cfa institute research challenge · pdf fileaustralian iron ore mining company in the pilbara...

03 October 2014 UNIVERISTY OF WESTERN AUSTRALIA STUDENT RESEARCH | PAGE 1

CFA Institute Research Challenge Hosted by

The CFA Society of Perth University of Western Australia – Team One

The University of Western Australia


Materials Sector, Metals and Mining Industry

Tough Times Ahead We ground our SELL rating for Fortescue Metals Group (FMG): based on a bearish iron ore price, a poor competitive position relative to the majors and being overvalued with higher risks. Using a Discounted Cash Flow (DCF) valuation with a Weighted Average Cost of Capital (WACC) of 9% (nominal), our estimates suggest the current market price will fall ~24% to our target price of AU$ 2.79.

Highlights China and Iron Ore Markets: Slowing growth in China has been met by reduced steel production growth. The supply side response of increased iron ore production, has resulted in an oversupply in the market causing current prices to plunge by 36% to US$ 79/dmt. Financial year (FY15): It’s forecasted that earnings will decrease by 88% to US$ 314m, as operating margins are squeezed. The major reason being a 39% fall in realised prices to US$ 65/dmt (FY13 US$ 106/dmt) based on the 62% Fe CFR China Platts Index. Uncertainty for debt and equity holders: Deterioration in earnings impedes FMG’s accelerated debt repayment strategy. We forecast FMG to make reduced debt repayments and for dividends to be cut until targeted gearing levels are reached later than planned in 2019. T155 expansion is complete: Developments cost US$9.2bn, leaving high levels of debt on the balance sheet. Future capacity to pay debt and dividends will largely depend on future earnings. Our forecasts suggest decreasing liquidity and cash reserves will pose significant credit risks to FMG. Production forecasted to increase slightly: An additional 5 Mtwpa from Solomon’s DID is expected to be realised in 2016 and so we model peak production at 163 Mtwpa. However we expect further expansions will be unlikely if iron ore prices continue to remain depressed. A long run EBITDA margin of ~ 24% is well below the majors: FMG is currently cheap on a trailing P/E basis (3.9x), but this discount is due to the high gearing and low operating margins. We expect FMG to become more expensive once they are ex-growth in FY16, based on a forward P/E of 26.1. Main risk is the iron ore price: with tight margins and 100% dependence on iron ore sales, FMG’s gearing of 56% creates a levered exposure to iron ore price fluctuations. With a breakeven cost of ~ US$70/dmt any short-term volatility below this price would cause operating losses and potentially could push FMG to the brink of disaster, as experienced in 2012.

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FMG AU Equity S&P/ASX200

Company Data

GICS Sector Materials

Volatility Index High

52-week Price Range (AU$)

3.45-6.20

Market Cap (AU$ millions)

10,774

Shares outstanding (millions)

3,144

Source: Bloomberg

Market Data

Spot Iron Ore

CFR China 62% Fe (US$/dmt)

81.40

FX (AU$/US$) 0.87

S&P/ASX200 5,188.3

Dow Jones 16,659.25

Source: Bloomberg

Figure 1: FMG Equity and S&P/ASX200 One year

Source: Bloomberg

Investment Fundamentals FY 30 June 2014A 2015E 2016E 2017E

Sales (US$) 11,796 9,155 9,527 9,562

EBITDA (US$) 5,606 1,784 1,851 1,842

Net Profit (US$) 2,773 314 410 451

Net Op CF (US$) 6,215 894 1,688 1,650

EPS (US¢) 89 10 13 14

P/E 3.9 34.2 26.1 23.8

DPS (US¢) 20 0 0 0

Dividend Yield 5.8% 0 0 0

ROA 12.7% 1.4% 2.0% 2.2%

ROE 43% 4% 5% 5.3%

Source: Team estimates

Fortescue Metals Group

Recommendation SELL (24% Downside) Date 3/10/14

Target Price AU$2.79 - DCF Valuation

Current Price AU$3.45 Ticker FMG: ASX (Bloomberg) AU$/US$ 0.88


Figure 3: Surface miner

Source: FMG

Figure 4: Revenue and net profits

Source: Company reports

Business Description Fortescue Metals Group (FMG) is an independent Australian iron ore mining company in the Pilbara region of Western Australia, exclusively trading sea-borne iron-ore to China. Operations: FMG operations are organised into two central hubs containing four mines: Cloudbreak, Christmas Creek, and the relatively newer Firetail and Kings mines (Figure 2). It also receives ore from the Nullingine joint venture (JV) (25% FMG) operated by BC Iron as a mine gate sale. The Solomon and Chichester hubs are connected to the Herb Elliot Port via FMG’s rail network. In August 2013, construction of a fourth berth was completed, with a fifth due in 2015. Resources and Exploration: FMG continues to explore its large (87,000Km2) Pilbara land base, with total resources summing to approximately 12bt dry in FY14. Current developmental hematite properties include Nyindinghu, the Western hub, greater Chichester and greater Solomon. Development: FMG is looking to access its large magnetite resources in the Pilbara by developing the Iron Bridge project in conjunction with Taiwan’s Formosa Group and China’s Boa Steel Group (see Appendix 5). This will begin realisation of its North Star

and Glacier Valley ore bodies. Production of 1.5 Mtpa of weathered magnetic hematite is expected to commence in 2015 along with 9.5 Mtpa of magnetite once the stage 2 development is completed (construction begins in FY15, pending approval). Production: The T155 expansion was completed in early 2014 and is expected to produce 155-160 Mtwpa in FY15. Smaller increases are also possible through utilisation of Detrital Iron Ore Deposits (DID) at Solomon. Currently FMG only produces fines and generally sells a discount product at an average grade of 58%. This is due to higher levels of impurities and lower average Fe grades of resources is ~ 56%, which require more processing and are lower quality than other Pilbara miners. The Cloud Break and Christmas Creek mines have used a continuous (surface) miner to closely manage and monitor its grade, whereas the newer Solomon mines use a traditional drill blast method. Priorities: Management has signalled priorities will shift from mine, port and rail infrastructure investment to consolidating existing operations and maximising annual output. Key targets are driving down C1 costs to US$31/wmt, improving product quality, maximising the benefits of low impurity Chichester ore and reducing their debt burden to a targeted gearing ratio of 40%. Strategies: FMG’s strategies remain grounded in the following initiatives:

Continuing exploration of potential mineralisation in and around Chichester and Solomon hubs will build upon their resource base and sustain their 5 mines and 5 processing facilities strategy once Iron Bridge commences production in FY15.

A 4 berths (5th berth due in FY15) 3-ship loaders strategy at Herb Elliot Port is paramount to increasing ship-loading efficiency in a tidally constrained port.

Detrital processing at Solomon will add another 5mtpa to capacity

An accelerated debt reduction strategy will target US$ 2-2.5bn of debt callable at Fortescue’s option over the next 12-18 months in addition to a committed US$ 0.5bn in October.

Gasification of operations through the Fortescue River Gas Pipeline aims to reduce energy costs by ~ US$20 m a year.

