Ferrexpo benefits as London’s only pure Iron Ore producer

It is the nature of the business, that the fortunes of a mining company are inextricably linked with the market for the resources they produce. In times of a weakness, this can often be a negative thing for an otherwise strong company. In bull markets however, a savvy company can ride a commodity rally to strong revenues and profits, building itself a firmer position going forward.

Never is this more so the case, than for smaller and medium mining companies, as well as those producers which focus solely on one resource. Ferrexpo (LON: FXPO) is both. It is a mid-tier miner who focuses exclusively on iron ore production. Lucky for Ferrexpo therefore, that iron ore is in the middle of a strong recovery from losses seen during the global recession.

Ferrexpo is a Swiss based resource company with assets in Ukraine, principally involved in the production and export of iron ore pellets, which are used in steel production. The company focuses mainly on its principal asset, Ferrexpo Poltava Mining (FPM), one of the largest iron ore resources in the world.

It was the first Ukrainian company to be listed on the main board of the London Stock Exchange (LSE), and is in fact the only pure iron ore play (for those looking to gain exposure to iron ore prices via a stock) currently listed on the LSE. It is this focus which gives Ferrexpo the potential to cash in on a bull market in iron ore, and accordingly, increase the company’s value on the back of those gains.

Iron ore prices have been steadily increasing over the past twelve months, having hit a low during the global economic crisis as industrial production around the world hit record lows. As economies begin to recover however, demand for iron ore has begun to spiral ever higher, particularly as the global need for steel (of which iron ore is the main component) rapidly returns to pre-recession levels.

China is the prime driver behind this increase in steel production and iron ore demand, with vast amounts of resources needed to continue to fuel its double digit growth. At this stage, this demand does not look set to falter, and one could expect iron ore demand to remain strong heading into 2011.

One major factor for the iron ore market in recent months has been the move by some of the major producers away from the traditional annual price negotiations, to a quarterly based system. Traditionally, iron ore prices have been negotiated between miners and steel producers once a year, where the first deal between the two groups would act as a benchmark for the wider industry, effectively setting one price for the year. Concurrently a spot market was in place, which although much smaller than the annual market, played a key role and in fact brought about the necessity for a fundamental change in the system.

Earlier this year the world’s three largest iron ore producers, Rio Tinto (LON:RIO, ASX: RIO, NYST:RTP), BHP Billiton (LSE: BLT, ASX: BHP) and Vale (NYSE:VALE), all negotiated deals with their steel producing clients (predominantly their clients based in Asia), to negotiate prices on a quarterly basis. This would allow prices to be more closely linked with the spot market, and allow producers to benefit from a rally in iron ore prices.

Ferrexpo has began a move towards quarterly pricing in line with what has become a broader shift in the industry to this new pricing methodology, although to date around 90% of their sales are still undertook through long term volume framework agreements.

Michael Abrahams, Chairman of Ferrexpo, said “Quarterly pricing has been introduced in some cases but there is, at the moment, no clarity with respect to the frequency with which price settlements will occur going forward.  We currently expect that it will be some time before a generally accepted methodology emerges and the transparency that existed under annual benchmark price arrangements returns”.

So how are these factors for iron ore expected to translate to Ferrexpo’s bottom line? At the company’s annual general meeting (AGM) in May, Ferrexpo told investors that it has seen an increase in iron ore demand from the 2009 lows, with prices in April significantly ahead of the first quarter. The company said it expects to secure significant average price increases for all of its production during the year, and because of this, believes it will realise a strong financial performance on the back on strong iron ore prices, compared to 2009 levels. In the financial year to May 2010, Ferrexpo reported production of iron ore has been 17% higher than in the comparable period of 2009, while concentrate production has been 18% higher and pellet production 24% higher.

According to Edison Investment Research, these gains in iron ore prices are likely to increase ahead of the rising costs of production for Ferrexpo, suggesting it could lead to a 38 pence per share price increase, even taking account of a 13% increase in unit costs on the back of Ukrainian inflation and higher oil prices. Further to this, Edison believes this could go up to an estimated 50 pence per share if the Yeristovskoye deposit is exploited.
Just today, Ferrexpo has released its first quarter results for the three months ending 31 March 2010, and all signs point to the upside. Headline numbers all climbed significantly during the quarter, with revenue up 34% to $188.9 million, earnings before income tax, depreciation and amortization (EBITDA) up 30% to $46.0mln, and with underlying profit up 28% to $26.2mln.
The company say they have seen a “material improvement in demand for our pellets”, with production in the quarter climbing 24%. They also confirmed that prices were still in line with the 2009/10 benchmark, opposed to a more quarterly based fixing, and average cash costs per unit in the period were $38.48 per tonne. The company reiterated that iron ore prices have recovered form their 2009 lows, and expect them to remain above 2009 levels for the rest of the year. They also gave positive guidance for the rest of the year, saying due to the improved pricing environment, they would expect a strong financial performance for 2010.
Kostyantin Zhevago, CEO of Ferrexpo said of the results: “I am delighted to report consistently strong production levels. We are maintaining disciplined cost control and the Group is well positioned to capitalise on current conditions in the iron ore market. As such, the Group is actively engaged in re-evaluating growth project budgets and schedules in order to realise full value for our shareholders".

For any investor looking to gain exposure to iron ore prices, or indeed considering a move into Ferrexpo, it should be noted that the potential strength it will see has not gone unnoticed by the market. Indeed the company’s share price has rallied by around 50% in 2010, predominantly on the back of the stronger outlook in the iron ore market.

That said however, as of yet the risk factors to the iron ore market would still seem somewhat weak in comparison with the broader economic recovery, and compared to ongoing industrial demand for the resource coming from the powerhouse that is China. General consensus is that iron ore prices will continue to recover through the second half of the year and into 2011, and if that does turn out to be the case, the only pure iron ore play on the LSE is destined to benefit.