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Morningstar | Fortescue Surprises with Larger Iron Bridge Development, FVE Raised to AUD 5.50 per Share

No-moat Fortescue’s approval of the 22 million tonne Iron Bridge project is the first concrete evidence of high iron ore prices encouraging a supply response. However, while Iron Bridge adds modestly to our long-term supply forecasts, as we had not expected any new magnetite mines to be developed in Australia, it’s not sufficient to impact our USD 40 per tonne midcycle price forecast from 2022. Instead, Fortescue’s move looks opportunistic given the current backdrop of tight iron ore supply following near-term concern about the supply of iron ore pellets globally given Vale’s recent issues. We raise our fair value estimate 6% to AUD 5.50 per share with Iron Bridge’s approval, but shares in the miner continue to screen as overvalued.

The Iron Bridge mine could add around 15% or USD 325 million to group EBITDA from fiscal 2024. This iteration of Iron Bridge is more than double the size previously contemplated. Fortescue has also extracted capital and operating cost savings through lengthy trial mining and processing. More than 1 million tonnes of ore has been processed to date. Leveraging off existing port infrastructure generates capital cost savings. Fortescue will receive a port access fee in return for using up its excess capacity.

Fortescue will develop a larger than expected 22 million tonne magnetite iron ore mine in the Pilbara. The USD 2.6 billion Iron Bridge project is the first meaningful iron ore development in Australia since Hancock Prospecting’s Roy Hill mine. Roy Hill started shipments in late 2015. Iron Bridge is a joint venture with Formosa Steel and Baosteel. Fortescue has a controlling 61% stake, will operate the mine and market the high-grade, 67% grade iron ore fines. The product will likely be used as feed for pellets, a high-value steelmaking feedstock.

The high-grade Iron Bridge product should secure a premium to the 62% and 65% index prices. The 65% index has sold at an average USD 12 per tonne premium over the 62% benchmark since 2014. We’ve assumed the 67% product attracts a similar premium over the 65% price. We estimate Iron Bridge’s product to attract a midcycle price of USD 70 per tonne from fiscal 2024. The price premium is key to the economics with Fortescue estimating an all-in sustaining cost of USD 45 to USD 55 per tonne. Reserve life is long, well over 20 years. Resources of over 5 billion tonnes could support about 80 years life.

Iron Bridge will mine magnetite, a much more process-intensive form of iron ore than is conventionally mined in the Pilbara. The resource grade in the ground is around 30% and will be upgraded to 67% iron. At conventional Pilbara mines, the reserve grade is very similar to the product grade. The need to crush, grind and concentrate magnetite ore means the mines are typically very energy and water-intensive. The generally high capital and operating costs means magnetite mines have a chequered financial history in Australia.

However, Iron Bridge will utilise dry crushing and sorting technology to minimise water and grinding requirements. The company will also take advantage of spare capacity at the port, which helps minimise the capital cost. The unit capital cost of about USD 120 per tonne is similar to Fortescue’s last major expansion. This is low for a magnetite mine. But with the project estimated to contribute less than 15% to midcycle group EBITDA, Iron Bridge overall is not material to our unchanged no-moat rating.

Fortescue intends to use a mixture of nonrecourse project debt and operating cash flow to fund the mine. The company is in strong financial shape with net debt of USD 3.0 billion at the end of 2018. We forecast net debt/EBITDA of less than 0.7 in 2019, declining thereafter. With forecast free cash flow of USD 1.5 billion per year, Fortescue is well placed to finance its USD 2.1 billion portion of Iron Bridge development costs.

The reduction in output from Vale’s tailings dam failure alone in 2019 is likely to represent about three to four years of production from Iron Bridge, once fully ramped up. Iron Bridge product sales are set to start in the first half of 2022, with the ramp up to 22 million tonnes taking a further year.

Iron Bridge is important strategically for Fortescue. The company aims to sell more than half its iron ore above 60% iron grade. This compares with an average grade of around 58% for the roughly 170 million tonnes a year produced currently. Iron Bridge alone allows Fortescue to meet its goal to have most of its iron ore above 60%, assuming the company chooses to blend it with the existing products.

Whether to blend the high-grade product or sell it as a standalone will depend on the relative premiums and discounts for the 67% material versus the 58% material. Based on historical premiums and discounts, it seems likely that most of the Iron Bridge product will be sold stand alone. But it does give important flexibility.

Fortescue recently suffered when discounts for its 58% product widened, as steel mills preferenced higher-grade ores. Adjusted net profit roughly halved in fiscal 2018 with higher product discounts, despite the 62% index price being relatively flat versus fiscal 2017. Those inflated discounts have normalised in 2019. But with Iron Bridge’s development, Fortescue will have a partial hedge against another blowout. If discounts for 58% iron ore again widen, it’s likely premiums for the 67% Iron Bridge product will grow too. So, in future, Fortescue will have some defence against widening low-grade discounts.