A Look At The Issuer
Switzerland-based Ferrexpo PLC (OTC:FEEXF) operates a mine and a processing plant near Kremenchuk in the Ukraine, an interest in a port in Odessa, and a sales and marketing company in Switzerland and Kiev. The company also owns a logistic group located in Austria, which operates a fleet of vessels operating on the Rhine and Danube waterways. In addition to operating the Ferrexpo Poltava Mine, the company holds licenses to explore or mine a 50 kilometers long strike, containing 10 identified iron ore deposits. Principally engaged in the production of high-quality iron ore pellets, pellets are far easier and more efficient for blast furnaces to run. Over time, pelleted ores have become the standard for higher quality iron ores. It has been argued that iron ore is "more integral to the global economy than any other commodity, except perhaps oil."
Ferrexpo's large open pit mines enable Ferrexpo to be one of the lowest cost, high quality metallurgical pelted iron producers in the world at around $40 per ton. The ongoing European crisis, which affected its main market, has dampened both the prices and demand for iron ore in 2012. Prices on the open market have improved about 20-29% since the September 2012 lows, which should soon reflect in Ferrexpo's bottom line. To mitigate the lowered overall investment climate in Europe, Ferrexpo is utilizing its near 50% ownership in a deepwater port and very low production costs over the last few years to expand into China, Asia and the Middle East. This has greatly increased its global footprint, and now accounts for about 40% of sales. Over 90% of sales for Ferrexpo's pelleted iron ore are in U.S. dollars.
We Like Companies That Are Profitable
The charts below helps to demonstrate how the progress of Ferrexpo's low production costs allow it, as the dominant Iron ore producer, to provide high quality Iron pellets at a price below most of its global competitors. This has allowed it to be cash flow positive from before and through the global economic crash, having a positive operating cash flow each quarter since 2006.
Six Year Production Summary:
|Total Pellet Production
In millions of U.S. Dollars:
|Net Debt at year close||80.2||104.4||257.7||220.1||117.6||278.5|
Ferrexpo has two major strategies to increase profits:
1. In an effort to improve efficiency, Ferrexpo has invested in building a distribution network. Ferrexpo was able to purchase a river based transportation company, Helogistics, for $37.8 million in order to increase river transport capacity on the Rhine/Danube River corridor. This gives it strong logistical support for Europe. Ferrexpo purchased approximately 900 railcars to make its rail network logistically better, lower cost due to fewer discounts and the improved quality of its shipment. Furthermore, owning 49.9 per cent in a bulk export terminal on the Black Sea, just a few rail miles from its main operational hub, secures access to the seaborne markets to supply new growth market customers globally.
2. By defining and developing its significant mineral reserves, Ferrexpo plans to increase annualized pellet production and extend mine by the end of this year. This is being done by the FYM mine, where iron ore is expected to be extracted by the first half of 2013. The estimated life of the existing mining operations at FPM is expected to be extended by 12 years, to 2038.
Interest Coverage Ratios
Interest expenses for the nine months ending Q3 2012 appear to be $61.515 million, while operating income (EBITDA) was about $328.8 million, indicating a healthy interest coverage ratio that's greater than five to one.
We Like Companies With A Lower Debt To Cash Ratio
The consolidated debt of Ferrexpo at the end of 3Q 2012 was $1,012 million, primarily attributed to the U.S. dollar denominated notes. Cash and cash equivalent at the end of Q3 was about $674 million, giving it a modest debt to cash ratio of less than 1.5 to 1. In late January 2013, the company announced that it intended to raise $500 million in additional debt notes to be used for general corporate purposes, to reduce reliance on secured lending and to add further liquidity. This is consistent with the company's strategy to maintain prudent financial ratios, enabling it to develop its substantial iron ore reserves through the current economic cycle. Furthermore, we see Ferrexpo's historical declaration and distribution of dividends as a ready target for conserving additional cash flow should it become necessary.
Considering its history of providing sound cash flow (even in the middle of a hard economic crash), its robust margins, its growing EBITDA and its maintaining an excellent cash position, we are of the opinion that it is a lower fiscal risk.