Corporate: Established in 2003 by Founder and now chairman Andrew Forrest, Fortescue Metals Limited is an ASX publicly listed company. The current CEO Neville Power has been an integral part of the key management team who have maintained an impressive track record of consistent revenue growth (Figure 4) and meeting ambitious production targets. Currently, ownership is dominated by Forrest family funds and institutional investors who constitute the top 20 shareholders owning 86.7% of FMG’s ordinary shares

Figure 2: FMG operations map

Source: FMG


Figure 5: Porter’s Five Forces Analysis


Figure 6: China’s shifting GDP composition

Source: Bloomberg

Figure 7: Falling property sales indicate drop in steel product

Source: Bloomberg

Figure 8: Additional seaborne supply will outweigh demand

Source: Goldman Sachs and company data

Figure 9: Flattening cost curve

Source: Macquarie Research, August 2014

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Industry Overview and Competitive Positioning

Transitioning growth drivers slow steel demand: The drivers of growth are changing, underpinned on the demand side by a shift from investment to consumption, and on the supply side a shift from manufacturing to services. Overheated investment has been driven by a real estate boom, which pushed construction in housing and transport, driving steel demand as a result. As the economy rebalances, we expect to see falling iron ore imports in the long term. Cooling real estate sector: Overdevelopment is raising bubble concerns, best illustrated by ‘ghost cities’, which have been built with government backing and now sit nearly empty. Government attempts to curb speculation via credit restrictions and a new real estate tax, in fear of a bubble burst, has led to rapid cooling of the sector. Property sales growth has been a leading indicator for crude steel production growth (Figure 7), so the downturn in the property market will likely result in lower steel output growth levels, with steel demand predicted to grow just 3.1% in 2014 and 3.3% in 2015, compared with growth of 3.8% in 2013 according to World Steel. In the medium term, slowing steel production growth will put downward pressure on iron ore prices. Seaborne iron ore surplus: High iron ore prices over the last decade, resulting from boom in demand from China, have incentivized new entrants and underpinned substantial growth in supply. It is expected to result in an oversupply in the short to medium term. As existing projects ramp-up and productivity gains are delivered in Australia and Brazil, global iron ore production capacity is expected to reach 790Mtpa over the next 3 years, according to incremental supply increases from the majors only. This occurring, in spite of falling demand, will put downward pressure on prices. However due to large profit cushions for majors, prices could fall by 20-30% before materially altering production capacities, putting producers with higher breakeven costs at risk (see Appendix 8 for breakdown of cost curve). Long term prospects are better for the iron ore market, as emerging economies will support steel production growth (see Appendix 9). China’s iron ore imports slump: Iron ore inventories in China recently reached record highs (see Appendix 10). Ample stock levels at steel mills coupled with slower demand from steel production will likely soften restocking momentum. Meanwhile, banks have tightened credit controls on import financing deals. These factors are causing short-term price volatility via downward pressure on import demand. Iron ore cost curve flattening: Majors have been committed to productivity, cost reduction and capital efficient growth (because the dropping price is squeezing margins), rather than major supply chain investment. Majors already sit low in the cost curve, helping them withstand future volatility in the iron ore price. High cost iron ore supply has been shown to be price elastic as private Chinese mines have responded to the price reduction, with 50Mtpa idled between December 2013 and August 2014 as reported by a SMM survey. Chinese state owned mines continue to operate at a loss. Closure of high cost mines may ease pressures on the iron ore price. Long term substitution: We also anticipate a large increase in steel supply from the scrap market in China, this currently does not have a significant impact on the market but with over 120 million new cars on the road in China since 2009 it is inevitable that there will soon be a glut of scrap supply.

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2013 2030Agriculture Industry Services

The iron ore industry is characterized by high barriers to entry, low buyer and medium supplier bargaining power, a medium threat of substitute products and a high degree of rivalry among competitors (see Appendix 6). Surging growth in China during the early 2000’s drove a boom in iron ore (see Appendix 7). However, the industry now faces a downturn, with the iron ore price plummeting from US$110 to ~ $US79 over the last 6 months. Slowing growth in China: China accounts for approximately 70% of global seaborne iron ore demand, and so slowing GDP growth raises concerns for the sustainability of iron ore producers, particularly FMG given it only sells to China and with falling demand putting downward pressure on commodity prices. The Chinese government has announced plans to target a growth rate above 7% in the near term.


Figure 10: Seaborne iron ore production 2013

Source: Based on public information at January 2014 Vale and BHP Billiton are inclusive of their share in Samarco. Rio Tinto inclusive of Iron Ore Company of Canada seaborne production.

Figure 11: Cash costs


Figure 12: EBITDA margins


Figure 13: Comparable company qualities

BHP RIO FMG AGO MGX

Mkt Cap US$ 172 B 108B 11.37B 572.7M 390M

Vol. Mtpa

225 290 155 4 10.9

Mine life

Long Long Medium Short Short

Net D/E

30% 28% 94% -4.9% 1.5%

Source: Bloomberg and Company reports

Competitive Positioning

Inferior product attracts discounts: FMG’s iron ore products have an average Fe content of ~58% with significant amounts of silica, alumina and phosphorous attracting a discount from the 62% Fe CFR Platts price. Whereas the majors the generally sell at the index price and also sell lump, which sells at a premium. The discount FMG receives accounts for their smaller operating margins, in tandem with higher C1 costs. This has resulted in significantly lower EBITDA margins than the majors (Figure 12). Higher costs than the majors: The biggest weakness in FMG’s cost structure is the higher processing and production costs. Due to lower grades and higher impurities, nearly 100% of run of mines (ROM) ore is put through a wet plant to improve ore quality. BHP and Rio generally engage in a dry processing operation and hence do not sustain wet processing losses, which coupled with FMG’s higher strip ratio of ~ 3.5 limits the prospect of closing the gap to BHP and Rio’s C1 cost levels. Without the same economies of scale as the majors, FMG’s C1 costs are significantly higher than BHP and Rio (Figure 11). FMG has size and locational advantages in their Pilbara land ownership: With 87,000Km2 in land tenements held for both infrastructure and mining purposes, FMG potentially has the largest resource base of the Australian majors. This land base enjoys close proximity to the Asian markets positioning them well to export China and other developing countries in the future - a key advantage over non-Australian competitors such as the Brazilian firm Vale. How much potential mineralisation can be converted into resources and mined is unknown due to long run price uncertainties. Financial position: FMG’s financial position is not strong at our forecasted long run iron price at US$80/dmt (real). Tight margins and relatively high debt levels make FMG much more susceptible than the majors to falls in the iron ore price, as reflected in a lower credit rating. FMG’s supply chain infrastructure: FMG has a modern, purpose built rail network that would be relatively low cost to expand in response to higher production. It also made a small (1.2%) contribution to operating sales revenue in FY14 through leasing arrangements. The key here is that FMG’s rail network is highly desired by many junior miners such as Atlas Iron and Brockman, who do not have the resources to develop their own infrastructure. While it is uncertain if Atlas or Brockman will acquire access to FMG’s train and port infrastructure (TPI), it undoubtedly gives FMG a competitive advantage against miners without their own TPI in the Pilbara.

Investment Summary Overvalued on a NPV basis: We issue our SELL recommendation based on our DCF Net Present Value (NPV) of AU$2.79 – a 24% downside to the current share price (AU$3.45). We base our recommendation on the DCF over the Comparable Company Analysis (CCA) for two key reasons: A DCF valuation is more suited to valuing finite life assets such as mines as it requires no terminal value calculation, and is therefore more reflective of intrinsic value. Also finding quality comparable Australian mining companies to FMG is difficult due to the lack of comparable qualities in terms of market capitalisation, production levels, mine life and gearing levels (Figure 13).

Lower diversification than the majors: FMG solely mines iron ore and ships 100% of their product to China, rendering their profitability entirely dependent on the iron ore price. For the majors BHP and Rio, iron ore contributes approximately 50% and 80% of underlying earnings respectively placing them in a better position to weather the iron ore downturn. FMG’s lack of customer diversification will also continue to be a competitive disadvantage if iron ore demand from China continues to fall.


Figure 16: Iron ore price gap

Source: FMG quarterly production reports

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62% Platts CFRIndexFMG Achieved CFR

