FEEXY - Ferrexpo: A Tale Of Survival

2023-04-05 04:31:27 ET

Summary

• Ukrainian iron ore company Ferrexpo has managed to survive the Russian conflict so far admirably.
• Operations continue and the company remains profitable, whilst having cleared its Balance Sheet of debt.
• Given the current state of the conflict in Ukraine and the impressive management of the company during the war, Ferrexpo’s shares seem potentially like an attractive investment opportunity.

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Thesis

Given the current state of the conflict in Ukraine and the impressive management of the company during the war, Ferrexpo's (FEEXF) (FEEXY) shares seem potentially like an attractive investment opportunity.

The reopening of export avenues and stabilisation of the electricity network would give Ferrexpo the opportunity to ramp up operations again very quickly, underpinned by strong steel demand particularly domestically as part of the country's rebuild.

Company Overview

Ferrexpo is the world's third-largest exporter of iron ore pellets with its mining and processing operations based in Ukraine. Iron ore pellets are an important primary product in the manufacturing of steel.

Iron ore is extracted out of Ferrexpo's three mines in central Ukraine ( Poltava, Yeristovo, and Belanovo ) and subsequently sent for processing in facilities also in Ukraine. At these facilities the ore is crushed, the iron is then separated from the ore and the result is then sent to be processed into pellets.

This leads to iron ore pellets of a higher grade (65% iron content and above) and thanks to the ore being in pellet form, can be put straight into a blast furnace for steel manufacturing without pre-processing. Thanks to the higher grade and pelletising, Ferrexpo's iron ore pellets are sold at a premium to standard iron ore products.

Ferrexpo's clients are generally steelmakers based in Europe, the Middle East, and Asia.

Latest Updates

Understandably, the Russia-Ukraine conflict that began in February last year has had a huge impact on the company. Ferrexpo's share price has tumbled as a result, falling close to -57% since 31st December 2021.

Operationally, the company has managed to continue production. Exporting goods has also been possible to Europe via both rail and barge. Export southwards via the Pivdennyi seaport to the Black Sea has had to be suspended as a result of the war making export to both the Middle East and Asia much more difficult.

Ferrexpo's iron ore pellet production fell -46% from 11.2 million tonnes in 2021 to 6.1 million tonnes in 2022 as a result of the issues caused by the conflict. Only one pelletising facility has been online for most of 2022, though a second of Ferrexpo's four facilities has been online since February 2023. This is thanks to Ukraine's electricity network beginning to stabilise. In the fourth quarter of 2022, stable production was not achieved for 10 weeks because of electricity shortages. The company aims to keep operations between one and two pelletising facilities as the war continues.

Ferrexpo continues to support Ukraine during these tough times, not only through significant tax and royalty contributions but also through its humanitarian efforts. The company has provided $19 million in humanitarian aid since the start of the war.

When it comes to factors outside of the war, iron ore prices have declined -25% as compared to 2021, though this has been mitigated by premiums on pellets increasing by +20% from $60 per tonne in 2021 to $72 per tonne in 2022. This is positive going forward for Ferrexpo, as it signals the broader global steelmaking industry's appetite for higher-quality iron ore inputs. Slowing global economics as a result of the inflationary environment could continue to pressure iron ore prices, though iron ore prices have more recently ticked upwards as a result of China reopening its economy after COVID-19.

Income Statement

Prior to 2022, Ferrexpo was a hugely profitable business. Margins were healthy thanks to both its low operating costs and the premium of its pellet offering. When you consider that during this time there was the COVID-19 pandemic, maintaining these margins and levels of growth is very impressive.

Looking at 2022, the figures are very impressive considering the war. With only one pelletising facility online for most of the year and with export being limited to only Europe, for sales to have only halved and to maintain margin is a testament to the strength of the business.

Worth noting the EBITDA margins have improved despite everything going on, with most of the difference between EBITDA and Gross Profits being down to significant asset impairments, again not a surprise that significant asset impairments were taken given the situation with the war.

The value of Ferrexpo's fixed assets, given that they are based in a warzone and have been operating at very little capacity, will have fallen, hence the impairment.

Balance Sheet

The balance sheet also shows significant resilience given the dramatic situation. Ferrexpo has managed to reduce debt over the course of the year and now has negative net leverage. The company can continue running at the limited level of operation it currently is without risking insolvency.

Additionally, inventories have remained high, which will put the company in a strong position when export avenues open up again. There are plenty of goods ready to ship out as and when that opportunity arises.

Also worth highlighting here is the value of the Property, Plant & Equipment. It is the impairment on these assets that led to the tightening in Gross Margin that we can see on the Income Statement mentioned previously.

