Ferrexpo: more to recover

From a shareholder perspective, Ferrexpo ended 2017 on a damp note. After peaking in September, the stock corrected amid concerns of slowing Chinese commodities demand, director selling, and a decrease in the company’s production. Although the latter had been planned to allow for maintenance, it seemed to spark a round of profit-taking.

In November, Ferrexpo signed a new $195m (£146m) secured credit facility, suggesting that – only two years after the Ukrainian lender that held most of the miner’s cash filed for bankruptcy – debt markets are no longer fretting about the group’s solvency. The BNP Paribas-arranged facility will be used to significantly reduce average funding costs and extend the group’s debt maturity profile.

Evidently buoyed by that deal, and a further drop in gearing since the half-year results, three weeks later the board announced plans to pay a special dividend of 3.3¢. And while this payout – equal to half of the total annual distribution – has now gone ex-dividend, it should give prospective investors confidence that they are well placed in the queue to receive some of those excellent cash flows.

Just how strong those cash flows are likely to be depends on which analyst you ask. But even after higher taxes and an investment programme that management expects will double capital expenditure to $100m, this year’s free cash flow should come in above the $275m booked in 2016.

The two key variables here are the iron ore price and C1 cash costs. The latter – which includes most mining, labour and processing costs – rose 23 per cent year on year to $31.7 per tonne in the first half of 2017. However, it is worth noting that wages, energy and raw materials – which make up the bulk of headline costs – tend to move in tandem with iron ore prices, meaning that margins should not be too badly hit if spot prices fade.

That iron ore prices will decline in 2018 is taken as read. Contracts for the metal averaged $70 a tonne in 2017 and the consensus view among analysts tracked by Bloomberg is for $59 a tonne this year, and just less than $57 in 2019. This explains the profit and revenue declines in the table below.

Yet Ferrexpo enters the year with optimism. That’s because almost all the FTSE 250 constituent’s output is 65-per-cent-pelletized iron ore, a product that carried a $34 net premium in 2017, according to the calculations of broker Cantor Fitzgerald. And although the company serves a diverse customer base in Asia and Europe through long-term agreements, pellet premiums are being propped up by a structural change in the world’s most important market for steel manufacturing – China.

Amid intolerable levels of smog, Chinese environmental authorities have been closing heavily polluting steel mills that sinter iron ore (a process that converts fines into lumps). Demand for higher-grade pellets therefore has a big driver. Commodity consultancy CRU expects pellets to account for the clear majority of the increase in iron ore product demand until 2021 and predict compound average annual growth of 4.4 per cent through the period.