We Like Companies That Have Good Balance Sheets
Ferrexpo's debt of $1,012 million appears to be at about 42% of its current $2.4 billion market capitalization. While this may not appear as low as we would prefer to see, the larger cash position of $673 million represents about 28% of the valuation given to it by the capital markets and adds good resiliency to its balance sheet.
We Like Higher Yields
Although the credit ratings assigned to this debt are widely different than that of our government's sovereign debt, when set in comparison to the paltry 0.88% yields of longer five-year U.S. Treasuries, we believe this nearly 6.5% difference in yield represents a savvy opportunity for higher rewards given the level of risks that we can identify.
The default risk is Ferrexpo's ability to perform. As most rating agency still rate Ukraine's sovereign debt at single B, the country's low rating pretty much ensures that Ferrexpo's rating has a glass ceiling equivalent to the only nation it operates within. Considering its historical and recent performance, its sound cash position, balance sheet and the excellent cash flow that is projected to service its interest bearing debt, as outlined above, it is our opinion that the default risk for this short to medium term bond is minimal relative to its more favorable return potential. Furthermore, it is our opinion that if or when the credit ratings for Ukraine sovereign debt rise, the ratings for Ferrexpo will be lifted as well.
The hardest risk for us to identify is the geopolitical risk, considering how difficult it has become to understand many of the political changes and potential changes for bondholders. With that said, Ukraine is trying to be a friend and ally to both Europe and Russia, a task few countries have taken. It is our opinion that diversification into other forms often serves to reduce risk. Our strategy here, as with other Yankee bonds, is to focus on unique or required services that can be seen as adding key economic value to the society it's associated with. Ferrexpo is a low cost supplier for the steel industry, and it is highly regarded as one of the top European suppliers.
Ferrexpo may face increasing competition from any of these substantially larger and possibly better financed companies. Ferrexpo has been blessed with huge reserves, and we believe is a lower cost producer in Iron Pellets than any of the above companies. Even though Ferrexpo has world class reserves, it has been hampered in the past in the global scale because of its lack of heavy transportation solutions, which it is ultimately improving.
Ferrexpo is a relatively small iron ore pellet producer compared to such companies as Australian-based global behemoths BHP Billiton Ltd (NYSE:BHP) or Rio Tinto (NYSE:RIO), both of which have massive resources and a vast array of mining services around the world. Fortescue Metal Group (OTCQX:FSUMF) is a similar, but smaller company that primarily exports iron ore out of Australia, where it is based. Vedanta Resources (OTCPK:VDNRF), of India, is a more diversified company (much smaller than BHP and Rio Tinto), but its strength is more in oil. Our previous bonds reports for both Fortescue Group and Vedanta are available.
The price of Iron Ore is directly affected by trends in the international and domestic prices, as well as by the exchange rate of the Ukrainian hryvnia. Fluctuations in the price of natural gas and diesel fuel are also is unpredictable, but an expanded widely diversified global footprint and Ferrexpo's low cost to produce product should help alleviate some of these uncertainties going forward.
As regulatory burdens continue to change, it often appears that companies outside of the United States might have an internal cash flow advantage. Consequently, we see these Ferrexpo bonds as having similarities to the yields, risks and maturities of other Yankees bonds such as the RusHydro (OTCQX:RSHYY), Myria Agro, or Georgian Railway bonds that we have previously reviewed.
Summary And Conclusion
All things considered, it is our opinion that Ferrexpo has established itself as a low cost leader in the supply of Iron ore. With its globally diversified sales, the majority being in U.S. Dollars, we see this as a world-class leading competitor in iron ore pellets. It has a very good cash position, excellent interest rate coverage, a strong balance sheet, and is evidently very well-connected both politically and socially for continued growth within one of the key and vital economic industries of the Ukraine. Given the fact that it has had positive cash flow every quarter since 2006, we think these Ferrexpo bonds represent both sound diversification and a high yield relative to the fiscal risks that we can identify, and believe that its lower "B" ratings are largely attributable to the sole country that it currently operates within. Therefore, we are adding these high yield, short 38 month maturity, Ferrexpo U.S. dollar (Yankee) bonds to our portfolio of Foreign and World Fixed Income bonds.
Yield to Maturity: ~7.4%
Disclosure: Durig Capital and certain clients may have positions in Ferrexpo bonds. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.