Price Relativity

Comparable Analysis: Our CCA valuation focused on both large and small cap Australian iron ore miners producing a wide range of implied prices. Figure 13 highlights FMG’s unique characteristics with respect to its small and large cap peers, and the difficulty of finding quality comparable companies. Consequently, our target price has not assigned any weight towards the CCA valuation. Rather it serves to outline the distinctive position FMG holds in the Australian iron ore market. Conservative DCF: An overarching feature of our DCF is the conservative nature of the models’ inputs. These have been based on current information, reasonably certain developments and management guidance we were able to rationalise. As a result, only the Chichester and Solomon operating hubs have been incorporated, omitting FMG’s developmental properties into our NPV (Figure 14). These assets were not included in the DCF due to the uncertainty of their development. Magnetite: We have chosen to limit the amount of value assigned to FMG’s magnetite resources. Given that Pilbara magnetite is relatively hard and costly to mine, the vast majority of Pilbara miners focus on the more economical hematite. Our conservative approach requires more guidance from FMG on magnetite cost of production and realised prices to justify its economic viability and subsequent inclusion into our NPV. The Iron Bridge magnetite project however, is expected to start production next year and has been included into FMG’s NPV, but has been valued separately to the model (see Appendix 5). FMG is Ex-growth: Current inflow and outflow capacities of 180Mtwpa and ~ 175Mtwpa respectively (upon completion of AP5) means Fortescue has the capability to manage increased production. However, we do not believe that production increases are likely once FMG reaches peak production in FY 16 of 162Mtwpa. This assessment is rooted in the uncertainty of FMG’s financial capabilities for funding developmental capex and the economic viability of new mines with a low long run iron ore price. As a result, we have made a simplifying assumption to value FMG on an ex-development capital basis from FY17. Balance sheet weakness: Debt is a key concern in our analysis and levels are forecasted to remain elevated as FMG is negative free cash flow in FY15 with significantly reduced cash levels. This will delay debt repayment goals to reach the targeted gearing level of 40% until FY19. Should FMG not meet our forecasted debt reduction rate, a higher discount rate is required and this would have a material effect on our NPV of the company (Figure 26). There is also the possibility of FMG’s credit rating being downgraded; an event that would increase our forecasted cost of borrowings. FMG’s profitability on the brink: FMG profitability in the short term will be impeded by the oversupply in seaborn iron ore – supply surpluses are expected to increase to 175 Mt in FY15 (Figure 8). As the market corrects, FMG’s levered position will be highly sensitive to iron ore price volatility. The key question is where prices will bottom out and crucially whether it falls below FMG’s breakeven price. Our FY15 forecasts suggest only a ~5% buffer before the company begins to operate at a loss. The effect of falling prices on margins is compounded by increasing product discounts, which tend to occur when the iron ore price falls (Figure 16). This assessment is based on the assumption that as steel demand falls in line with slowing growth in China, Chinese steel mills demand higher Fe grade and low impurity iron to improve the productivity of their blast furnaces. Long run prospects better: As the Chinese property market begins to moderate and with GDP targeted at ~7%, we do not expect China’s economy to go back to the levels seen over the last 10 years. However prospects improve in the long run, as demand will be supported by emerging economies. Hence our long-run assessment of the iron ore price is US$80/dmt (real), which we believe will not fall below US$70/dmt. At this price, FMG will struggle to outperform its competitors considering their smaller operating margins. Investment summary: Our analysis has found FMG to be a high-risk investment with a poor expected return prospect. We reaffirm our SELL rating based on the following key conclusions:

Overvalued: Expected negative capital growth of ~24% and a cut to dividends until FY19.

Overexposed: The company’s lack of commodity diversification concentrates risks.

Figure 14: Components of NPV

VALUATION NPV 01/01/2015 US$m US$/ps %

Chichester 7,685 2.47 107%

Solomon 5,355 1.72 74%

Iron Bridge 1,280 0.41 18%

Closing Value 40 0.01 1%

Enterprise Value 14,359 4.61 200%

Net Debt (7,159) (2.30) 100%

Total US$ 7,200 2.31 100%

AU$m AU$/ps

Total AU$ 8684 2.79 100%

Shares m 3,114

WACC (Nominal) 9.00%

MACRO - ASSUMPTIONS

Company Tax Rate 30%

Inflation 3%

Long-Run Avg.USD/AUD 0.83

Figure 15: NPB Breakdown

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Chichester Solomon Iron Bridge


Highly leveraged: FMG’s high debt levels exacerbate its financial risks. The market correction to the iron ore price will result in a sharp deterioration of earnings and cash.

High competition: Operating in an industry where competitors are increasing supply surpluses with higher quality products at lower costs

Falling profitability: The falling iron ore price alongside relatively high production costs squeeze FMG’s margins.

Valuation

Discounted cash flow: Our implied share price of AU$ 2.85 was derived projecting production on a per-mine per-year basis over the life of the mine/resources (Appendix 2(a)). We used a nominal WACC of 9% and a long run AU$/US$ of 0.83 (real) within our model, producing a long run EBITDA margin of ~ 20% (Appendix 2(e)). The most crucial inputs and assumptions are discussed below. WACC: Our WACC is determined by a long-term capital structure of a 40%/60% debt-to-equity mix, which is a function of management’s targeted capital structure. A higher discount rate was not used to reflect FMG’s current high levels of balance sheet debt, but rather is accounted for in a more conservative projection of cash flows (Appendix 2(f)). Production: Forecasts for each mine was based on production reports from FMG & BCI. We expect FY15 production to be ~ 157 Mtw (152mtw FMG equity) with full ramp up of kings to bring the Chichester hub to 60 Mtpa, 90 Mtpa from the Chichester Hub and 6.2mtpa from the NJV. Further expansion can be achieved through developing detrital deposits (DID) at Solomon. A processing plant was approved in May 2014 and is expected to be functioning within one year. We therefore add management’s expectation of 5Mtpa and model peak production at ~163Mtpa in 2016 (Figure 18). Expanding to 180Mtw pa: Further expansion is possible through the Western Hub (WH) and Nyidinghu (ND). However, the uncertainty in funding for developmental capital, timing of such projects and tight operating margins means we have not inputted them into our model. Furthermore, these long-dated undeveloped resources would provide a small NPV benefit, and not be material to our valuation.

Price: Future contracts were used to derive the forward curve, until FY18 where we anchored the price on consensus of estimates to derive a long run iron ore price of US$80/dmt (real) (Appendix 2(a)). Mine-Life: Total saleable ore was based on 100% reserve and 50% resource conversion ratio, which seems reasonable as it produced a life-of-mine ~10 years above on reserves (Figure 33). We have chosen to be conservative in our model and not factor in any increase in mine-life through potential mineralisation in producing hubs. Resulting in an average mine life of 30 years and saleable ore of 3907 Mdmt (Figure 19 & 20). Once again we believe that extending mine-life beyond our models forecasted end of 2050, would only produce a small NPV benefit (US$ 1bn in cash flow is only worth US$46m in NPV).

Magnetite: We have not ascribed any value on the any of FMG’s large magnetite resources (see upside risks), with exception of Iron Bridge. It is not included in the model but we have valued it separately at ~ US$ 1.3bn (Appendix 5). Grade & Impurities: We have noted that FMG does have a challenge with their low Fe grade and high impurities, especially with alumina. While Decreasing Fe grade can be expected as a mine ages, we assume FMG will continue to process and throw away low grade ore to maintain an average 58% grade. However, we have increased the discount received by FMG’s above management guidance of ~ 14% to 16% as our analysis shows FMG’s high level impurity ores discounts generally increase as iron ore prices decreases (Appendix 2 (g)).

Figure 18: Production and price forecast

Source: Company data and team estimates

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Figure 17: WACC inputs

WACC Inputs

Pre-tax Cost of Debt 5.36%

Tax rate 30%

Cost of Debt 3.35%

Risk Free rate 3.31%

Equity beta 1.375

Market risk premium 6.90%

Cost of Equity 12.80%

Equity % 60%

Debt % 40%

WACC 9.00%

Source: Bloomberg and team estimates

Figure 19: FMG operating mine lives


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Dry In-Situ Mt FMG Mineral Resources

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Costs: Cost reduction is one of the key drivers of value C1 costs down to $ 32/wmt in FY15, based on management guidance: We model a further decrease until FY17, where C1 costs are held constant at US$ 30/wmt (real). We believe a further reduction is possible, mainly from reduced mining costs as strip ratios decrease (less dirt moved) through the ramp-up of both Firetail and Kings - relatively newer mines with lower ratios - and is held constant as mines age. Capex: capex of $1.3 bn in FY15 has been based on management’s guidance. Further development capital, apart from those already stated by management (Figure 22) has not been modelled and is in line with our simplifying assumption that FMG is ex-growth from FY17 onwards. The main reason for this assumption is the ability of FMG to fund development capital expenditure. We have assessed various ways FMG could raise development capital and deemed none plausible:

We do not expect financing through debt as management intend to reduce gearing.

Equity through a rights issue, would be difficult as the falling price has reduced equity holders’ appetite for iron ore exposure.

While through generated earnings will be difficult with reduced cash flow forecasted over the short-term.

This leaves joint ventures but is too early to start speculating on potential partnerships.

