Fortescue Scores A Buy Rating

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

 By Greg Peel

Few stocks in the Australian market have witnessed such euphoric hysteria since listing as has Fortescue Metals ((FMG)), which one might describe as the Poseidon of the twenty-first century. The initial rush to invest in Fortescue was driven by talk of a Chinese-inspired commodities super-cycle, along with a seemingly endless stream of iron ore reserve upgrades. Fortescue became the little battler ready to take on the might of iron ore stalwarts BHP Billiton ((BHP)) and Rio Tinto ((RIO)).

The GFC took its toll on all three stocks, but record Chinese iron ore imports in the first half have seen a return to favour. While BHP and Rio are two of the three major iron ore producers in the world, they are also both diversified resource companies with fingers in many pies. Fortescue, on the other hand, is simply a pure-play iron ore producer. The recent surge in Chinese demand has seen Fortescue’s share price bounce from a GFC low of $1.16 back to around $4.00 today. Once again, the market is excited.

But while the market might be excited, stock analysts are not. Prior to today, of the nine brokers in the FNArena universe who cover Fortescue, eight have Sell ratings on the stock. GSJB Were is at least content with Hold.

The problem is simply that Fortescue has potentially a vast amount of iron ore, but it’s all in the ground. The company only recently made its first shipment and it’s a long road from here to iron ore major. Fortescue does not have the funding, nor access to the funding in a post-GFC world, to finance its mine expansion and infrastructure plans. To that end, the company recently took on board a cornerstone Chinese investor, agreeing to a discounted iron ore contract price in the process.

Chinese involvement should ensure Fortescue is able to reach its ambitious production target over time, but it is all still a longer term future proposition. As far as the stock analysts are concerned, the market is pricing Fortescue as if it were already challenging BHP and Rio for iron ore supremacy.  Stock analysts will always apply a risk probability factor to valuation models, and given Fortescue is a long, long way from reaching its target production and sale levels that risk probability is currently high. Brokers cannot see short term upside in an already overvalued stock.

Until today.

FNArena noted in yesterday’s story The Iron Ore Floor Price that the high cost of marginal iron ore production in China has seemingly set a floor price for iron ore at US$75/t. Adjusting for the freight cost means this equates to US$65/t for seaborne Australian high-grade ore. This morning RBS Australia released a report which reached a similar conclusion, and suggested that next year’s iron ore contract price will be 10% higher than the US$65/t price this year settled by the Japanese and Koreans for Australian “fines”. This is up from the analysts’ earlier forecast of a 5% increase.

But RBS also increased its long term iron ore price forecast by 30%. On that basis, pure-play producer Fortescue Metals sees its RBS target price jump from $2.89 to $4.84 (on the assumption of 95Mtpa production). As such, RBS has upgraded Fortescue directly from Sell to Buy.

RBS has increased its long term iron ore price forecast from US65c/dmtu to US85c/dmtu. This is all a bit confusing when one thinks of iron ore prices in US dollars per tonne but in fact the “cents per dry metric tonne unit” provides a more ready comparison between differing iron ore grades. In simple terms, a c/dmtu price is a price for the iron in the ore, not the ore itself. Thus Australian producers of high-grade ore, in excess of 60% iron, receive more per tonne of seaborne ore than Chinese domestic producers with their low-grade, around 20% iron, land-shipped ore.

To balance the equation, the Japanese and Koreans this year agreed to a price of US97c/dmtu which for Australian “fines” equates to around US$65/t.

Readers may thus be confused that the aforementioned article suggested iron ore may have a floor price of US$75/t, and yet RBS is only forecasting a long term price of an equivalent of about US$52.50/t. However, a “long term price” is not a prediction of a future price, it is simply a conservative number suggesting a discounted historical average. Note that the RBS analysts’ 30% increase in long term price has translated into a 67% target price increase for Fortescue. Fiddling about with long term prices extrapolates into very big valuation shifts in discounted cash flow levels out several years, and so analysts do not treat such figures lightly at the risk of vastly overstating short term value.

Indeed, RBS has increased its forecast 2010 contract price to US107c/dmtu, which equates to US$71.70/t for Australian ore and represents a 10% increase from the 2009 price. (Note that the 2009 dollars per tonne price varies dependent on the grade of ore.)

The irony here is that given Japan was for a long time the biggest buyer of Australian iron ore, being a world-leading steel producer with no ore of its own, and the forecast contract price for 2010 is based on what Japan would have to pay. But the reason for the RBS price upgrade is because China is now the world’s dominant buyer of iron ore, despite having its own domestic sources. Yet given 2009 contract price negotiations broke down, to date China has been buying ore at the Japanese price anyway. RBS has reached its price by blending the Australian incentive contract price with the marginal Chinese domestic price.

RBS does warn, however, that investors should not rush in to buy Fortescue just yet. Post its stockpiling exercise, Chinese iron ore buying should weaken over the next three months in the RBS analysts (and just about everyone else’s) view. The Buy rating equates to a 12-month view.

Fortescue now shows a 1/1/7 Buy/Hold/Sell ratio in the FNArena database, with an average target of $3.34, up from $3.09 pre the RBS upgrade. That’s 16.5% below today’s trading level.

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