Iron ore is budget’s saviour – and its risk

Article by James Thomson courtesy of the Australian Financial Review

The mid-year economic and fiscal outlook suggests the government’s famous bridge from the pandemic to the recovery is nearing completion. It’s also clear that the bridge has been reinforced by lots of Chinese steel made with Aussie iron ore.

Soaring iron ore prices – driven in part by supply issues from Brazilian miners and in part by China’s own pandemic recovery measures – have led Treasury to push back its estimate of when the price will retreat from its current level of $US150 a tonne to $US55 a tonne from the end of the March quarter next year to the end of the September quarter.

That change means a $25 billion boost to GDP over this financial year and 2021-22, with tax receipts to be $6.1 billion higher than forecast in the budget just a few months ago.

And that’s probably conservative, given the supply issues in Brazil won’t be quickly resolved and China is unlikely to take its foot off the stimulus pedal. Morgan Stanley released updated iron ore price forecasts this week that tipped the price to reach $US100 a tonne by the end of next September, and said the price would likely finish 2022 at $US86 a tonne.

The heavy lifting done by iron ore during the depths of the recession should continue into the recovery.

Treasurer Josh Frydenberg was justifiably thrilled that the mid-year budget update – which came just two months after the delayed budget proper – shows how quickly the economy is climbing out of its hole.

The revised GDP forecasts – 0.75 per cent growth for 2020-21, compared with a fall of 1.5 per cent predicted in the budget in October – suggest real short-term momentum. Page 11 of 26 © 2019 Factiva, Inc. All rights reserved.

The outlook for business investment, particularly outside the mining sector, is sharply better than in October’s budget. So is the medium-term outlook for unemployment, which is now expected to hit 5.75 per cent in 2022-23, down from the 6 per cent forecast in the budget.

This should give Australian businesses and households real cause for optimism heading into 2021. The combination of the difficult sacrifices made to fight and contain the virus and extraordinary fiscal support from the government have put it in a strong position to make a sustainable recovery.

But the battle ain’t over. Clearly COVID-19 remains a live threat – yesterday’s cluster of cases in Sydney is a stark reminder of that – and Frydenberg rightly called out the potential threat to export markets from trade tensions.

Our coal miners, winemakers and farmers already know all too well about the value that can be destroyed when China bares its teeth. Frydenberg and Prime Minister Scott Morrison will be praying iron ore isn’t dragged into a broadening spat.

But the risk is real. Attempts this week by the powerful China Iron & Steel Association to suggest that Rio Tinto had agreed to review the market-based pricing mechanism, which has been used for more than a decade, appeared to represent an attempt to nudge iron ore into the broader basket of trade tensions.

That Rio didn’t reject the suggestion directly – instead attempting to defuse the situation by saying it would “continue to work with customers, suppliers and other industry stakeholders to play its role as markets continue to evolve” – was equally telling.

No one wants to poke the bear – or more accurately, the dragon – even if it’s hard to see China having any realistic alternative to Australian iron ore.

The miners’ nervousness is hardly surprising given they must maintain strong relationships with customers and, in the case of Fortescue Metals Group and Rio Tinto, Chinese shareholders.

They will do everything they can to keep their heads down and hope their mines can continue to play an outsized role in Australia’s economic recovery and, eventually, help with budget repair.

Zip must juggle building scale with execution risk

Zip’s $150 million capital raising neatly encapsulates both the opportunities and the risks facing Australia’s army of buy now, pay later providers.

Just consider where the proceeds of the capital raising will be used.

About 60 per cent, or $85 million, will be invested in Zip’s US expansion, where the QuadPay business it acquired in June has grown three-fold in the last 12 months.

There’s $15 million for Zip’s British business, which is just getting off the ground. About $12 million will be directed to Zip’s local expansion into small business lending, known as Zip Page 12 of 26 © 2019 Factiva, Inc. All rights reserved.

Business; this includes a partnership with Facebook which will let SMEs use Zip to buy advertising.

And finally, there’s $35 million that will be poured into what Zip calls its new markets division. This unit announced its first deals yesterday with the acquisition of a stake in Spotii, a buy now, pay later firm based in the United Arab Emirates, and an investment in Twisto, a payments platform focused on the Czech Republic and Poland, which could be a platform to expand into the European Union.

It’s a seriously large growth agenda that speaks directly to the land grab that is under way in the buy now, pay later sector as a plethora of participants – probably too many – try to get a foothold in as many markets as possible.

But therein lies the eternal conundrum of the early stage venture, which is really what most of these firms are. What’s the right balance between building scale and not biting off more than you can chew?

Or as Citi put it recently: “While we acknowledge the first/early mover advantage in entering new markets, we are concerned that Zip could be taking on too much.”

Zip chief executive Larry Diamond is alive to the challenge. “It’s a very good question and we obviously debate it extensively at board level.”

He says what gives him and the board comfort is what he calls the “coalition of founders” – these are the founders of the businesses that Zip has bought, QuadPay being a prime example – who have joined the group and bolstered its capacity to handle growth.

Diamond and his Australian-based executives are keenly aware they can’t run the empire from Australia, so have taken the approach that where they can “make the boat go faster” by becoming involved in the management of an overseas business, they will. But where the team on the ground is doing a good job, Diamond and his Australian executives step back and let them go.

He argues that the investment in the US, which will mainly go towards customer and merchant acquisition and technology, is all about capturing the clear momentum that QuadPay has built up in recent months, which he says is built around strong efficiency and unit economics. “We just need to double down on the US.”

Diamond also says the new growth business unit isn’t perhaps as grand as it might sound. The idea here is not that Zip itself will try to expand into a range of geographies, but that this division will act as an “investment committee that’s made a few minority investments that could pay over 24 to 48 months”.

Zip will have no day-to-day involvement in the Middle East or European minnows it’s bought into, and for now won’t even provide them with any technology, as they have their own platforms. For now, these equity investments are about assessing the opportunities in these markets, building up global retail relationships and sharing knowledge.

If investors have any concerns about Zip biting off more than it can chew, they weren’t Page 13 of 26 © 2019 Factiva, Inc. All rights reserved.

showing them yesterday. Having raised capital at $5.34, Zip shares jumped 3.2 per cent to $5.75 in early trade. The stock is up more than 60 per cent for the year.

But there’s no doubt there are some real execution risks here for Zip and many of its rivals. Growing a start-up business is hard. Growing a start-up business in an emerging sector is harder still. Growing a start-up business in an emerging sector in multiple foreign markets is a serious challenge.

In their short lives, Zip and its peers have been blessed with mainly tailwinds – the ever-accelerating transition to e-commerce, the accommodative regulatory environment, and enormous government stimulus keeping incomes strong through the pandemic.

We probably won’t know which companies have managed execution risk best until market conditions become more difficult.