Sustaining capex (SC): The critical factors for our SC projections have been the number of mines and age of infrastructure. As our model assumes no future mine development we have gradually reduced FMG’s SC until FY19, where we make SC equal to normal straight-line depreciation (half of accelerated depreciation) (Appendix 2(d)). Debt repayments and dividends: According to our analysis FMG’s reduced cash flow in FY15 brings cash levels dangerously low to ~US$ 750m. In order to hold this level of cash we forecast dividends to be cut and a reduced debt repayment strategy (Figure 23, Appendix 3(f) for financing assumption and notes 22), delaying targeted gearing of 40% to FY 19. We believe reducing debt is the most prudent action in the current climate and FMG will prioritise this over dividends.

Lower net interest: A benefit of reducing debt is a lower interest cost. We calculate a lower cost of debt at ~ 5.3% (Figure 23 and Appendix 3 (f)). Comparable company analysis: We applied comparable company analysis by dividing our average multiples between two groups (Figures 24 & 25): (1) small caps, consisting of Mount Gibson Iron Ltd. (MGX) and Atlas Iron Ltd.; and (2) large caps, consisting of BHP Billiton Ltd. (BHP) and RIO Tinto Ltd. (RIO). When compared to the small caps, multiples produced a price of $1.81 for the trailing twelve months (TTM) and $2.33 for the forward-looking (FWD) multiples. Compared to the large caps multiples produced a price of $2.91 (TTM) and $3.88 (FWD). The ability of comparable analysis to reflect intrinsic value is dependent on the quality of comparable companies and so we believe comparable analysis is not appropriate for FMG. While BHP and RIO have relatively similar production tonnages they are different on a commodities, leverage and size basis to FMG. Conversely the minors are different on a production and size basis but like FMG mainly focus on iron ore production (Figure 13).

Figure 21: Forecasted costs and breakeven price

Source: Company data and team forecast

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Figure 22: Forecasted capital expenditure


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Figure 28: Debt/EBITDA


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Figure 27: Cash and debt US$ billions


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Figure 26: Sensitivity analysis +10% +5% +1% Iron Ore

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$5.18 $3.99 $3.39 <- $2.79 -> $2.19 $1.59 $0.39

+86% +43% +8.5% Base case price

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$2.32 $2.54 $2.74 <- $2.79 -> $2.84 $3.05 $3.35

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change

+1.8% 9% +20%


Sensitivity Analysis While there are many inputs into our DCF the greatest driver of NPV is the iron ore price and the discount rate used. Our sensitivity analysis shows how a percentage change in our long-term iron ore price of US$ 80/dmt (real) affects our target price, which translates into a -/+1% change in the iron ore price results in a -/+8.5% change in NPV. This sensitivity can be attributed to the tight margins, leveraged balance sheet and ~100% of their revenue dependent on iron ore sales. We noted that a key risk is short-term fluctuation in the iron ore price, and the snowball effect this would have on FMG, especially in regards to the liquidity and credit rating. We also noted that any change to these metrics would warrant a higher cost of debt for FMG and therefore a change to our WACC of 9% (nominal). Accordingly, our sensitivity analysis also shows that a -/+1% change in WACC produces a +/-1.8% change in NPV.

Financial Analysis

Earnings: Driven down by lower prices and increasing costs. Iron ore prices are expected to drop to by 36% to US$77/dmt 62% Fe CFR China, (2013:US$123/dmt).

Net Profit After Tax set to decline to US$ 314 m in FY15: Despite production increasing to 157Mtw, we forecast a significant decline in operating revenue of 20% and earnings of 83% in FY15.The major reason for this is the significant decline in the iron ore price but also a further 2% increase to the discount FMG receives translating to a lower realised price of US$ 66/dmt. Degearing but not fast enough: High levels of debt and 100% exposure to iron ore are the biggest risks to the financials. While FMG has utilised the opportunity of a strong performance to repay US$3.1Bn debt, it’s current gearing D/(D+E) of 56% is still high and FMG are not out of the woods yet. Management reiterating its strategy to pay down debt with a targeted gearing of 40% in the next 12-18 months seems optimistic, as their ability to make the additional debt repayments is hindered from deteriorating operating cash flows in the next few years, and instead we predict targeted gearing will be reached in FY19 (Figure 29). Credit and liquidity risk increases: A large fall in earnings and cash reserves results in FMG’s credit metrics deteriorating significantly (Figures 28, 30. While gearing has gone down to ~53% (Figure 29) with our assumed US$ 500m in repayments, interest coverage has almost halved (figure 30) and puts FMG at risk of breaking debt covenants and suffering a downgrade to its credit rating. Dwindling cash reserves poses cuts to dividends: After US$1.3bn capital expenditure and our assumed debt repayment of US$ 0.5bn, FMG’s cash balance reduces to ~$UD700M. At these low cash levels, FMG will be constrained to pay both debt holders and equity holders a return in the next few years and forecast a temporary cut to the dividends (see notes 23). We expect dividends to be reinstated once gearing of 40% is achieved in FY19 at a payout ratio based on management’s comments of 30-40%.

Reducing costs on a per tonnage basis but break-even price is still high: This trend of lowering breakeven price is being replicated amongst all iron ore miners currently as a strategy to deal with the decreasing price. We expect the range of initiatives from FMG to be able to reduce TDC by ~ 7% and all in cost by ~ 15% throughout our model. Despite this, FMG’s break even with the CFR 62% China Platts price is still relatively higher than the majors at $US70/dmt, and averaging US$66/dmt in the long run.

A reduced margin increases risk: The falling price and relatively high cost of production results in FMG’s margins being squeezed in FY15. While our analysis expects slight improvement, they do not return to 2014 levels at our long-run iron ore price of US$80/dmt (real). As a result FMG’s long run EBITDA margin is ~ 20%. Ratio analysis: A look at FMG’s net profit margin shows a sharp decrease in FY15 to 3.4% in line with the falling iron ore price. A DuPont analysis highlights how FMG’s return on equity is mainly propped up by its leverage and is reflected in its share price volatility.

Figure 29: Gearing D/(D+E)


56 53 51 48 45 41

0%

10%

20%

30%

40%

50%

60%


Figure 30: Interest coverage (EBITDA/Interests)


7.8x 4.1x 4.6x 4.8x 5.8x 6.0x

0.0

2.0

4.0

6.0

8.0

10.0

Volatile share price: Small margins, 100% dependence on iron ore along with a leveraged balance sheet, makes FMG’s share price extremely sensitive to price fluctuations. Our financial analysis ends by simply describing FMG as essentially a leveraged play on the iron ore market, and therefore a relatively riskier investment than other miners. Figure 32 graphs the iron ore price and BHP’s, Rio’s and FMG’s share price indexed to a base of 100. From July to September 2014 FMG’s share price has decreased 31% while BHP and Rio have decreased by 15% and 13.5% respectively in response to a 13% decrease in the iron ore price.

Investment risks

Downside Risks Commodity price risks: The most critical risk is whether iron ore prices will fall below FMG’s break-even price of ~US$69/dmt, and is the most sensitive input into our DCF (Figure 26). This risk is especially pertinent over the next few years as we expect a surplus of supply to create short-term volatility in the iron ore price until the market is rebalanced by significant closures at the top end of the cost curve. Figure 33 shows the majors, who are able to operate profitably at lower prices, and other miners ramping up production over the short-term. Increased Impurity Discounts: Lower grade iron ore and ore with impurities receives a discount to the 62% CFR price. Fortescue supplies lower grade ore than its major competitors and due to the oversupply in the iron ore market the discounts received for the lower grade ore have been increasing. The Fortescue annual report states: as balance is restored to the iron ore supply and demand, Fortescue expects to realise between 85 and 90% of the average 62 per cent Platts CFR index. Fortescue current discount averages ~15%, further discounts from historical averages will squeeze margins further. Reserves Reduction: A key risk to our models life-of-mine estimate is changes to

reserve estimates with changing iron ore prices, as reserves needs to be deemed to

be profitably mined for recognition.

