FEEXY - Scenarios For Ukraine's Ferrexpo plc

2023-04-11 04:57:39 ET

Summary

• In this article, we examine Ukrainian iron-ore miner's Ferrexpo recent 2022 full-year results and speculate what the future could hold, based on a deep dive into the operating environment.
• Given the uncertainty around the outcome of the war, which is impacting the company's production and export volumes, we consider four possible scenarios.
• While normally profits are driven by iron-ore prices, now the company is driven by the power supply and export considerations.

Ferrexpo plc (FEEXF) (FEEXY) is a Ukraine based iron-ore miner, listed on the London Stock Exchange. Traditional valuation is somewhat meaningless because when there is so much uncertainty in the outlook for a company, it's foolish to make a forecast and think it's going to be a better forecast than any other forecast in the market and buy or sell the stock based on that view.

In this report, we consider four scenarios. First, Ferrexpo plc loses complete access to electricity supply. Second, the company's wartime level of production and exports continues at roughly the same level forever. Third and fourth, wartime level of production and exports continues at roughly the same level until the war "ends" either next year or three years from now.

We incorporate Ferrexpo's recent full year results for 2022, which give us an idea of what wartime production looks like. We highlight key findings from the results presentation.

We don't attempt to make any recommendation on the stock in this article. The objective is just to provide a few scenarios for investors to think about. The next step would be to assign cash flows and probabilities to each scenario and put together a weighted average discounted cash flow analysis.

Scenario 1

A prolonged electricity outage would be detrimental to Ferrexpo's future. However, numerous factors in the Group's logistic and operational network may reduce the damage it would incur.

Ferrexpo has a significant stockpile inventory, 1.6 billion tonnes of ore reserves, representing a 50-year lead in current yearly processing. Ferrexpo cannot sell the unfinished product, and the electricity-intensive requirement would render such an advantage obsolete in a prolonged outage.

Ferrexpo's energy consumption is listed below.

Figure 1; Ferrexpo's energy consumption in Terajoules

Electricity accounts for 38% of Ferrexpo's energy consumption, highlighting its importance. Figure 1 shows the Group's commitment to decarbonisation, using sunflower husks as a biofuel in its pelletisers. 18% of the power supply in the Group's pelletisers comes from biofuels, which increased to 22% in 2022. Additionally, Weir Group Plc has signed a 36 million contract with Ferrexpo for energy-saving solutions, i.e., high-pressure grinding rolls to reduce energy consumption by 40%. Ferrexpo also plans to reduce 50% of its diesel usage by employing trolley-assisted overhead cables and reducing 40% of diesel consumption in its trucks by utilising battery technology. Although Ferrexpo has a clear strategy ahead to reduce energy consumption in line with scope two emission reductions, such projects are in the exploration stage, and an immediate electricity outage would prevent development in such areas.

Ferrexpo has recently developed a 5 MW solar panel, producing 495,000 kWh of energy, or 1.79 Terajoules. This is 0.02% of the electricity purchased by 3rd parties. Ferrexpo has backup diesel generators on-site but needs to be more transparent on how much energy they can produce. These generators are short-term contingencies rather than long-term buffers.

Proof of an outage's harm on Ferrexpo's success was demonstrated in Q4 2022 when only one pelletiser was in operation. Ferrexpo's pellet production was 0.4 million tonnes in Q4 2022, down from 3.1 million tonnes in Q4 2021. Russia's relentless attacks on infrastructure networks caused severe disruptions in Ukraine's state-owned electricity grid. 2022 saw a 46% reduction in production. Ferrexpo stated it had "sufficient" quantities to meet consumer demands without disclosing any numbers to back its claim. A sustained loss of electricity would damage Ferrexpo's production ability.

Ferrexpo's exporting capacity would be impaired. The Group does not disclose its type of railcars, but most freight transportation involves diesel railcars. This would mitigate the harm done by an electrical outage. The Group owns 2850 railcars, a fleet of 218 vessels to reach its established customer base via the Danube River, reducing friction in its logistical network. Ferrexpo's exporting ability would be less damaged than its production ability in an electric outage. However, indirect consequences could alter this. For example, Ukraine's rail network is 45% electrified; an electrical outage would cause bottleneck issues on the network, disrupting The Group's ability to transport its goods.

To conclude, an electrical outage would most harm Ferrexpo's production ability more than anything else. Although it has a loyal customer base, its long-term agreements would not be fully honoured without products. Although Ferrexpo has inventory, its processed finished stock would not last longer than a long-term outage. Ferrexpo is in a competitive market; Vale SA increased its iron ore sales by 24% q/q in Q4 2022. Therefore, its market share would quickly deplete.

