Sandstone Insights: FMG's green zero strategy

ASX code: FMG

Suggestion: Hold

Need to know

• ‘Real zero’ strategy should attract a discount
• Share price now back to traditional discount to BHP and RIO
• Capital allocation policy unclear, leaving shareholder returns uncertain.

Strategic retreat and share price adjustment

A strategic retreat from a major shareholder in FMG, selling $3bn worth of stock, has burst the share price bubble. FMG is back trading at more normal levels, but it begs the question of whether the green premium has been removed or is now more correctly valued at zero or less.

We examine FMG’s last ten years and the next five to consider:

1. Does the company deserve a discount to its closest peers BHP and RIO?
2. Should FMG trade at a larger discount for the green investment risk factor in its business?

For context, FMG’s iron ore production in FY15 was 165mt, reaching 191mt in FY24 at a weighted average price across the decade of US$96/dmt. That represents a 10-year compound annual growth rate of 4.7% in revenue, 7.1% in EBITDA, and 8.9% in EPS.

Disappearing discount to peers

Over the same period, FMG has traded at a ~20% discount to the EV/EBITDA multiples of BHP and RIO. This discount disappeared around 2021, as noted by the outgoing CEO Elizabeth Gaines, who attributed the rise in FMG’s share price to its Fortescue Future Industries (FFI) division. At the same time, FMG’s share register was expanding to include investors with ethical, ESG, global sustainability, and socially responsible traits.

Quality and infrastructure factors

The discount to BHP and RIO is also attributable to FMG’s lower quality ore, which has attracted an average discount to the benchmark Platts 62% Index price of 18% over the last ten years. A third factor is the infrastructure (rail, port, and shipping) used by FMG, which is smaller in scale compared to BHP and RIO. FMG’s C1 cost in recent years has been comparable (or better) to BHP and RIO, but this is likely due to better strip ratios.

Decarbonisation strategy

Decarbonisation strategy. FMG’s strategy to decarbonise its metals business began in earnest back in 2020. The company announced a US$6.2bn capital investment plan to 2030 to eliminate its ‘fossil fuel risk’ and reduce operating costs by US$818m per year. At the time, FMG was consuming about 650ml of diesel each year at US$1.00 per litre and 3.6m GJ of natural gas.

Fortescue Future Industries (FFI)

Concurrently, Fortescue Future Industries (FFI) was emerging as Part 2 of FMG’s strategy, with the goal of reaching ‘real zero’ emissions using no fossil fuels and no carbon offsets. In FY20, FMG’s Scope 1 and 2 emissions were 2.43mt of CO2e.

FFI was to be the vehicle that transitioned FMG into a global green metals, minerals, energy, and technology company. FMG also crucially changed its capital allocation policy to enable FFI to fund its strategy by utilising up to 10% of FMG’s net profit each year. Effectively, the iron ore business would fund the ‘real zero’ decarbonisation plan.

Navigating global subsidies

The subsidy honey pot. The most visible of the world’s subsidy schemes is the US Inflation Reduction Act (IRA), which has allocated trillions of dollars to renewable energy investments. FMG has been alert to the possibilities and has sought to use such funding to pursue various projects in the US.

However, FMG’s Arizona hydrogen project has run into difficulty accessing subsidies due to US Treasury rules that have forced up the cost of FMG’s 80MW power plant by up to 200%. FMG may also miss out on the US$3/kg subsidy for hydrogen production that it was seeking. This project must surely be under review by FMG.

The Australian Federal Government has also provided substantial funding for renewable energy projects and critical minerals.

Financial health

FMG has a strong balance sheet with gross debt of US$5.4bn as at 30 June 2024, offset by cash of US$4.9bn. FMG spent US$2.9bn on capex in FY24.

Investment view

Dr Forrest’s green ambition is only temporarily thwarted and will be prosecuted nonetheless.

FMG’s recent reorganisation has largely gutted the Energy division (700 jobs removed), which Dr Forrest partly blamed on the inability to access cheap (subsidised) power for its electrolyser business in Gladstone.

We note that Dr Forrest’s privately owned Squadron Energy has recently conducted two transactions with FMG that were not disclosed to the ASX. We wonder if FMG may consider a full takeover of Squadron Energy to fulfil its pursuit of renewable energy capacity in Australia.

The large sale of a stake in FMG over the last month seems to indicate that at least one large shareholder has recognised there is no longer any justification for a green premium in the share price.

Share price discounts

We argue that there should be a two-factor discount in the share price:

1. A traditional iron ore product discount to BHP and RIO
2. An investment risk discount for the various green projects that are reliant on government subsidies and have no transparency on the return on investment potential, if any.

As a corollary to the second factor, we would be wary of future impairment charges that might be made against existing investments.

Since FY21, FMG has expensed almost US$2.5bn on FFI and FMG Energy business, with capex amounting to around US$1.3bn (including FY24). FY25 guidance includes US$700-900m for decarbonisation and specifically allocates US$500m to Energy capex (plus US$700m opex). This indicates FMG fully intends to continue with its four green hydrogen projects (and others such as Belinga Iron Ore) even though the headcount is being drastically cut. FMG also points to further opportunities in Morocco, Oman, Egypt, and Jordan, which are subject to power prices falling sufficiently to make such projects economically viable.

Concerns over capital returns

With the disappearance of FMG’s original target of producing 15mtpa of green hydrogen by 2030, and the vagueness of the capital allocation policy, we have concerns over the future capital returns to shareholders. For now, the dividend policy remains 50-80% of net profit, which is enabling a fully franked net dividend yield of around 7%. Consensus forecasts, however, have EPS falling to just over US100cps from an estimated US205cps in FY24.

This week's price adjustment has brought the discount back to around 11% to BHP (EV/EBITDA) compared to an average of 16% since 2014 (this includes a period of high financial leverage for FMG). This implies that further downside for FMG is possible, which is 4.5x EV/EBITDA or $16.50 per share. However, we need greater clarity on the direction of the Chinese economy and its demand for crude steel, which has plateaued in the last two years. If China stimulates its economy, this would support iron ore prices and would suggest FMG is fairly valued at the current level. Better insight into FMG’s capital allocation policy would also raise confidence in the current share price.

Risks to investment view

The iron ore price could be much stronger over the forecast period than expected. Chinese demand for iron ore could be much greater than anticipated. The green hydrogen projects could become commercially successful, providing shareholders with a return. Government policies towards green hydrogen could become more accessible and even larger, making projects viable.

Figure 1: FMG's EV/EBITDA multiple average is a 16% discount to BHP since 2014

Figure 2: Net debt to EBITDA vs peers BHP and RIO

Figure 3: Market consensu EPS forecasts are declining on lower iron ore prices

• _{The information provided by Sandstone Insights does not constitute investment advice and does not have regard to the specific needs of any person who may receive it. No warranty is given as to the accuracy or completeness of the information and any person acting on it does so entirely at their own risk.}