Fortescue Cops An Underperform

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This story features FORTESCUE LIMITED, and other companies.
For more info SHARE ANALYSIS: FMG
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

It has a touch of the Poseidons about it, but in this case no one’s challenging the existence of actual reserves. Fortescue Metals Group ((FMG)) has gone from obscurity to front page headlines in the short space of a year or so, which is extraordinary when you realise the company can become the world’s fourth largest iron ore producer behind BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Brazil’s CVRD. Third if the former two merge.

Until this morning only one broker in the FNArena database had chosen to cover Fortescue. JP Morgan initiated coverage with a Neutral rating in October 2006 and a target price of $10.55. Friday’s closing price was $58.50. JPM has maintained Neutral over that time, but the analysts have since ratcheted up the target price to $45.00. That’s still 23% under the trading price, which under most normal circumstances would dictate an Underweight from JPM or any other broker. But the Fortescue story is compelling, for its potential is enormous. The only problem is you can own all the iron ore in the world but it’s no good if you can’t get it to market.

And Fortescue might have made its CEO Andrew “Twiggy” Forest Australia’s third richest individual, the reality is it has not yet sold one rock.

Fortescue has many hurdles to overcome, but its most pressing is infrastructure. It’s astonishing to think that a company such as Macarthur Coal ((MCC)) should see its earnings wallowing when global coal demand has never been stronger. Macarthur isn’t suffering from production problems – it just can’t get its coal down the railway line and onto a ship as fast as it can dig the stuff up. The company still doesn’t know what sort of port access allocation it’s going to score in 2008. And its coal mines are but a spitting distance from the Queensland coast. Fortescue’s proposed mines are over 300km from the coast, in Western Australia’s Pilbara region.

And in the absolute middle of nowhere.

This means that Fortescue has had to start from scratch. Not only does it need to build mines and associated infrastructure, it has to build a town for the workers, a railway line to Port Hedland, and a port facility that can cope. Fortescue’s tenements cover some 40,000 square kilometres. A railway line is currently being constructed, but has already been beset with the usual problems one might expect when building something in outback Australia during a mining boom. Costs have blown out substantially, and progress was seriously impeded during the last cyclone season. Unfortunately for Fortescue, the weather bureau expects this year’s cyclone season to be worse than the last.

And one railway line is not going to cut it anyway. Fortescue’s reserves are located across a vast area. This is where BHP and Rio come into the picture.

Both BHP and Rio own railway lines which they built to service their own Pilbara iron ore operations. Some of Fortescue’s most promising reserves actually lie closer to one or other of these railway lines than the one the company is building for itself. The obvious thing to do would be to save money by paying a fee to use the competitors’ lines rather than building more. However, BHP and Rio are not just going to roll over.

For BHP and Rio have the same problem as everyone else – they are both battling to get as much iron ore as they can down their own lines, let alone freeing up space for a competitor to have a go. It doesn’t really matter what fee they might be able to charge. But in a move that could have come straight out of Ayn Rand’s “Atlas Shrugged”, Twiggy Forest wants to take BHP and Rio to court and make them provide access for Fortescue ore. It doesn’t matter that the big two went to all the trouble and expense to build that infrastructure in the first place, not bowing to Fortescue’s demands is anti-competitive as far as Twiggy is concerned.

Which is why he is seriously hoping the BHP-Rio merger eventuates. If it’s just little Fortescue up against a Broken Hill Tinto leviathan, Forest believes there’s a much better chance the ACCC will see things his way.

A merger between BHP and Rio, assuming it does actually happen, could take 12-18 months to achieve. That’s not so much of a problem for Fortescue, as the major expansion of its iron ore production is realistically not going to happen before 2013. That’s six years away. There’s an awful lot that could transpire in six years.

In the meantime, Fortescue is hoping to get its first ore to market in 2008. The plan is to rapidly push production to 120Mtpa by 2011. Then it hopes to increase by a further 80Mtpa to achieve 200Mtpa by 2013-15. And there is the small matter of the other billion tonnes of ore the prospectors stumbled across last week. There is no problem about selling the stuff – China’s steel giants Baosteel and Tangshan, for example, have already signed up for long term supply. And there’s supposedly no reason to expect the global iron ore price won’t remain elevated at current levels for a long time yet – right through 2013 and beyond. Supposedly.

So Fortescue’s biggest problem remains the question of infrastructure. But there’s also another problem.

The company plans to adopt a mining method known as “surface mining”. This method has never been tested for a large scale iron ore operation. So apart from skyrocketing costs, the railway problem, and rising Aussie dollar and destructive weather, Fortescue is yet to prove it really can reach the sort of production levels it anticipates.

Macquarie initiated coverage of Fortescue this morning. The analysts acknowledge that the company is “on the cusp” of entering a highly lucrative market, and they have already pencilled in a 50% increase in the global iron ore price come the end of next year’s price negotiations. But can a price of $58 be justified? Not in Macquarie’s reckoning.

There are just so many risks to balance out the potential rewards. One definitive element of the great commodities boom is that the market has often pushed the value of resource company shares to levels which assume current spot prices forever, and ramp-up targets that are incontrovertible. But time and time again those investors have been disappointed when production schedules meet inevitable setbacks and cost overruns. Such problems are as certain as the day is long. Take a company such as uranium miner Paladin Resources ((PDN)) for example. The market pushed Paladin’s share price over $10 on the euphoria of ever-rising uranium prices and a trouble-free ramp up of the company’s Namibian operations. It was ultimately wrong on both counts, and Paladin’s share price quickly halved before recovering once more.

This is the scenario Macquarie analysts are taking into account for Fortescue. On that basis, the analysts have set a price target of $35.57. As that’s 39% under the current trading price, they can do no more than set an Underperform rating. And Macquarie is arguably the most bullish in the market on iron ore price assumptions, expecting a full 50% increase. This is more than JP Morgan is prepared to believe, yet JPM has set a higher target for Fortescue.

The other driving factor behind the Fortescue share price is, of course, industry consolidation. When BHP announced its intentions for Rio, a dozing giant was reawakened. Suddenly takeovers were back in the frame, having taken a breather as the credit crunch unfolded. Baosteel seems the obvious candidate to cut the malarky and simply buy Fortescue outright. Rumours to that effect abound. Macquarie acknowledges Fortescue will likely be taken out at some point, but it is still not prepared to apply a stronger valuation than it has. And that’s despite the Rio share price having jumped from $80 to over $130 since August.

So for those looking to jump on the fabulous Fortescue bandwagon, analysts are offering a warning. The ship has sailed, and if you weren’t on it then that’s shame, but it would not be advisable to try to get on now. At least as far as JP Morgan and Macquarie are concerned.

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