Operational risks Industrial Action: Ongoing conflict between Teekay Shipping and its unionised employees have led to repeated threats of stoppages on work. This disruption has the potential to remove FMG’s ability to export for the duration of the strike. This would cause a loss of revenues to Fortescue in the order of $37.5M per day. The risk is mitigated by the $7 million per day of lost royalties that the state

Figure 33: Anticipated production increases over the next 5 years


0

20

40

60

80

100

120

140

160

Vale BHP RIO Roy Hill

Mwtpa

Figure 34: Mine life Reserves (actual) Team modelled

Mt Dry % Fe Life (years)

Mt Dry

%Fe Life (years)

Cloud Break

500 57.6 14 831.5 57.6 23

Christmas Creek

970 57.3 22 1514.5 57.3 33

Nullingine 71.65 56.8 13

Firetail 174 58.7 10 272.5 58.7 15

Kings 729 56.9 20 1288.5 56.9 36

Total/ Average

2373 58% 19 3979 58% 30

Source: Company reports and team estimates

Figure 32: FMG, BHP, RIO share price sensitivity to iron ore price

Source: Bloomberg

50.00

60.00

70.00

80.00

90.00

100.00

110.00

16/10/2013 13/01/2014 15/04/2014 14/07/2014

Index

FMG Index BHP Index RIO Index Iron Ore Index

Figure 31: DuPont Analysis 2014A 2015F 2016F 2017F 2018F

NET PROFIT MARGIN % 24% 3.4% 4.31% 5% 7%

ASSET TURN OVER 52% 44% 45% 46% 47%

LEVERAGE 299% 266% 252% 239% 225%

ROE 37% 4% 5% 5% 7%



government would incur by a port closure; we anticipate that the WA government would intervene due to the national significance of iron ore exports from Port Hedland. Weather and Natural Disaster: The Pilbara region is subject to unpredictable weather and cyclones, which have the capacity to hinder production and potentially damage equipment. There is also moderate seismic activity in the Pilbara region, it is not anticipated but a major earthquake could damage property, plant and equipment. Employee Injury/Death: Fortescue has suffered several deaths of contractors in the past. If there are further deaths or serious injuries and Fortescue is found to be culpable there could be major fines or penalties imposed on them.

Regulatory risk Environmental Regulations: Requirements such as mine rehabilitation represent a significant financial burden to the company. If these environmental regulations were to become more stringent or if there was a carbon tax imposed FMG, emissions this could cause costs to balloon. The Iron Bridge magnetite project has received conditional approval from the Environmental Protection Agency (EPA), ongoing mine production is estimated to take 7 years to reach an exclusion zone around an endangered bat colony’s cave. It is expected FMG will come up with an action plan to protect the bat colony, but if they cannot satisfy EPA regulators, then the company will be denied access to the resources. Our NPV calculation assumes no regulation barriers. Native Title Claims: Claims may arise at any point for land Fortescue is operating on. The risk of this occurring is not possible to quantify but if it does occur the expense could be huge, with complicated and costly legal work being involved.

Political Risk Royalties Increases: Bullish forecasts of the iron ore price by the WA state government have resulted in a significantly lower level of iron ore royalties received than they anticipated. After a recent downgrade by rating agencies the government is desperate to maintain surplus budgets, this may result in the government increasing royalties. MRRT Reapplication: The current government repealed the Mineral Resources Rent Tax (MRRT) that was imposed by their predecessors. Should there be a change of government at the next election we may see this tax reimposed which would express itself in an increased taxation burden for FMG.

Financial Risks

Exchange Rates: Iron ore prices are quoted in US$ so any appreciation of the US$ relative to the AU$ will result in Fortescue’s exports becoming more competitive and improving margins as most costs are in AU$. Conversely a depreciation of the US$ has the potential to increase relative costs. Operating costs are subject to movements to in exchange rate – every 1 cent movement in US to AU$ has an impact of US$0.25 to US$0.30 (FMG Annual Report 2014). Interest Rates: Fortescue’s substantial debt means that it is highly sensitive to changes in interest rates. If margins are already squeezed then the interest expense may represent a major cost to the company, any increases will damage free cash flows. Debt Repayment: We have already factored in depressed iron ore prices to reduce FMG’s ability to make planned debt repayments. If FMG is unable to reduce debt to its desired level of 40% gearing this will result in higher than forecasted interest expense and a higher risk profile. This critically undermines our 9% discount rate and our assumed a long-term capital structure of 40/60 debt-to-equity (Figure 26). Credit Risks: Downgrades to Fortescue’s credit rating would increase their cost of debt and compress cash flows lowering ICR. Balance sheet weakness and poor liquidity metrics then places debt covenants at risk and could reduce BB+ rating. Market Risk: Inability of the firm to refinance its debt at a later date is a threat to Fortescue’s solvency. This will not be an issue in the short term as Fortescue has no scheduled debt repayments until 2017, provided the company deleverages as desired there will still be a requirement for periodic refinancing, there is always an element of risk that the firm is not able to obtain new loans if there is a reduction in liquidity of debt capital markets.

Upside Risks Mine life, ongoing exploration and greater conversion of resources into reserves may lead to an increase above and beyond our models forecasted mine life. Future identification of large quantities of high grade/low cost ore would represent potential upside for FMG. However from a discounted cash flow perspective, any long-dated increase in mine life would represent a small NPV benefit. Depreciation of the AU$ will lead to improved margins for Fortescue, as discussed above this would leave Fortescue as a more competitive player in the iron ore market. Unfortunately many of Fortescue’s rivals would enjoy the same benefits as they are predominantly Australia based. Gasification of Fortescues truck fleet is a future option that the business is exploring. The excess capacity that FMG built into their gas pipeline suggests that this will be considered in the future. The combination of increased truck automation and a potential gasification would be expected to decrease FMG’s C1 costs, as well as reducing Fortescues greenhouse emissions, having the additional benefit of reducing their exposure to future environmental regulations and taxes. Monetisation of South Australia tenements may be an additional source of income for Fortescue. There are currently no published plans regarding the development of these tenements but in the long term, if FMG can raise sufficient capital it may allow them to diversify into uranium production. The chance of this occurring, and the metrics surrounding it are not possible to quantify at this point. Iron Bride Magnetite project, with resources at 4.5bn mt provides a long life of mine, and magnetite into the company’s product mix to combat FMG’s low Fe grade. Sell down of development assets could provide a much-needed injection of cash. Developments such as the high phosphorous laden Nydinghu would be better off FMG’s portfolio in a low iron ore price environment. Further dilution of FMG’s JV interest in IB is another alternative to realise sooner the NPV of the project.


Appendices Appendix 1(a) FMG Income Statement

Appendix 1 (b) FMG Statement of Financial Position

3 BALANCE SHEET 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

ASSETS

US$m US$m US$m US$m US$m US$m US$m US$m

Cash 2,343 2,158 2,398 749 812 995 1,112 1,151

Trade & Other Receivables

625 415 585 454 472 474 488 496

Inventories 617 961 1,467 1,139 1,185 1,189 1,224 1,243

Other Current Assets 12 36 27 27 27 27 27 27

Current Assets 3,597 3,570 4,477 2,369 2,497 2,685 2,852 2,916

Intangible Assets 19 40 67 67 67 67 67 67

Other Non-Current Assets

90 90 77 77 77 77 77 77

Property, plant & equipment

11,357 17,159 18,068 18,465 18,324 18,094 18,131 18,142

Non-Current Assets 11,466 17,289 18,212 18,609 18,468 18,238 18,275 18,286

Total Assets 15,063 20,859 22,689 20,977 20,965 20,923 21,127 21,203

LIABILITIES

Trade Payables 1,182 1,043 1,338 1,038 1,081 1,085 1,116 1,133

Deferred Income - 38 936 726 756 759 781 793

Provisions 100 128 176 137 142 143 147 149

Borrowings 283 205 154 154 154 154 154 154

15 Current tax Payable 551 - 666 - - - - -

Current Liabilities 2,116 1,414 3,270 2,056 2,133 2,140 2,198 2,229

Trade Payables 225 155 101 101 101 101 101 101

Deferred Income 5 331 556 432 449 451 464 471

18 Provisions 516 387 467 467 467 467 467 467

Deferred Tax Liabilities 221 805 1,154 131 171 188 268 266

Deferred Joint Venture Contributions - - 160 160 160 160 160 160

Borrowings 8,218 12,486 9,403 8,903 8,403 7,903 7,403 6,903

Non-Current Liabilities 9,185 14,164 11,841 10,193 9,751 9,269 8,863 8,367

Total Liabilities 11,301 15,578 15,111 12,249 11,884 11,409 11,062 10,597

SHAREHOLDERS' EQUITY

Share Capital 1,293 1,291 1,289 1,289 1,289 1,289 1,289 1,289

Reserves 41 (49) 69 69 69 69 69 69

14 Retained Earnings 2,428 4,043 6,211 6,525 6,936 7,387 8,032 8,483

Non-Controlling Interest - 4 14 14 14 14 14 14

Total Equity 3,762 5,289 7,583 7,897 8,308 8,759 9,404 9,855

2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F


1 Operating Sales Revenue 6,716 8,120 11,796 9,155 9,527 9,562 9,843 9,992

2 Cost of Sales (3,753) (4,813) (6,190) (7,372) (7,675) (7,720) (7,790) (8,013)

EBITDA 2,963 3,307 5,606 1,784 1,851 1,842 2,053 1,979

3 Depreciation (260) (437) (924) (903) (858) (815) (775) (736)

EBIT 2,703 2,870 4,682 881 993 1,027 1,278 1,243

4 Net Interest Expense (505) (553) (720) (432) (407) (382) (357) (332)

Profit Before Income Tax 2,198 2,317 3,962 449 586 645 922 912

Income Tax Expense (704) (720) (1,189) (135) (176) (193) (276) (273)

