Solid Interim Results Merit a Return to Ferrexpo's High Yield Bonds
Last week, Switzerland based Ferrexpo PLC (OTC:FEEXF) announced its interim year results for the six months ended 30 June 2013. We are impressed with its performance, and we see less risk in these very short 31-month high yielding US dollar (Yankee) bonds from when we first brought them to the attention of our clients in our initial review of Ferrexpo last February. Therefore, we think these bonds will not only uphold our unblemished record of acquiring higher yielding bonds that steer clear of default, but the near 9.5% yields currently indicated with its below par price represents an excellent opportunity for adding to our Foreign and World Fixed Income holdings.
A Brief Review of Ferrexpo
Ferrexpo PLC operates a mine and a processing plant near Kremenchuk in 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 USD 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 their global footprint, and now accounts for about 40% of sales. Over 90% of sales for Ferrexpo's pelleted iron ore are in US 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 US Dollars:
Net Debt at year close
Compared year over year, Ferrexpo's 1H 2013 pellet production was 11% higher than 1H 2012, driven by the ramp-up of production from the new Ferrexpo Yeristovo Mine. Sales volume grew by 19%, driven by stronger demand, however the achieved price was 6% lower as a result of decreases in market pricing and the timing of fixed price settlements with traditional customers. Average freight costs to the Far East have been reduced substantially (33%), and these reduced freight costs contribute to a higher net sales price for the Group. Benefiting from strong volume performance and continued cost controls, Ferrexpo was able to mitigate price volatility and its first half's EBITDA of $224 million was in line with 1H 2012. Mining giant Rio Tinto (RIO) this week revised its production forecast for iron ore over the next five years amid lower volume of orders for the key steel-making ingredient from China. One possible implication of this policy is that Rio may possibly not open new mines or expand after current projects are finished even if demand for iron ore remains healthy or steady.
In the period to 30 June 2013, Ferrexpo stabilized its gross VAT recoverable position, with the balance due from the Ukrainian Government remaining similar to 2012 year end levels at US$305 million (31 December 2012: US$302 million). Prepayment of corporate profit tax increased during the period by US$40 million to US$65 million. Ferrexpo is continuing to work constructively with Government authorities for repayment of the outstanding and overdue VAT. This amount, together with corporate profit tax prepayments, effectively accounted for 65% of the Group's net debt at 30 June 2013 of US$566 million. At the period end, Ferrexpo had net debt of US$566 million (31 December 2012: US$423 million), which included cash on hand of US$446 million (31 December 2012: US$597 million).
The Group's US$647 million capital investment program to increase the quality and quantity of its pellet output is ongoing, supported by internally generated cash flows. During the period, the Group spent US$147 million (compared to 1H 2012: US$222 million) on these projects. As is common with brownfield developments, opportunities have arisen for the refinement and optimization of project plans. These projects are still expected to be completed on time and to budget.
The Group's policy is to pay a modest but consistent dividend throughout the economic cycle and return capital to shareholders when appropriate, while maintaining adequate liquidity to support the business and its growth plans. The Directors recommend an interim dividend of 3.3 US cents per Ordinary Share (1H 2012: 3.3 US cents) for payment on 20 September 2013 to shareholders on the register at the close of business on 16 August 2013.
Interest Coverage Ratios
Interest expenses for the six months ending Q2 2013 appear to be $48.5 million, while operating income (EBITDA) was about $244 million, indicating a healthy interest coverage ratio that's greater than five to one.
We like companies with lower debt to cash ratio
The consolidated debt of Ferrexpo at the end of 3Q 2012 was $1,012 million, primarily attributed to the US dollar denominated notes. Cash and cash equivalent at the end of Q3 was about $446 million, giving them a modest debt to cash ratio of about 2.25 to 1. 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), robust margins, solid EBITDA and maintaining a good 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 44% of its current $2.3 billion enterprise value, giving it a reasonably flexible balance sheet should additional equity be needed or sought from the capital markets.
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 0.7% yields of longer three-year U.S. Treasuries we believe that this nearly 9% difference in yield represents an excellent 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 their historical and recent performance, their sound cash position, balance sheet and the excellent cash flow that is projected to service their 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 a lower cost producer in Iron Pellets than any of the above companies, Ferrexpo even though they have world class reserves they have been hampered in the past in the global scale because of their lack of heavy transportation solutions, which they are ultimately improving.
Ferrexpo is a relatively small iron ore pellet producer compared to such companies as Australian based global behemoths BHP Billiton Ltd. (BHP) or Rio Tinto, both of which have massive resources and a vast array of mining services around the world. Fortescue Metal Group (OTCQX:FSUGY) is a similar, but smaller company with higher costs, 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 reported 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 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 Yankee bonds such as the RusHydro, Myria Agro (MAYA:(GR)), or Georgian Railway bonds that we have previously reviewed.
Summary and Conclusion
After our reviewing Ferrexpo's interim 2013 performance, it has further confirmed our opinion that Ferrexpo is a low cost leader in the supply of iron ore. With its globally diversified sales, the majority being in US Dollars, we see this as a world class leading competitor in iron ore pellets. It has a good cash position, excellent interest rate coverage, a flexible 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 Ukraine. Given the fact that they have 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 their lower "B" ratings are largely attributable to the sole country that they currently operate within. Therefore, we are again adding these high yield, short 32-month maturity, Ferrexpo U.S. dollar (Yankee) bonds to our portfolio of Foreign and World Fixed Income bonds.
Yield to Maturity: ~9.66%
Disclosure: Durig Capital and certain clients may have positions in Ferrexpo bonds.
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. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for their retail clients.