and also the likelihood that Fortescue’s green energy and green steel efforts will take a lot of capital investment that won’t likely be profitable for a while, I rate the stock a ‘Hold’ or sideline.

Fortescue doesn’t trade for a high valuation.

In FY2023, the company shipped 192 million metric tons of iron ore and had C1 cost of US$17.54/wet metric tonne. Fortescue earned US$1.56 giving the company a P/E ratio of 10.69 for the period at the price of US$16.67 as of December 5.

Given management expects to ship 192-197 million metric tons for FY2024 and the C1 cost of Pilbara Hematite is expected to be US$18-US$19/wet metric tonnes, the ultimate production is around the same and the costs are slightly higher. If average iron ore prices are slightly higher for FY2024 than FY2023, I think Fortescue could earn roughly around where it earned last year. The one uncertainty, however, is how much management spends on its green energy efforts.

Looking past the next year and more into the longer term, however, Fortescue will need to do well in green hydrogen and green energy to offset any potential uncertainty from less Chinese iron ore demand.

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