Materials / Metals & Mining / Ukraine
LSE - FXPO
28 / 03 / 2023
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.
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.
A Tale of Survival
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 USD 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 mediated by premiums on pellets increasing by +20%. 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.
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 given the situation with the war.
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. More evidence that the company can continue to run profitably for the short term.
cash flow statement
The Cash Flow Statement again highlights Ferrexpo’s resilience. Cash from Operations was USD 301m for 2022, and this cash has been sufficient to maintain some Capital Expenditure of USD 161m, pay off the remaining debts, and issue a USD 155.1m 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.
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. For years when the war ends, I think it is also fair to assume not everything will be back online to 2021 levels. 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 in.
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 modeling 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.
If we believe these probabilities to be fair, a fair price could be GBP 2.24 a share. Given that Ferrexpo’s shares are currently trading at GBP 1.15 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.
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.