More Coverage, Another Sell On Fortescue

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

By Chris Shaw

Prior to Credit Suisse initiating coverage on Fortescue Metals ((FMG)) today the FNArena database showed a total of six Sell ratings and one Hold, so the broker’s decision to rate the stock as Underperform is no great surprise – it simply conforms with market consensus.

The broker’s rating comes despite it acknowledging the company has the potential to deliver a four-fold increase in production from current levels, an increase supported by not only the group’s low operating cost structure but financial support for such an expansion.

As well, Credit Suisse suggests the near-term outlook for iron ore is more indicative of upgrades to consensus prices rather than downgrades, an outcome it expects would flow through to increases to earnings forecasts for the company. If this occurs and the company’s proposed US$5-6 billion in additional funding from Chinese soures flows through, the broker sees scope for the share price to trade above $5.00, which would be well above its current price target of $4.21.

There is further upside depending on to what extent the company can lift its production, which is limited more by end-user demand than any difficulty in actually increasing the scale of the project, says Credit Suisse. The broker’s model suggests if output were to increase to more than 155 million tonnes per annum beyond 2015, as is planned, then its valuation would increase to something in the order of $9-$10 per share.

Such an increase is possible depending on the form of the financing coming from China, as the broker notes if equity can be issued that behaves like debt, such as redeemable preference shares, then the full amount could be used to increase output to something close to the 150 million tonnes per year level. The flip side is it would leave the company with gearing of around 87%, meaning an annual interest bill of somewhere around the US$700 million mark.

As a result the broker’s issue is, while the upside potential of the company is immense, so too are the risks associated with it, particularly given the highly geared capital structure in place. The other point Credit Suisse makes is while the group appears to have a good alignment with the Chinese, who are the major buyers of the company’s ore, they are very difficult to predict and remain a difficult customer to trust. This means while on face value the relationship appears favourable, it is no certainty things work out in a beneficial way for the company in the future.

This means the broker has taken a conservative view with respect to its valuation based price target, as while its model based on various scenarios can support valuations from $2.51 to $8.23, Credit Suisse has settled on a target of $4.21. Given this is below the current share price, the broker has initiated with an Underperform rating.

By way of comparison, the average price target according to the FNArena database stands at $3.10, which goes a long way to explaining why most brokers covering the stock have a negative rating. While all acknowledge there is upside potential, all also believe the share price doesn’t adequately reflect the risks involved.

Deutsche Bank explained in a recent note while the company appears to be taking the right steps to resolving its near-term cash flow issues, while still allowing production expansion to be achieved, this is more than priced in. This is why Deutsche Bank considers the stock as no more than a Sell at present.

Macquarie agrees, pointing out while the market is pricing the stock as if it is selling iron ore near current spot prices, the reality is sales are occurring closer to the new iron ore contract price, which caused Macquarie to reduce its earnings estimates last month. As with Deutsche Bank, Macquarie argues the stock is simply overpriced at present.

Shares in Fortescue today are weaker and as at 12.40pm the stock was down 9c at $4.32. This compares to a trading range over the past year of $1.16 to $8.20.

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