Treasure Chest: Value Returning To Fortescue

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Two brokers have upgraded Fortescue metals to Buy from Sell, seeing value now apparent in the iron ore miner.

– Iron ore price stabilising?
– Fortescue share price fallen sharply
– Low cost production supports cash flow and dividends
 

By Greg Peel

Shaw & Partners notes Fortescue Metals’ ((FMG)) earnings trajectory has now rolled over to the downside following “a flurry of recent iron ore price adjustments”. Bell Potter has cut forecast earnings by -16% and -19% in FY17-18 and cut dividend forecasts by -10% and -9% respectively.

Both have upgraded the stock to Buy.

Neither are FNArena database brokers. The most recent update from a database broker came from Citi a week ago, who downgraded to Sell based on a bearish outlook for the iron ore price. The broker noted Chinese port inventories have been building and more low-cost supply is coming on to the market. The broker also estimates a price below US$50/t is required to close down high-cost Chinese domestic production.

Fortescue produces lower grade ore than BHP Billiton ((BHP)), Rio Tinto ((RIO)), Roy Hill and Vale. Price discounts for lower grade ore have widened in recent times and while this is more cyclical than structural, Citi believes wider discounts could yet remain in place for some time.

Credit Suisse agrees with Citi’s thesis. But CS sees Fortescue’s realised prices for its ore rising back to normal levels. The broker retains Outperform. Morgans agrees with CS on the realised price argument, and suggests the factors driving wider discounts for lower grade ore are beginning to reverse. Morgans upgraded to Add mid-June.

Shaw’s analysis suggests to the broker the iron ore price may be forming a base and Fortescue’s earnings trajectory should follow suit. After a -40% drop in share price, mimicking the drop in the iron ore price from earlier in the year, Shaw believes Fortescue is now offering value.

Not only has Shaw upgraded to Buy, but it has “double-upgraded” straight from Sell.

Bell Potter remains “wary” of the iron ore price and agrees concerns over the ramp-up of high grade production at Roy Hill in the Pilbara and Vale’s S11D in Brazil is causing concern. Elevated Chinese stockpiles are also a concern, but Bells believes this reflects an increase in Chinese exports as high-cost domestic production is indeed cut back.

On the demand side, steel prices and production remain robust, with manufacturing PMIs across key global economies remaining in expansion territory. The broker also notes the removal of 100mt of the most expensive production, keeping the high end of the cost curve well above US$50/t.

The cost curve is the important element. Fortescue may be looking at lower iron ore prices translating into lower earnings and dividends but the miner’s low cost of production supports ongoing strong free cash flows through the cycle and a robust balance sheet backs up dividends. Even after forecast cuts, Fortescue is offering a 6% yield (9% after franking) on Bell Potter’s numbers. The fall in share price has brought valuation back to an attractive level.

Bells has cut its target to $5.55 from $5.75, which is still well above the current share price. Hence the broker has also “double-upgraded” to Buy from Sell.

Shaw has set a target of $5.50.

When Citi downgraded to Sell last week the broker cut its target to $3.90 from $5.80. Citi is alone in its Sell rating, with the database otherwise showing four Buy and three Hold (or equivalent) ratings. The consensus target is $5.67 despite Citi’s sharp downgrade, but high marker UBS ($7.00) has not updated since April.

With the quarter coming to a close, brokers are currently readdressing their commodity prices forecasts and miners, Fortescue included, will shortly be releasing quarterly production and sales reports.

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