Cashflow Earns Fortescue Some Respect

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

By Greg Peel

Fortescue Metals ((FMG)) has proven an enigmatic investment proposition from the get-go. Having burst on to the scene late in the pre-GFC mining boom with promises of untold iron ore riches, Fortescue's initial Poseidon-like rise polarised analysts.

No one denied that the market for iron ore had taken off parabolically as China revved the engines, nor that Fortescue was sitting on impressive reserves of ore. But the production goals espoused by gregarious magnate twiggy Forest seemed extraordinarily ambitious, and where on earth was the company going to get the money to fund them?

It was not a stretch for Forrest to announce further ore reserve upgrades with every company update, given, as one veteran WA mining analysts put it, that the Pilbara is quite simply made of iron ore. But without a railway line, without a port facility, with nothing much more than a lot of rock sitting out in the back of beyond, most analysts preferred to be healthily sceptical. They acknowledged the potential, but applied a lot of risk discounting to Fortescue's production plans. With the share price running away on an investor frenzy, it wasn't hard to apply a Sell recommendation.

To this day, two Sell recommendations remain among the nine brokers in the FNArena database covering the stock, and the reasons for those ratings has not much changed despite the rollercoaster ride through the GFC and out again. But Fortescue now has railway access and a port facility, investment funding from the Chinese and the market in general, and is producing and selling iron ore. Slowly but surely Twiggy has been knocking down the Doubting Thomases.

Which is largely the reason why Fortescue can now boast four Buy ratings in the FNArena database, to accompany the two Holds which make up the balance. One of those Buy ratings comes from Goldman Sachs which this morning upgraded. Realistically, it's all about cash.

Friday's FY10 profit result from Fortescue was a messy one, requiring analysts to dig through the numbers and adjust for tax rate and interest expense differences before announcing that the result basically beat consensus estimates by some 10%. What was most notable, however, is that the cash is now pouring in. Sustained high iron ore prices and rising production volumes mean FMG has now exceeded its debt covenant requirements. Twiggy may remain a larger than life caricature of a dust-covered, go-for-broke mining entrepreneur, but as BA-Merrill Lynch put it this morning, Fortescue has now achieved an “air of respectability”.

In other words, we can no longer smirk at the raving Ranga and his quixotic plans for Australia's third iron ore empire. The actual results are starting to stack up.

As to whether FMG is a Buy or a Sell, nevertheless, requires comparing its stock price to valuations that can quite simply vary wildly depending on what assumptions one makes. To put this into perspective, consider that FNArena's Stock Analysis service shows forecast FY11 earnings per share ranging from 35.5c (Credit Suisse: Underperform) to 58.0c (Citi: Buy) and FY12 ranging from 35.1c (Credit Suisse) to 72.8c (Merrills: Buy).

Twelve month stock price targets average $5.01, or 6% above today's level, but range from $4.35 to $5.80. The high price belongs to Citi, but the low price belongs not to the obvious Credit Suisse but to Deutsche Bank (Hold).

How does the humble investor interpret that spread of calculations?

Well given Fortescue does one thing and one thing only – mine iron ore – it's no leap of logic to appreciate that EPS forecasts vary dependent on analyst iron ore price forecasts. And the iron ore price is proving more enigmatic than Fortescue itself. Having achieved a major coup via BHP Billiton's ((BHP)) success in forcing Asian customers into quarterly contract pricing, recent global economic weakness, including deliberate slowing from China, along with a falling iron ore spot price, has had analysts suggesting the “coup” might come back and bite Australia's iron ore producers on the backside. Expectations have recently been for lower contract prices in the September and December quarters and maybe beyond. Right now the world just doesn't need that much steel.

Or does it? Citi notes that spot iron ore prices in China have now “rocketed” back up to around US$155/t, surpassing the analysts' US$130/t forecast for FY11. In upgrading Fortescue to Buy this morning, Goldman Sachs noted the analysts were forecasting strong iron ore prices for the next two years.

But Goldmans also noted growing steel production intensity in China, which would eventually see that industry “mature” after a few more years while global iron ore production is still growing. At that point iron ore prices must fall, such that the winners will be those producers with low production costs and strong balance sheets. Clearly BHP is in that camp, and maybe even Rio now, but Fortescue?

That's why Goldmans provides a caveat with regards to the way in which Fortescue executes its expansion and funding. If the company is too aggressive and over-levers, look out. Or to use Goldmans' words, shareholders will need to be “nimble in their actions”.

As to whether Fortescue can actually achieve its ambitious expansion goals is still as much of a debate among analysts as it was before Twiggy's first rock arrived at Port Hedland. The fact that FY10 saw the company achieving some US$60/t in margin on its iron ore revenues, which allowed it to pull in significant amounts of cash, goes a long way to offering confirmation. But then there is still a long way to go.

The first target of 55mtpa looks safe now. The next target of 95mtp is still questionable. Once again, its not about the iron ore. Chichester has the capacity to expand to 80mtpa and Solomon 40mtpa. But where will the money come from? Goldmans suggests internal cash generation should see the 95mtpa achievable, but anything beyond that would require additional external capital and if Fortescue can't find it, the company is “at risk”.

On the other hand, JP Morgan for example has a Neutral rating because it is not yet convinced of anything beyond 55mtpa in the time frame suggested.

The sceptics at Credit Suisse further warn that the market is not taking into account how much of that lovely cash currently being generated will be absorbed by “capex creep”. This has nothing to do with new capex requirements, rather the costs involved in maintaining and enhancing existing capacity.

Citi suggests debt funding could deliver 155mtpa of production by 2014, but the need to manage two major projects is a “significant” constraint before one even looks at restrictions on port allocation and a tight labour market in WA.

To give you an idea of just what sort of a roll of the dice a Fortescue valuation can be, Credit Suisse acknowledges that FMG offers “unparalleled” valuation leverage to the iron ore price, but that the analysts' model can generate a net present value for the stock of a mere 49c on a mid-cycle scenario through to $11.84 if today's spot prices continue in perpetuity.

Macquarie (Underperform) doesn't need to argue whether Fortescue can or can't, it is simply arguing that the “can” is already priced in. On the other hand, RBA Australia (Buy) suggests FMG's current share price is at a “significant” discount to the analysts' net present value calculation, and that FMG can deliver superior production growth in the medium term to the two majors.

It's no wonder Merrills ascribes a “High” risk volatility rating to FMG. For the punters, it's a play on the iron ore price with tremendous upside potentially available as long as either that price doesn't collapse (as it did in late 2008) and as long as Twiggy doesn't get too carried away and tilts at windmills.

There is also the small matter of what some consider a “call option” embedded in FMG at present. Were the Coalition to form a government, one assumes it will stick to its original policy of completely scrapping any idea of a mining tax. While BHP, Rio Tinto ((RIO)) and Xstrata have declared themselves happy with the MRRT, Twiggy has continued his campaign against the tax suggesting the smaller miners have been given short shrift. Thus one assumes a Coalition victory should mean a jump in the FMG share price.

But neither Tony Windsor or Rob Oakeshot are opposed to a mining tax, even if Bob Katter is. That means we're still in limbo over both who will form a government and just what the policy concessions might be.

For investors, Fortescue simply remains a high risk/high reward proposition.

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