Scenario 2

An indefinite war in Ukraine would damage the Company's operations; still, such a scenario would fare better than scenario 1, as the Group could adapt.

Ferrexpo's unprocessed stockpiles can last 50 years at current production levels. Ferrexpo's mines, i.e. Poltava, are in central Ukraine, away from the war front. Ferrexpo's new $7 million investment in its Belanovo mine is also in the central zone. Therefore, assuming the war continues at a stalemate, Ferrexpo's stockpiles and facilities are not the primary concern in scenario 2.

Ferrexpo's power supply would be harmed should Russia's infrastructure targeting continue. Russia has been using drones to "exhaust" Ukraine's defence systems, allowing enhanced damage to its electrical grid. According to Reuters, among rationing of energy in Q4 2022, Ukraine's energy minister has claimed that there are "sufficient" energy reserves, which would go towards families and homes as a priority, not a public company like Ferrexpo. Russia's new operation is to attack critical node points where transformers are in the grid, breaking the grid into isolated islands to prevent electrical flow in different areas. The overhead cables are exposed, causing Ferrexpo's power supply to be in jeopardy should Russia continue reshuffling troops from the South. Ukraine uses soviet-style high-voltage electrical equipment, which is incompatible with Western replacements. 40% of Ukraine's energy has been damaged since the war began; a sustained stalemate would only worsen this.

Labour depletion also must be considered; 6% of the workforce is under conscription under Martial law, which would likely increase should the war continue forever.

Ferrexpo's revenue dropped by 24% from 2021 to 1H 2022; a continued drop would likely continue, reducing the Group's market share significantly.

Ferrexpo has spent $1 million procuring its railcars, showing the Group's continued effort to own its logistical network. However, the national rail operator (Ukrzaliznytsia) has had regular attacks. Ukraine's Ministry of Infrastructure has increased rail tariffs by 70% on cargo to raise repair funds, or US $7-9 per tonne of Ferrexpo's distribution cost. Forty-two thousand wagons lined up at the border compared to an average of 1900 railcars, enhancing congestion issues and straining supply-side disruptions.

Ferrexpo has 1,006 thousand tonnes of finished inventory to distribute, which would only sustain half a year's worth of exports (using 2022's figures); a war forever would quickly deplete such assets.

Ferrexpo's costs must be considered in scenario 2. Ferrexpo sits at the "bottom half" of the pellet cost curve, allowing it to remain competitive with its counterparts in Brazil and Australia, even when commodity prices are high. However, 50% of the cost base relies on global commodity prices. A second driver of its cost is Ukraine's local currency, the Hryvnia, which depreciated during the war. Although the war in Ukraine affects global commodity prices, this would affect all mining companies. However, a depreciation in the local currency would disproportionally hurt Ferrexpo.

(Figure 2; Pie chart showing cost per tonne in Ferrexpo's 2021 Annual report)

Ferrexpo's main cost is in electricity and fuel. Global prices can vary massively, i.e. in January 2021, it was $55 per barrel of oil, to peak at $81 in October 2021, an increase of more than 50%. Therefore, to reduce its costs, Ferrexpo must direct its capital investment in on-site energy and improvements in energy efficiency for it to survive. In 2021, Ferrexpo spent $361 million on capital investment, compared to $206 million in the previous year, with $111 million spent on a wave one expansion, which would increase pellet production capacity by 25%. A majority of capital investment was going towards growth rather than mitigation measures, as the war had not begun in 2021. Reducing production volumes concentrates fixed costs rather than diluting them, which cannot offset external cost inflation. Nevertheless, Ferrexpo has a "Business Improvement Programme" which reduces costs by 1-2% per annum - Ferrexpo's transparency is bought into question, as there are no details on how this would be achieved.

Finally, Ferrexpo's "Summary of Policies" states, "a material uncertainty still remains as some of the uncertainties are outside of the Group management's control, with the duration and the impact of the war unable to be predicted at this point of time" . The Group has "sufficient liquidity" for buffering. However a "further interruption to the logistic network may result in a significant decline of the Group's operating cash flows".

Ferrexpo has performed stress tests, which showed the Group has liquidity for up to twelve months before utilising available mitigation actions in its control, including reductions in uncommitted capital expenditure and reducing operating costs. An indefinite war would force Ferrexpo to consolidate its operations in cost control, hampering its market competitiveness.

Scenario 3 and 4

A war lasting one or three years would damage Ferrexpo. However, ending the war would ease logistical and operational issues plaguing Ferrexpo, allowing it to recover.

Generally, the demand for Ferrum Premium, i.e. for high-grade ores, remained in line for 2021 and 2022. Ferrum Premium demand remains high despite global iron ore price reductions due to post-covid stimulus packages ending. This is due to consumers' net-zero targets, such as the EU, which favours high iron content due to less blast furnacing in steel processes. 96% of Ferrexpo's long-term contracts were honoured in 2022, which provides stability to weather out the war. Global pellets exports decreased by 15% in 2022, mainly due to imposed sanctions on Russia (reduced exports of 7 million tonnes) and China's downturn in demand by 60%. This means even in scenario 3, Ferrexpo could maintain market competitiveness due to the luck in the timing of the commodity cycle. This is further supported by the loyal customer database Ferrexpo has cultivated for decades with its European market, which it can still reach through rail work, albeit at a higher cost. However, the primary issue that Ferrexpo faces in its exporting capacity is the depreciation of the local currency (Ukrainian hryvnia), which was depreciated by 25% against the US dollar by the central bank. If such a trend continued, Ferrexpo's profit during scenarios 3 and 4 would be seriously harmed.

(Figure 3: Financial summary for 2022)

Improvements in Ukraine's electricity grid mean two out of the four pelletisers are in operation (February 2023), improving output and buffering against war damage continuing for years.

However, a 64% decline in the movement of iron ores can be attributed to different factors. In Q2 2022, steel mills curtailed orders to build inventories, reducing supply-side risks. In Q3 2022, major congestion of rail works was due to increased grain demand, and Q4 2022 saw infrastructure damage from Russian aggression. Despite this, Ferrexpo still spent significant funds on its wave one expansion, which will increase its exporting capacity by 3 million tonnes, putting it in a strong position if the war were to end.

Ferrexpo had "replenished" its pellet inventories after Russia attacked Ukrainian infrastructure in Q4 2022; the Group's strategic planning may allow for a consistent inventory if Russia were to continue a periodic cycle of attacks. The situation is volatile; in November 2022, no pelletisers were in operation due to heavy attacks. One to two pelletisers have been in operation since the war began. Jim North has claimed a 3rd pelletiser may open in the near future by considering alternative ports to sell down inventory. Ferrexpo has increased its biofuel usage of sunflower husk (21% in 2022 y/y 18% in 2021) to mitigate commodity risk.

Nevertheless, for full production, Ferrexpo needs access to the black sea port.

Ferrexpo has put mitigation measures which may improve its survivability throughout the war. Ferrexpo has an owner-operator model, owning its logistical networks, such as railcars and vessels, reducing its infrastructure risk.

Total shipments were reduced by 46% in 2022, yet EU shipments decreased by 23%, highlighting Ferrexpo's established customer base. The Group has an in-house freight manager helping Ferrexpo receive competitive rates based in Singapore, where many shipping brokers are based. Additionally, the Group has a 49.9% equity stake in the berth at the Pivdennyi port in South Ukraine, alongside a trans-shipment vessel, "Iron Destiny", which coasts away from Ukraine during wartime, securitising Ferrexpo's logistic assets. Ferrexpo owns its inland waterway logistics provider (First-DDSG) based in Austria, with key locations along the Danube River.

Ferrexpo is in "talks" with alternative port operators for seaborne exports, yet no specifics were given.

Should the war continue, it would likely be a frontline stalemate in eastern Ukraine, meaning its mines in the country's centre would likely remain in contact.

The "primary concern" of the Group is workforce safety. Ferrexpo has provided on-site air-raid shelters and shifts to fit local curfew hours, recording zero fatalities in 2021. 6% of the Group's workforce was conscripted to the Ukrainian military, which would damage production abilities, but by a smaller amount than expected.

Ferrexpo also complies with the UK cooperate governance code and market abuse regulation by listing on the London Stock Exchange, with most of the Board of Directors independent of Mr Zhevago.

Jim North gave further mitigation measures in a live presentation on 15th March 2023. Ferrexpo is closely working with the transmission provider and regulators, discussing in February 2022 with energy ministers to improve infrastructure capacity. Ferrexpo is also looking into a private heating plant to bring in additional power to the company. Ferrexpo is planning mobile generation capacity in winter 2023. Ferrexpo plans to expand its 5 MW solar to 20 MW. Its intention has been delayed due to the ongoing conflict. As previously discussed, a 5 or 20-MW solar farm would be insufficient to meet the energy-intensive demands of Ferrexpo. Furthermore, no mitigation measures were backed up numerically.

Mr North also states Ferrexpo is taking a careful "conservative" approach to its operations to deliver reliably to its "loyal" customer base. The Group plans to form two new logistic routes via seaborne exports to remain competitive, albeit at a higher cost. The CEO does admit for full nameplate capacity; the black sea port would need to be accessible. The CEO nevertheless remains hopeful Ferrexpo may have access to the port by the end of 2023 via a humanitarian green corridor (like grain exports). Such a change is improbable, given that iron ore is less important than food stock regarding humanitarian aid.

In the "Summary Report" of Ferrexpo's 2022 results, the Group predicts production and sales volumes to be 50-75% below pre-war levels for 2023-2024 before recovering in 2025. However, this is a crude approximation, given the recent infrastructure instability in Ukraine. The Group has sufficient liquidity to operate as planned for the next "18 months", meaning adverse effects would affect the company in scenarios 3 and 4.

Therefore, Ferrexpo's success would be damaged in both scenarios, but the company would survive and recover, unlike the previous scenarios. Given Ferrexpo's extensive mitigating measures and liquidity buffer of "18 months", the war ending in 1 year in scenario four would not likely damage Ferrexpo. On the other hand, scenario three would likely mean Ferrexpo would lose market share. Its adaptability (i.e. seeking new ports) and established customer base would mean it could weather out the war until 2026. However, a reduction in capital expenditure would likely occur.

Scenario 3 and 4: Ukraine Reconstruction

This section assesses the potential for future supernormal local steel demand once Ukraine is able to rebuild and reconstruct, and considers the role Ferrexpo can play in this reconstruction. Firstly, on a local level, with Russian pellet material under sanction, analysts and investment bank Peel Hunt suspect European mills are increasing their demand for Ferrexpo's material, helping sustain higher than normal volumes to Europe. With these sanctions likely to continue, and strengthen, both during and after the war, Ferrexpo is an advantageous position to exploit this extra demand and potentially charge premiums on its various products. There is also potential for supernormal global steel demand in general, especially for high-grade, high-quality iron ore in Europe. This arises because of the significant steps being taken to reduce greenhouse gas emissions on the road to decarbonisation. With Ferrexpo's existing capacity to be one of the world's largest producers of blast furnace iron ore pellets, they are well-situated to serve this shift, alongside that which occurs once Ukraine is able to rebuild. It must be noted, however, that these opportunities can only be maximally exploited once Ferrexpo's infrastructure is fully repaired and operational. It must also be noted that currently Ferrexpo seems to be in dispute with the Ukraine government. However, it is not obvious that this will affect its operations and the post-war environment.

In terms of current market factors - economies worldwide are under pressure as a result of high energy costs, inflation and economic uncertainty. The iron ore price (62% Fe Index) has declined to below US$100 per tonne and the European steel sector has seen capacity closures in recent months, reducing steel output. The outlook for global steel markets has deteriorated sharply. Factors contributing to weaker prospects include the global economic slowdown, high energy prices and accelerating inflation, the impacts of the war in Ukraine and supply chain disruptions, and a sharp downturn in the People's Republic of China due to an ailing real estate sector and strict COVID lockdown policies. China represents the largest market for seaborne iron ore and the main determinant of iron ore prices globally. World crude steel production has decreased sharply in 2022 as global demand for steel contracts. The destruction of steel production facilities in Ukraine has led to a collapse in steel production, while soaring energy prices have led to widespread plant idling and production stoppages, especially in Europe. Global steel consumption is expected to decline by 2.3% in 2022 and to rebound by 1% in 2023.

According to Eurofer, steel demand in EU is expected to decrease by 1.9% in 2022 and rebound by 5.1% in 2023. Energy and commodity price increases, inflationary pressure, lower demand from China and political instability have worsened steel demand trends globally. Rising interest rates and the tightening of monetary policy, high inflation, weak consumer spending and higher energy prices are expected to impact steel demand significantly going forward, and risks to the outlook are on the downside. In Ukraine, the war has taken a large toll on steel production, which dropped by 58.2% during the first half of 2022, year-on-year.