Net Profit 1,494 1,597 2,773 314 410 451 645 638


Appendix 1 (c) FMG Statement of Cash Flows

STATEMENT OF CASH FLOW 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

OPERATING CASH FLOW

6 Cash Receipts US$m 6,625 8,725 12,212 9,405 9,492 9,558 9,817 9,978

Cash Payments US$m (3,694) (5,026) (5,847) (7,710) (7,628) (7,715) (7,754) (7,994

)

8 Tax

US$m (123) (695) (150) (801) (176) (193) (276) (273)

Net Cash flow Operating US$m 2,808 3,004 6,215 894 1,688 1,650 1,786 1,711

INVESTING CASH FLOW

10 Capex

US$m (6,044) (6,355) (1,995) (1,300) (718) (585) (812) (747)

11 Sale Proceeds PPE & Other

US$m (69) 158 422 - - - - -

9 Interest

53 31 181 21 21 21 21 21

Net Investing Cash flow US$m (6,060) (6,166) (1,392) (1,279) (697) (564) (791) (726)

FINANCING CASH FLOW

11 Debt Proceeds

US$m 3,638 7,330 - - - - -

-

12 Debt Repayments

US$m (15) (3,232) (3,092) (500) (500) (500) (500) (500)

9 Interest Expense

US$m (584) (893) (853) (453) (428) (403) (378) (353)

13 Dividends

US$m (251) (131) (581) (311) - - - (93)

Other

US$m 5 (85) (99) - - - -

Net Financing Cash flow US$m 2,793 2,989 (4,625) (1,264) (928) (903) (878) (946)

Net Change in Cash flow US$m (459) (173) 198 (1,649) 63 183 117 39

Free Cash flow US$m -3,252 -3,162 4,823 -385 991 1,085 995 985


Appendix 2 Discounted Cash Flows Model (a)

ASSUMPTIONS - PRODUCTION 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

Mine Production (wet, product)

Mwmt Mwmt Mwmt Mwmt Mwmt Mwmt Mwmt Mwmt

Cloud Break

31 33 37 40 40 40 40 40

Christmas Creek

23 41 45 50 50 50 50 50

Nullingine JV BCI

1 5 5.8 6.2 6.2 6 6 6

Firetail

- 3.6 20 20 20 20 20 20

Kings

- - 15 40 40 40 40 40

Detrital Iron Ore Plant

- - - - 5 5 5 5

TOTAL 5 83 123 157 162 162 162 162

16 SALES (wet, product)

FMG Equity 53 80 118 152 157 157 157 157

3rd Party

2 3 4 5 5 5 5 5

TOTAL SALES 55 83 123 157 162 162 162 162

ASSUMPTIONS - PRICES 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

AUD/USD US$/AU$ 1.03 1.03 0.90 0.85 0.84 0.83 0.82 0.82

Iron Ore (Fines) CFR 62% Fe US$/dmt 150 127 123 77.0 77.5 77.7 80.0 81.2

FMG Realised Price CFR US$/dmt 131 114 106 65 65 65 67 68

Discount % 13% 10% 14% 16% 16% 16% 16% 16%

Average Grade % 58% 58% 58% 58% 58% 58% 58% 58%

Average Moisture % 9.5% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3%

Source: Company reports and team estimates

(b)

REVENUE 2014A 201F5 2016F 2017F 2018F 2019F

Iron Ore Shipped-Dry Mdmt

109.94 139.32 144.13 144.13 144.13 144.13

Realised Price-Dry USD$/dmt

106.00 64.68 65.07 65.28 67.20 68.20

Revenue Sale of Iron Ore USD$M 11,653.94 9,011.38 9,378.30 9,408.72 9,685.67 9,829.88

Other Revenue USD$M

142.00 144.11 148.44 152.89 157.48 162.20

Operating Sales Revenue USD$M 11,795.94 9,155.49 9,526.74 9,561.61 9,843.15 9,992.08

Revenue per Tonne USD$/dmt 106.00 64.68 65.07 65.28 67.20 68.20

(c)

ASSUMPTIONS - COSTS 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

C1 Costs US$/wmt 48 44 34 32 31 30 30 30

17 Royalty US$/wmt 6.6 6.4 6.5 4.5 4.5 4.6 4.7 4.8

Shipping US$/wmt 12.1 9.9 10.2 10.2 10.6 10.9 10.2 10.5

Corporate (Admin) US$/wmt 1.9 1.4 0.9 0.9 1.0 1.0 1.0 1.1

Total Delivered Cost US$/wmt 68.6 61.7 51.7 47.7 47.1 46.4 45.9 46.3

Sustaining Capex US$/wmt 16.2 7.8 7.6 6 4.6 3.7 3 3

Net Interest US$/wmt 6.3 7.1 6.1 2.8 2.6 2.4 2.3 2.1

All in Costs US$/wmt 91.1 76.6 65.4 56.6 54.2 52.6 51.6 51.4

Discount 16% 16% 16% 16% 16% 16% 16% 16%

(d)

ASSUMPTIONS - CAPEX 2012A 2013A

2014A 2015F 2016F 2017F 2018F 2019F


Development & Exploration

4,500 5,285 1,105 383 - - 275 280

Sustaining

1,600 1,005 937 917 718 585 537 467


Total 6,100 6,290 2,042 1,300 718 585 812 747

Source: FMG Annual Report 2014, 2013 and team estimates

(e)

Valuation 2014 A 2015F 2016F 2017F 2018F 2019F

US$m

Revenue

11,795.94 9,155.49 9,526.74 9,561.61 9,843.15 9,992.08

Total Delivered Costs

(6,103.00) (7,259.63) (7,556.12) (7,596.86) (7,663.61) (7,882.54)

Other Expenses

(87.00) (111.89) (119.23) (122.80) (126.49) (130.28)

EBITDA

5,605.94 1,783.97 1,851.39 1,841.95 2,053.05 1,979.26

Margin %

19% 19% 19% 21% 20%

Depreciation

(924.00) (903.40) (858.23) (815.32) (774.55) (735.82)

EBIT

4,681.94 880.57 993.16 1,026.63 1,278.50 1,243.43

Income tax

(1,404.58) (264.17) (297.95) (307.99) (383.55) (373.03)

EBIAT

3,277.36 616.40 695.21 718.64 894.95 870.40

Plus: Depreciation and Amortisation

924.00 903.40 858.23 815.32 774.55 735.82

Less: Capital Costs

(1,931.00) (1,300.00) (717.71) (585.23) (811.86) (746.95)

Net Working Capital (3% of revenues)

(398.00) (308.91) (321.44) (322.61) (332.11) (337.14)

Change in NWC

(89.09) 12.53 1.18 9.50 5.03

UNLEVERED FCF 2,270.36 130.71 848.26 949.90 867.14 864.31

(f)

WACC Computation

Pre-tax Cost of Debt 5.36% Team computed cost of debt based on FMG senior secured credit facility.

Tax rate 30% Corporate tax rate. Cost of Debt 3.35% Risk Free rate 3.31% Effective Annual Spot rate of Australian 10 year Government Bonds

Equity beta 1.375 FMG returns regressed against the S&P/ASX 200 Index.

