Expansion Plans Remain Key For Fortescue

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

By Chris Shaw

The collapse of recent talks with Chinese investors to fund ambitious expansion plans have not impacted ongoing operations for iron ore producer Fortescue Metals ((FMG)) as the company delivered a solid production result for the quarter, with iron ore output of 9.5 million tonnes as much as 12% above the estimate of stockbrokers such as UBS.

Compared with other expectations, however, the production result proved more in line. One such stockbroker is Morgan Stanley. The September quarter report annualises out to full year production of 38 million tonnes, which matches what Morgan Stanley had factored into its forecasts. This suggests guidance from management is somewhat conservative as it remains for sales of 35 million tonnes for FY10, though as Citi notes the upcoming wet season will present challenges in maintaining production at current run rates.

What disappointed in the quarterly release were costs as they increased to US$26.60 per tonne from US$22.92 per tonne in the previous quarter. A stronger Australian dollar against the US dollar was a major contributor to this increase, while Citi notes there were also higher costs associated with having to truck ore from the Christmas Creek mine. Including royalties, the broker estimates direct costs now stand at almost US$30 per tonne.

Even allowing for the increased costs, RBS Australia has lifted its earnings forecasts as it takes the view the cost increases will be offset by higher production and sales. RBS has increased its profit forecast by 76% in FY10 and in FY11 by 17%. In earnings per share (EPS) terms this implies outcomes of US7c and US17c respectively, while Deutsche Bank lifted its EPS estimates to US9c from US6.2c in FY10 and to US16.7c from US15c in FY11.

Not all brokers reacted the same way however, as JP Morgan cut its numbers by 16% in FY10 and by 23% in FY11. JPM’s EPS estimates now stand at US6.7c and US9.8c respectively, while Credit Suisse lowered its EPS numbers by 8% and 2.6% to US9.2c and US13.2c respectively.

Along with the production report, the company also announced its plan to expand output from 35 million tonnes to 55 million tonnes has been approved, the increase to require an A$360 million expansion of Christmas Creek from its current six million tonnes to 23 million tonnes per year. To achieve this work on a rail spur, processing plant and mine infrastruture will begin in November and are scheduled for completion in early 2011.

According to Citi, this capex estimate will likely prove conservative, so the company’s ability to fund this expansion will be something the market is likely to focus on. The broker estimates cash on hand increased by $50 million in the quarter and now stands at US$704 million, with around US$500 million available to fund the expansion plans.

Things could change if the company is able to strike a financing deal with Chinese or other investors and Morgan Stanley suggests an agreement could be announced in the next six to 12 months. Such a deal is necessary if the company is to meet its longer-term goal of lifting production to an annual rate of 90-110 million tonnes.

But the collapse of the Chinese funding deal sees RBS Australia push out its timetable for the group to expand production by one to two years, which flows through to reductions in its implied scenario valuations, the result being a cut to its target price to $4.42 from $4.86 previously.

Overall, the FNArena database shows an average price target of $3.35, which compares to $3.39 prior to the quarterly report. The range of targets is wide, with JP Morgan the lowest at $1.95 and RBS Australia the most bullish with its $4.42 target.

This matches with the broker’s more bullish outlook as the database shows RBS Australia is the only broker with a Buy rating on the stock, compared to two Holds, one Avoid and five Sell ratings. Morgan Stanley is not part of the daily FNArena coverage, but it rates the stock as Underweight, compared to an In-Line industry rating.

Shares in Fortescue today are slightly weaker and as at 12.35pm the stock was down 4c at $3.86. Over the past year the shares have traded in a range of $1.16 to $4.75.

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