Ukraine's steel capacity has also taken a large hit from the war, most significantly, the shutdown of the major Azovstal steelworks in Mariupol city, the biggest steelworks in the country. While all other blast furnace-based steelmakers in Ukraine outside of Mariupol have resumed operations, utilization rates remained lower than optimal. Kametstal, ArcelorMittal's ( MT ) Kryvyi Rih, Dniprovskyi, and Zaporizhstal are running at 20-65% of their capacity. It is estimated that Ukraine has lost 40% of pig iron export capability, 100% of plate and slab export capabilities, 30% of hot-rolled coil and cold-rolled coil export capacity and 30% of domestic hot-dipped galvanized supply, due to the war, especially with integrated mills in Mariupol - Azovstal and Illyich - suffering damage from the conflict. After the end of the war, Ukraine will require large volumes of steel to restore houses, enterprises, infrastructure. Due to this large damage to Ukraine's steel capacity, some have predicted that Ukraine will become a net importer of steel and EU and US steelmakers will be able to supply steel in Ukraine.

However, while the steel market in 2022 and 2023 may not seem overly attractive, one must consider the extent of the damage in Ukraine, and the subsequent future supernormal local steel demand that arises as a consequence. Current estimates of direct and indirect losses to Ukraine from Russian aggression range from $564 billion to $600 billion. As of December 2022, the total amount of documented damage to Ukraine's infrastructure was estimated at $137.8 billion (at replacement cost). Such huge damage to Ukraine's infrastructure represents a big opportunity for Ferrexpo in the future. With the rebuilding of Ukraine requiring vast amounts of steel, Ferrexpo could be uniquely positioned to take advantage of this. This, of course, also depends heavily on when the war "ends." On the one hand, the later the war ends, the greater the damage to Ukraine's infrastructure, and thus the greater the opportunity for Ferrexpo. However, the longer the war continues and the greater the damage, the more likely that Ferrexpo's operational infrastructure is broken down, meaning it will be more difficult to quickly exploit the supernormal demand for steel.

Another key consideration is the aid foreign governments and international organisations have provided for Ukraine. This stimulus is pivotal for building Ukraine's infrastructure back up. Currently, The IMF is finalising a four-year lending programme worth $15.6bn for Ukraine, with a person close to the talks saying an announcement is "imminent". The IMF previously granted Ukraine $2.7bn of emergency funding and in December approved a four-month programme for the country aimed at shoring up the economy and preparing it for a significant loan from the fund. The country has also received funding directly from the EU, US, and other allies. The World Bank has estimated that more than half of the country's energy infrastructure has been destroyed by Russian attacks, meaning a large amount of aid will be required to repair this. The European Bank for Reconstruction and Development is also providing a significant amount of aid to Ukraine. As the largest institutional investor in Ukraine, they have committed to providing €3 billion of financing over 2022-2023 to help keep Ukraine's businesses and economy functioning. In 2022, they deployed €1.7 billion in support of Ukraine. In addition, €200 million was also directly mobilised from partner financial institutions. Russia's devastating attack has also stirred calls to muster a Marshall Plan for Ukraine in response. A World Bank official estimated that fully restoring Ukraine would cost at least the equivalent of $540 billion. Hence, a much greater amount of aid and investment is needed, and no entity seems likely now to take the lead in creating a Marshal Plan like framework for Ukraine. Private investors will also be key to the reconstruction of Ukraine. To facilitate this, BlackRock's ( BLK ) Financial Markets Advisory will provide advisory support for designing an investment framework, with a goal of creating opportunities for both public and private investors to participate in the future reconstruction and recovery of the Ukrainian economy.

Overall, the potential for Ferrexpo to play a key role in the reconstruction of Ukraine is quite evident. Firstly, there exists a huge opportunity by virtue of the huge amounts of steel that will be required to rebuild Ukraine. Furthermore, Ferrexpo as company has shown resilience and flexibility in surviving during the war, finding a way to continue supplying a number of customers, via the railway network, their barging subsidiary on the river Danube, and other logistics partners in Europe. A key constraint to exploiting any opportunities remains the supply of power to Ferrexpo's operations. This remains variable and limited, which has an impact on the cost effectiveness of production. A stable source of electricity will be a necessity for Ferrexpo to make the most of Ukraine's reconstruction. In terms of specific scenario analysis, these findings do not change significantly between scenario 3 and 4. While the longer the war goes on, the more likely damage and thus the greater the rebuild, we cannot ignore that the longer the war goes on, the more likely there is more severe damage to Ferrexpo's infrastructure, and thus, less of an ability to play a role in the reconstruction of Ukraine.

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