Total Market return

10.21% ASX 200 average 10 years annual return with dividends reinvested.

Market risk premium 6.90% Market return above the risk free rate.

Cost of Equity 12.80%

Equity % 60% Optimum capital structure based on management’s targeted gearing level

Debt % 40%

WACC 9.00%

(g)

Source: 2014 Quarterly

Report, pg 4

Jun 2013

Quarter p1

Sep 2013

Quarter p1

Dec 2013

Quarter p1

Mar 2014

Quarter p1

Jun 2014

Quarter p1

FY 14

Forward Guidance FY 15

Forecast

62% Platts CFR Index

US$/pdmt 126 133 135 120 103 123

FMG US$/pdmt 113 121 125 107 82 106


Achieved CFR

Price Realisation, Avg. Plats 62% Index

90% 91% 93% 89% 80% 86% 85-90% 84%

ASSUMPTIONS - Saleable Ore Reserves (FMG) Team Modelled

Mt Dry % Fe Life (years) Mt Dry %Fe

Life (years)

Cloud Break

500 57.6 14 831.5 57.6 23

Christmas Creek

970 57.3 22 1514.5 57.3 33

Nullingine

71.65 56.8 13

Firetail

174 58.7 10 272.5 58.7 15

Kings

729 56.9 20 1288.5 56.9 36

Total/Average 2373 58% 19 3979 58% 30

Production (dry, product) LOI 2015F 2016F 2017F 2018F 2019F

Cloud Break

8% 36.7 36.7 36.7 36.7 36.7

Christmas Creek

8% 46.1 46.1 46.1 46.1 46.1

Nullingine JV BCI - (FMG25%) 12% 1.4 1.4 1.4 1.4 1.4

Firetail

7% 18.7 18.7 18.7 18.7 18.7

Kings

9% 36.5 36.5 36.5 36.5 36.5

Detrital Iron Ore Plant 4% 0.0 4.8 4.8 4.8 4.8

TOTAL 139.3 144.1 144.1 144.1 144.1

SALES (dry, product)

FMG Equity 139.3 144.1 144.1 144.1 144.1

3rd Party

4.1 4.1 4.1 4.1 4.1

TOTAL SALES 143.4 148.2 148.2 148.2 148.2

Breakeven Cost forecast 2015F 2016F 2017F 2018F 2019F

C1 Costs

US$/dmt 34.46 33.38 32.31 32.31 32.31

Royalty

US$/dmt 4.93 4.96 4.98 5.12 5.20

Shipping

US$/dmt 11.17 11.50 11.85 11.09 11.42

Corporate (Admin)

US$/dmt 1.03 1.06 1.10 1.13 1.16

Sustaining Capex

US$/dmt 6.58 4.98 4.06 3.72 3

Net Interest

US$/dmt 3.10 2.82 2.65 2.48 2.30

All in Costs - Breakeven US$/dmt 61.27 58.71 56.94 55.85 55.64

Discount

% 16% 16% 16% 16% 16%

Breakeven 62% Fe Index Price US$/dmt 72.95 69.90 67.79 66.49 66.00

CLOSING VALUES 2050

US$

24 PPE (50%)

8,194

Working Capital

(96)

25 Net other balance sheet items (excluding WC & debt) (344)

Borrowings (C&NC) (7,557)

Detrital Iron Deposit 650

Total 847

PV 40


Appendix 3 Financial Statement Calculations (a)

RETAINED EARNINGS 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

Net Profit

US$m 1,494 1,597 2,773 314 410 451 645 638

Dividend

US$m (126) (125) (623) - - - - (187)

Retained Earnings US$m 2,428 4,043 6,211 6,525 6,936 7,387 8,032 8,483

Share Capital

US$m 1,293 1,291 1,289 1,289 1,289 1,289 1,289 1,289

Reserves US$m 41 (49) 69 69 69 69 69 69

(b)

OPERATING CASHFLOW ADJUSTMENTS 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

Operating Sales Revenue

6,716 8,120 11,796 9,155 9,527 9,562 9,843 9,992

(Increase) decrease in Inventory

(201) (244) (405) 328 (46) (4) (35) (19)

(Increase) decrease in Receivables

(67) 190 (302) 131 (18) (2) (14) (7)

6 Increase (decrease) in Deferred Income

- 38 1,123 (210) 29 3 22 12

Cash Receipts 12,212 9,405 9,492 9,558 9,817 9,978

Cost of Sales

3,753 4,813 6,190 7,372 7,675 7,720 7,790 8,013

Increase (decrease) in Trade Payables

490 (139) 295 (300) 42 4 32 17

Increase (decrease) in Provisions - 28 48 (39) 6 1 4 2

Cash Payments (5,847) (7,710) (7,628) (7,715) (7,754) (7,994)

(c)

WORKING CAPITAL 2012A 2013A 2014A 2015A 2016A 2017A 2018A 2019A

Trade & Other Receivables

588 409 585 454 472 474 488 496

Inventories

617 961 1,467 1,139 1,185 1,189 1,224 1,243

Deferred Income

- 38 936 726 756 759 781 793

Trade Payables

1,182 1,043 1,338 1,038 1,081 1,085 1,116 1,133

Provisions

100 128 176 137 142 143 147 149

Net Working Capital (77) 161 (398) (309) (321) (323) (332) (337)

5 % Of revenue

-1.1% 2.0% -3.4% -3.4% -3.4% -3.4% -3.4% -3.4%

Increase (decrease) in NWC

-89 13 1 9 5

(d)

BALANCE SHEET PROJECTIONS 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

Revenue

6,716 8,120 11,796 9,155 9,527 9,562 9,843 9,992

Trade & Other Receivables % Revenue 8.8% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Inventories % Revenue 9.2% 11.8% 12.4% 12.4% 12.4% 12.4% 12.4% 12.4%

Deferred Income % Revenue 0.0% 0.5% 7.9% 7.9% 7.9% 7.9% 7.9% 7.9%

Trade Payables

% Revenue 17.6% 12.8% 11.3% 11.3% 11.3% 11.3% 11.3% 11.3%

Provisions

% Revenue 1.5% 1.6% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%

Other Current Assets Held constant 12 36 27 27 27 27 27 27

Intangible Assets Held constant 19 40 67 67 67 67 67 67

Other Non-Current Assets Held constant 90 90 77 77 77 77 77 77

Current Tax Payable

551 - 666 - - - - -

Trade Payables NC Held constant 225 155 101 101 101 101 101 101

Deferred Income NC

5 331 556 432 449 451 464 471

% Revenue 0.1% 4.1% 4.7% 4.7% 4.7% 4.7% 4.7% 4.7%

Provisions NC Held constant 516 387 467 467 467 467 467 467

Deferred Tax Liabilities

221 805 1,154 131 171 188 268 266

% PBIT 10% 35% 29% 29% 29% 29% 29% 29%

Deferred Joint Venture Contributions Held constant - - 160 160 160 160 160 160


(e)

ASSUMPTIONS - DIVIDENDS

2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

Annual Dividend US¢ cps

8 10 20 0 0 0 0 6

13

Dividend Payout

% 16% 16% 21% 0% 0% 0%

30%

Interim US¢ cps

4 - 10 - - - - 3

Final 0.04

US¢ cps

4 10 10 - - - - 3

Dividend Payable US$m 126 125 623 311 - - - 93

Weighted Avg. Shares M 3,113.80

m 3,114 3,114 3,114 3,114 3,114 3,114 3,114 3,114

(f)

ASSUMPTIONS - FINANCING 2012A 2013A 2014A 2015F 2016F 2017F 2018F 2019F

Borrowings (Current + NC) US$m 8,501 12,691 9,557 9,057 8,557 8,057 7,557 7,057

22 Debt Reduction US$m

(500) (500) (500) (500) (500)

Cost of borrowings % 6.65% 4.62% 5.30% 5.00% 5.00% 5.00% 5.00% 5.00%

Interest Expense US$m (565) (586) (741) (453) (428) (403) (378) (353)

Interest Income US$m 60 33 21 21 21 21 21 21

Source: company data and team estimates


Appendix 4: Notes to the financial statements

1

Operating sales are the sum of iron ore sales and other income from third party port access and provision of services

2 Components of operating costs are calculated on unit cost per production and have been based on 2014 year figures divided by 2014 production

3 Accelerated depreciation at 5% has been used and calculated as one over the life of the last operating mine (40 years) - actual depreciation charged as a % of PPE provide a similar % (5.39%). We assume accelerated depreciation as it seems logical FMG would use this accounting treatment as it provides a greater NPV benefit by expensing larger depreciation charges earlier.

4 Cost of borrowing has been reduced to 5% in 2015 (5.30% 2014) and is held constant, a reduction in the cost of borrowing is based on lower levels of debt in 2015 and on our estimated cost of FMG's debt

5 Net working capital each year is 3% of revenues, based on 2014 year numbers and checked with the previous years’ % for consistency

6 2014 saw a huge spike in prepayments resulting in an increase to deferred payments, we hold this % constant despite an expectation of decreasing prepayment

8 Despite companies paying last year’s income tax in the current period and adjusting for lag, we have assumed tax for cash flow purposes is the same as the current year's income tax payable from the profit and loss

9 Interest expense and revenue for cash flow purposes has been assumed to be the same as on the profit and loss

10 We have assumed no further development and exploration capital expenditure except those that have already been stated by management, including the purchase of four very large ore carriers (VLOCs) to be delivered around 2017 and another four VLOCs in 2018, with payment on delivery - US$ 275 m and US$ 280 m respectively.

11 We have assumed no further sell off of PPE or raising of additional debt

12 We have based debt repayments on management guidance and our forecasted cash constraints (FMG Annual Report FY14, p11 & 94) and a targeted additional US$ 0.5-1bn this year and an overall (2015-2016) US$ 2-2.5bn in repayments over the next two years). In our model we have assumed US$ 0.5bn debt repayments equally over the four years until FY19.

13 Because of the limitations of balance sheet cash reserves we have modelled a cut to the dividends until gearing reaches 40 % (FY19). The dividend payout ratio from then has been based on management's comments on a pay-out ratio to 30%-40%.From FY19 the payout ratio is set to 30% and we hold debt and cash levels constant and from FY20 and assume full pay out of earnings as dividends keeping a constant gearing ratio ~40% in line with our optimum capital structure for our WACC.

13 Dividend payable for cash flow purposes includes last period's final dividend and current year's interim dividend, we have assumed an even split between interim and final dividends as well.

14 Retained Earnings for our forecasted period has been calculated as opening balance (last year's closing) plus net profit minus dividends

15 Assumed that current tax payable in FY14 (US$ 666 m) is paid off in FY15 and is kept at zero.

16 We have assumed that 100% of what is produced is sold

17 Royalties have been calculated using a rate of 7.5% for fines

18 Non-current provisions of US$ 467 m includes estimates for rehabilitation costs (US$463 m)


and has been held constant, in line with our assumption of no further significant development and hence land disturbance.

19 We believe our WACC capital structure assumption is robust as management has claimed it wants to maintain debt at ~40%. Debt is cheaper than equity capital and so any further decreases would be under utilising its balance sheet.

20 We have used 3% as inflation based on the RBA's target of 2-3%

21 We assume what is mined equals what is sold and shipped. We assume no processing losses when FMG's run of mine ore is processed through a wet plant to reduce impurities.

22 Debt repayments are forecasted on the assumption FMG intend to pay it down as fast as possible (in line with their accelerated debt repayment strategy) but limited by maintaining cash balances at the US$ 750 level.

23 We assume that management will priorities debt reduction over dividend payments as it is more prudent and necessary to financial stability in a low iron ore price environment

1 OPERATING SALES 2014A 2015F 2016F 2017F 2018F 2019F

US$m US$m US$m US$m US$m US$m

Iron Ore Sales 11,654 9,011 9,378 9,409 9,686 9,830

Other Income 142 144 148 153 157 162

Operating Sales 11,796 9,155 9,527 9,562 9,843 9,992

1 IRON ORE SALE 2014A 2015F 2016F 2017F 2018F 2019F

IRON ORE SHIPPED (Mdmt) 109.9 139.3 144.1 144.1 144.1 144.1 REALISED PRICE US$/dmt 106 65 65 65 67 68

2 COST OF SALES 2014A 2015F 2016F 2017F 2018F 2019F

C1 (4,006.0) (4,872.8) (5,029.9) (5,013.7) (5,164.1) (5,319.0)

Shipping (1,210.0) (1,556.2) (1,658.2) (1,707.9) (1,598.4) (1,646.4)

Admin (112.0) (144.0) (153.5) (158.1) (162.8) (167.7)

Royalties (775.0) (686.7) (714.5) (717.1) (738.2) (749.4)

Total Delivered Costs (6,103.0) (7,259.6) (7,556.1) (7,596.9) (7,663.6) (7,882.5)

Other operating (87.0) (111.9) (119.2) (122.8) (126.5) (130.3)

Cost of Sales (6,190.0) (7,371.5) (7,675.3) (7,719.7) (7,790.1) (8,012.8)

3 DEPRECIATION FMG Source: FMG Annual Report 2014

Accelerated Depreciation

Expense FY13 543

1/40 x 2

PPE 11357

5%

Dep rate 4.78%

Expense FY14 1030

PPE 17159

DEP rate 6.00%

2-Year Average 5.39%


Appendix 5 Iron Bridge JV ownership structure

Appendix 6 Porter’s Five Forces

Source: Team estimates Overall rating = 2.4 Legend: 0 = no threat to business 4 = high threat to business

0

1

2

3

4

BargainingPower ofSuppliers

Threat of NewEntrants

Threat ofSubstituteProducts

CompetitiveRivalry within

Industry

BargainingPower of

Customers

Series 1

Source: Company data

We have valued Iron Bridge JV on its capital costs and applied a discount rate to reflect the risk and uncertainty of the project as it has not yet commenced. Cost: Formosa has paid US$527m to fund the first capital expenditure in the FMG Iron Bridge JV project, second stage of development will require US$1050m to be funded from FMG IB Ltd. Total investment into FMG IB JV ~US$ 1.55bn. We have valued IB by capitalising 100% all capital expenditure and applying a discount of ~20%. This produce a notional value of ~US$ 1.27bn


Threat of new entrants:

1. High barriers to entry 2. Large capital requirements 3. Need access to high quality reserves 4. Existence of economies of scale 5. Threat of China increasing the number of state owned mines

Threat of substitute products:

1. No perfect substitute for iron ore 2. Electric arc furnace allows steel to be manufactured entirely from scrap, accounting for

approximately 30% of world production 3. Increasing availability of scrap will effect long term demand for pig iron in China

Competitive rivalry within industry:

1. Seaborne iron ore industry has CR3 of 62% indicating oligopoly with the three majors 2. Economies of scale 3. Large ramp production ramp ups following iron ore price increase 4. Competition to drive down costs and increase productivity 5. Product differentiation based on ore quality 6. Large exit costs

Bargaining power of customers:

1. Highly fragmented steel market 2. Threat of increasing consolidations 3. Ore quality impacts buying decision 4. Oversupply enhances customers’ bargaining power

Bargaining power of suppliers:

1. Limited number of mining equipment producers 2. Specialised labour force required 3. Influential labour unions

Appendix 7 China driven iron ore boom

Source: Bloomberg

0

2

4

6

8

10

12

14

16

0

500

1000

1500

2000

2500

3000

3500

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014f2015f2016f

%Mt

Mine production of iron ore world total (Mt) China % GDP Growth


Appendix 8 Breakdown of iron ore cost curve

Source: FMG Appendix 9 Emerging economies will support long term demand Steel production in emerging Asian countries is outpacing China, supported by urbanization and industrialization, with significant potential for further growth in steel intensity per capita, therefore sustaining long term iron ore demand. More industrialized countries, like Vietnam and Thailand, will push towards the steel intensities of developed countries. The rise of manufacturing will support steel demand in service oriented economies, like Indonesia and India, despite lower levels of steel intensity. Hence long term iron ore demand will be supported by developing countries.

Source: BHP Billiton


Appendix 10 China Iron Ore Inventory (total) Source: Bloomberg

50

60

70

80

90

100

110

120

Mt


Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA Society of Perth, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

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