Fortescue Not Dealing From A Position Of Strength

This story features FORTESCUE LIMITED. For more info SHARE ANALYSIS: FMG

 By Chris Shaw

Back in August iron ore miner Fortscue Metals ((FMG)) reached an agreement with Baosteel and CISA of China to sell all of its fines output into that market at a price of around US$55.50 per tonne, a price 3% lower than the previous settlement by the major players in the iron ore market for sales into the Japanese and Korean markets.

The agreement also had a condition that the company would reach agreement with Chinese financiers for between US$5.5-$6 billion in funds for its planned expansion and this agreement has not been met within the agreed timeline. According to Macquarie, this poses problems for the company, as outside of Chinese backing the company appears to have limited funding options available to it for its expansion plans given its current gearing levels.

As well the broker suggests while the company is trying to tie up additional funding it is not operating from a position of strength, as while the major iron ore producers are price makers to a certain degree Fortescue is simply not in that class and is unlikely to be given what it views as a number of question marks surrounding the group.

These include the fact the company’s balance sheet and cash flows simpy don’t match its growth ambitions, making the new funding a necessity rather than a luxury if the company hopes to meet its previously stated target of expanding production to 95 million tonnes from 2012.

To reflect this the broker does not have any expansion factored into its model at present, supported by its view there remain questions over Fortescue’s ability to handle a higher production rate as well as the quality of the company’s resource base outside of the Chichester Ranges resource.

The broker is forecasting earnings per share (EPS) for the company of 9.8c this year, increasing to 18.7c in 2011, which compares to consensus EPS forecasts according to the FNArena database of 12.7c and 20.2c respectively. While it doesn’t go as far as to suggest a funding package won’t be reached, Macquarie argues the funding terms and any offtake volumes and likely discount ore pricing that could accompany any deal needs to be taken into account when assessing the return from any expansion of output.

In the analysts’ view this implies the rest of the market continues to overvalue the potential upside from an expansion of output as risks are not adequately being considered. To reflect this the broker retains its Underperform rating, while the FNArena database shows a total of one Buy courtesy of RBS Australia, one Hold and Six Sells, with Aspect Huntley rating the stock as Avoid.

RBS Australia’s positive view, and the broker only recently upgraded to Buy from Sell, was based on increases to its medium and long-term iron ore price forecasts, which resulted in its target on the stock increasing to $4.84 from $2.89. This put the broker at the top of the list with respect to price targets according to the database, with JP Morgan the low marker at $2.07 and an average target of $3.36.

Shares in Fortescue today are slightly weaker and as at 11.40am the stock was down 8c at $3.74. Over the past year the shares have traded between $1.16 and $5.31.

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