Cash Flow Statement

The Cash Flow Statement again highlights Ferrexpo's resilience. Cash from Operations was $301 million for 2022, and this cash has been sufficient to maintain some Capital Expenditure of $161 million, pay off the remaining debts, and issue a $155.1 million dividend to shareholders.

To reiterate, despite the war and the operational issues it has caused Ferrexpo, the company has still managed to pay a dividend to shareholders. Another strong indication of the company's resilience.

In recent years, the company has always issued a dividend, and given it has paid another one again in 2022 despite performance issues, it would be a fair assumption that Ferrexpo will continue to issue one in future.

Future

Looking forward to 2023 and beyond, Ferrexpo's production is dependent on both the accessibility of its export markets and how many of the pelletising facilities will remain operational.

Currently, production can continue to serve European customers via rail and barge. If access via the Black Sea returns, then that could be a significant catalyst for the company. Asia is a huge market, particularly as China re-opens. This will be dependent on how Ukraine manages to recover Russian-controlled territory.

On the operational side, again this is hugely dependent on how the war develops. If Russia continues to attack Ukraine's infrastructure, in particular, infrastructure related to the electricity network, this could significantly impact pelletising operations.

Understandably, given the wide range of scenarios, Ferrexpo have declined to provide guidance.

To best understand the potential value of the company, it's best to consider different realistic scenarios. Given the current situation with the war which seems to be pretty much at a stalemate, it is difficult to see how Russia manages a full invasion of Ukraine given the support being given to Ukraine from the West. Therefore, I think the realistic set of scenarios are the following (note that I will consider here a 5-year investment window):

• The conflict ends in 12 months' time, and Ferrexpo can begin fairly quickly ramping up operations;

• The conflict ends in 3 years' time, and Ferrexpo takes longer to get operational;

• The conflict continues beyond our 5-year investment window.

In these scenarios, I think we can comfortably assume the company can continue to operate at current levels if the war continues. As such for years in the scenarios where the war still goes on, we assume all operations match that of 2022.

For years when the war ends, I think it is also fair to assume not everything will be back online to 2021 levels immediately. For these periods we will assume around 75% of 2021's operations.

For other years of no war and no ramp-up, 2021 levels of operations seem totally fair. Operationally the company can ramp up quickly, facilities are not currently damaged and iron ore pellet demand should be strong, particularly as Asian export channels become available. Additionally, there would be demand from the steel industry as part of the Ukrainian rebuilding effort, in which Ferrexpo can play an integral part.

Although it seems somewhat remote, we need to include the situation where Russia wins the war. In that case, the infrastructure and facilities will be destroyed and the equity value will likely be zero.

When modelling the dividend payments under these assumptions and discounting these at 10%, to be conservative, I get the following model prices for the Ferrexpo shares when considering a 5-year investment horizon. We can attribute some probabilities to these outcomes and get an overall weighted target price for the shares.

The dividend projections and underlying assumptions for the scenarios can be found in the Appendix.

It is difficult to obviously to judge exactly what the probabilities of these scenarios are, but given the current stalemate of the war and the momentum going in Ukraine's direction thanks to the West's help, we can weigh the overall scenarios in favour of the conflict going the way of Ukraine being more likely than other scenarios.

If we believe these probabilities to be fair, a fair price could be GBP2.24 a share. Given that Ferrexpo's shares are currently trading at GBP1.15 a share, this seems to potentially be a very attractive proposition.

Though a fairly risky one at that, with a very real possibility of the value of those shares going to zero.

Risks

The obvious risk is those associated with the ongoing war which we have included in part of the scenario modelling, however, there are other risks.

The other main risk would be the risk to underlying iron ore market dynamics. Ferrexpo's profitability is dependent on both the underlying iron ore price and the premium based on the pelletisation. The current slowing macroeconomic environment could dampen both iron ore and pelletised iron ore prices. Slowing economics globally would impact overall steel demand and as such the demand for iron ore. If steel demand dramatically falls, we can expect lower cash flow generations from the company due to lower margins and sales and would impact the valuation.

Another risk worth considering is that associated with former chief executive Kostiantyn Zhevago who was arrested at a ski resort in France in December on fraud charges. He is accused by the Ukrainian state of embezzling more than $100m. The company has looked to distance itself from Zhevago, however, there could be repercussions depending on whether the accusations are substantiated and how closely these link to the company.

Conclusion

Despite the dreadful conflict, Ferrexpo has managed to impressively continue operations and support the Ukrainian war effort via both taxes and humanitarian aid. The company is in a healthy position to continue operating during the current stalemate, and there is certainly potential for the company to thrive if the war would begin turning in Ukraine's favour.

Appendix

For further details see: