Fortescue Upside Linked To Targets, Iron Ore Prices

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– Fortescue result meets consensus expectations
– Cost guidance increased, earnings forecasts trimmed
– Production guidance maintained, brokers factor in some slippage
– Buy ratings continue to dominate

By Chris Shaw

Full year underlying earnings for iron ore play Fortescue Metals ((FMG)) came in at US$1,634 million, a significant increase from the US$707 million earned for the same period last year. The result was broadly in line with consensus estimates, UBS noting this was no surprise given some revenue and costs numbers had previously been advised to the market.

One feature of the result for Goldman Sachs was an increase in costs, with Fortescue indicating operating costs are likely to remain around the US$50 per tonne level for the immediate future. Higher stripping ratios for Fortescue should mean ongoing higher structural unit costs than for the likes of BHP Billiton ((BHP)) and Rio Tinto ((RIO)), notes Goldman Sachs.

Factoring in higher unit costs has seen cuts to earnings estimates for Fortescue, UBS lowering its numbers in coming years by 5-8%. UBS's valuation has also been lowered by 5% to $8.18. Citi similarly trimmed its FY12 earnings estimate by 4% to account for the increase in cost guidance, noting costs are unlikely to come down much prior to the Solomon project coming on-line in 2013/14.

Even adjusting for higher costs, Citi sees solid upside risk to earnings from continued strength in iron ore prices, estimating potential upside of as much as 40% in FY13 and 80% in FY14 based on current spot prices.

Fortescue continues to guide to a production target of 155 million tonnes per annum in coming years, with management currently indicating this target should be achieved by 2013. The market is taking a more cautious view, JP Morgan factoring in a two-year delay relative to this target and Citi building in related capex assumptions of US$10 billion compared to management's forecast of US$8.4 billion.

Gaining a 5th berth at Port Headland remains a key to achieving production targets notes Citi, as its numbers suggest consistently achieving more than 140 million tonnes per year will be difficult with only four berths at the port. 

Deutsche notes Fortescue intends to deal with the problem by using wider shops and faster loading to still reach 155 million tonnes in shipments, but this is seen as optimistic given movement constraints in the harbour.

Assuming production growth guidance is achieved, Morgan Stanley sees upside, pointing out its base case valuation of $7.50 attributes risk weightings of 90% and 60% respectively for the Chichester and Solomon projects. If 100% risk weightings were assumed, the stockbroker's valuation would increase by 50c and $1.90 per share respectively.

Given Fortescue's leverage to iron ore prices and the fact expansion plans remain on track, Macquarie suggests valuation is undemanding at current levels. The rest of the market agrees, as the FNArena database shows Fortescue is rated Buy by seven of the eight brokers to cover the stock as well as by Goldman Sachs and Morgan Stanley. The latter is within an Attractive view on the Australian Metals and Mining sector.

The exception to the Buy ratings is Deutsche Bank, which viewed the higher mining and capex costs and the berth 5 negotiations as additional uncertainties for Fortescue. This implies some downside risk to both valuation and shipping rate expectations, while earnings in coming years have been cut to account for higher mining costs.

On Deutsche's numbers, Fortescue is only likely to hit 146 million tonnes in shipments by FY17. Assuming this is not achieved and total shipments only reach 130 million tonnes, Deutsche's valuation would fall to around $5.00 per share from a current $5.86.

The consensus price target for Fortescue according to the FNArena database is $7.97, down from $8.14 prior to the profit result. Targets range from Deutsche at $5.85 to Macquarie at $9.10.

Shares in Fortescue have displayed an annual trading range of $4.33 to $7.34. The current share price implies upside of almost 38% relative to the consensus price target in FNArena's database.

 

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