Abstract: Due to the sharp adjustment in iron ore prices, iron goods have recorded significant losses in the past few years. However, when the K&S project commences commercial operations in 2017 and 2018, the company is expected to recover. Based on our scenario analysis, we estimate that if 65% iron ore costs $60-90 per ton (latest price: about $90 per ton), we estimate the company's price-earnings ratio in 2018 to be 1.4 times - 4.07 times.
As the stock price of iron goods has soared 42% over the past two days, profit recovery may occur in the short term, but this will present a good buying opportunity because the stock is still heavily undervalued based on current stock prices.
Company Background: Iron Goods produces iron ore concentrate products in the Russian Far East near northeastern China. The K & S project has begun trial production and is expected to commence commercial operation in early 2017. Meanwhile, the Kuranakh mine has been out of operation since the first half of 2016 due to high cash costs. Russian gold miner Petropavlovsk PLC owns 35.8% of the shares in iron goods. Additionally, Hong Kong-based mining exploration and trading company Jun An Development owns 20.5% of the shares.
Performance did not recover in 2016. The company recorded a net loss of $9 million in the first half of the year due to weak iron ore prices (realized price of iron ore: $39 per ton) and the high cash costs of the Kuranakh project (over $50 per ton). Since the Kuranakh project has been discontinued, and the K&S project is still in the stage of trial production and production limited, the company's performance in the second half of the year is still not optimistic.
The K&S project will change the company landscape in 2017 and 2018. Currently, management expects the K&S project to commence commercial operations in early 2017. On an annualized basis, when fully operational, the K&S project produced 3.2 million tons. Since each tonne of cash costs only $34 (let's say dollars:
The five-year average of the ruble exchange rate is 67, currently 66). Judging from the latest price of about 90 US dollars per ton (65% is iron), the profitability of this project is very high. Even at $60 per ton, cash profit per ton was still high, reaching $26, and the corresponding full-year EBITDA was around $82 million. The mining period for the K&S project is expected to be around 29 years.
The price-earnings ratio in 2018 was 1.4 - 4.07 times. In Figure 1 and Figure 2, we made a scenario analysis based on the assumption that the K&S project produced 3.2 million tons in 2018. If the price of iron ore remains at $90 per ton, we estimate that the company will record a net profit of $147 million, representing 1.4 times the price-earnings ratio; if the price of iron ore remains at $60 (the company's basic assumption), the company will still record a net profit of 51 million US dollars, representing a price-earnings ratio of 4.07 times.
If we assume that production in 2017 was about 2.5 million tons, based on the assumption that iron ore prices were $90 and $60 per ton, the price-earnings ratio of iron goods in 2017 was 2.1 times and 9 times, respectively. If we make a more conservative assumption - production in 2017 was 2 million tons, then with iron ore prices of $90 and $60 per ton, respectively, the company's price-earnings ratio in 2017 was 3.3 times and 66 times, respectively.
The company's mine is well located and has become an important competitive advantage. The company's mining assets are located near northeastern China, and the local railway infrastructure is perfect, enabling the company's iron ore products to be shipped to Chinese customers in a short period of time. This helps its steel mill customers manage their production schedules and inventory. According to management, delivery from Australia to Heilongjiang may take more than 15 days, while iron goods can deliver products within a week.
Cash flow pressure was under pressure in the fourth quarter of 2016, but it remained manageable. The company will need to repay about $26 million in bank loans in the fourth quarter, while the company's cash balance at the end of September 2016 was only $14.6 million. However, the company has a full performance bond worth 37 million US dollars in ICBC as a down payment for the K&S project construction project. Due to delays in the contractor's past projects, Iron Cargo can use performance bonds to repay its bank loans. The company is also negotiating debt restructuring with ICBC (for example, loan repayment after recording stronger cash inflows in 2017).
Mid-term development direction: K&S project phase II. In the short term, since the K&S project has been completed, the company does not expect much demand for capital expenditure. In the medium term, the company may consider developing the second phase of the K & S project, which will double production capacity.
There is an opportunity to recoup the impairment. The company's total impairment losses between 2013 and 2015 were $770 million (share capital was $114 million as of the end of June 2016). Due to the strong rebound in iron ore prices, management did not rule out the possibility of reversing the impairment.
Trading volume has soared. In the past, due to falling iron ore prices, the trading volume of iron goods stocks was very low. However, the average daily volume rose to $6 million over the past five trading days.
Risk factors: (i) K&S commenced commercial operations later than anticipated; (ii) the execution of the K&S project was risky (such as higher than expected cash costs); (iii) iron ore prices were drastically adjusted; (iv) the ruble appreciated sharply against the US dollar because the company's revenue was mainly denominated in dollars while most of the costs were denominated in rubles; (v) the failure to repay bank loans in the fourth quarter of 2016.