Brokers Cut Fortescue Earnings Expectations

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

-Price discounts problematic
-Downside pressure on earnings
-Detrital ore key to lower price
 

By Eva Brocklehurst

Fortescue Metals ((FMG)) has had a hair cut. The company shipped 124 million tonnes of iron ore in FY14, around 3mt short of guidance. That is not all. Brokers are most concerned about the discounts the company had to endure in the final quarter.

The 58% iron index has steepened in its discount to the benchmark 62% index materially since May. This indicates that demand has weakened for the 58% material coinciding with an increase in supply. Fortescue Metals did not provide any commentary regarding the reasons for the larger-than-expected discount or how long the wider discounts are expected to stay in place. The average realised price of US$106/t pre-discount for FY14 implies an average selling price in the June quarter of around US$81/t. The price Fortescue received is US$22/t lower than the average 62% iron benchmark price. 

Shipments reconcile with UBS' estimates as the broker never expected the company to reach guidance. Still, the ramp up of production has progressed well. Citi believes the company needs to maintain consistency in its production but the risk that the infrastructure could not handle 155mtpa is receding significantly. The fact that nameplate capacity was reached and exceeded in the quarter also gives Morgan Stanley more confidence in future volumes. Still, the broker remains cautious on price and retains an Underweight rating.

Production is not the problem. It is price. The ramp up to 155mtpa was an impressive feat, in CIMB's view, despite iron ore price and Australian dollar headwinds. At the spot price, the company's margins are positive. If low prices persist there is clear risk to Fortescue's earnings, in CIMB's estimation. The broker expects the discount will narrow over the medium term but the downside risk remains clear, with margins coming under real pressure. Despite these being preliminary figures – the production report is due out on July 16 – CIMB was concerned enough to downgrade to Hold from Add.

UBS did expect the price discount to widen, particularly for Fortescue Metals, as the initial King's product was high silica detrital ore, which attracts a bigger discount compared with the rest of the company's products. Detrital ore is expected to cease this month and the more standard product will then be delivered. Despite this, the level of discounting does raise concerns for realised prices – and the wider iron ore sector. The low price is difficult to reconcile for Credit Suisse. The broker acknowledges the discounts for low grades expanded in late May, so only the June loadings should have been affected. Still, questions remain and the broker looks forward to further clarification later in the week.

Citi has downgraded earnings forecasts, not only to account for the production/pricing but also higher Australian dollar forecasts. The broker suspects the increased discounting reflects a move to delivered pricing across the industry in order to reduce price risks in an over-supplied market. The broker envisages structural challenges to the iron ore market in 2015 and 2016 as seaborne supply increases. The key question is how readily high-cost supply, notably Chinese domestic supply, exits the market. Based on the latest information BA-Merrill Lynch has also reduced FY14 revenue estimates by 3.5% and earnings by 5%.

The news was disappointing but not unexpected and JP Morgan does not expect one weak quarter to make a substantial difference to Fortescue's price realisation, although ample supply could ensure discounts are maintained at wider spreads over the near term. The implied quality discount is 16% compared to the prior quarter's 6%. Over time the broker thinks the discount will return to the historical average – typically 5% after grade adjustments. The broker acknowledges the company's ability to pay down debt but that is now happening at a slower rate. Nevertheless, JP Morgan is happy to retain an Overweight rating as the stock offers 20% potential upside to valuation on the broker's target. Investor confidence may have taken a hit recently but the broker does not think this is permanent.

On FNArena's database Fortescue Metals attracts four Buy and four Hold ratings. The consensus target is $5.19 which signals 19.7% upside to the last share price. The dividend yield on FY14 and FY15 forecasts is 4.4% and 5.1% respectively.
 

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