Fortescue Steadily Ticking The Boxes

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

By Greg Peel

Fortescue Metals ((FMG)) suddenly burst into investor consciousness back in 2007 when the contract price of iron ore was rocketing on Chinese demand. Previously the unexciting world of iron ore had been left to the majors BHP Billiton ((BHP)) and Rio Tinto ((RIO)) and few were aware of any other miners with a claim to Pilbara riches.

But with a bit of publicity from one stockbroking firm in particular, Fortescue was not only able to shake off the poor reputation of Andrew “Twiggy” Forest and his lack of success with Minara Resources, but overnight the junior miner became the Poseidon for a new age. And Twiggy became Australia's richest man – at least on paper.

In short, Fortescue could lay claim to large resources of Pilbara iron ore, and indeed resource estimates seemed to grow every month. Starstruck investors jumped on the bandwagon. The analyst fraternity was far from convinced. Sure, the company may have found at lot of iron ore but, as one veteran WA analyst suggested, “the Pilbara is made of iron ore”. Fortescue's real challenges had only just begun.

How was the company going to fund its projects? How would it get the iron ore to Port Hedland? How was it going to get the stuff onto a boat? Were its annual production targets anywhere near realistic? Mining is a game fraught with risks, delays and set-backs. Analysts simply shook their heads in wonder at the supposed naivety of the investor herd.

We have had a GFC in between, but for iron ore miners it was just a bad dream. Not only has the iron ore price returned to rocketing higher again on Chinese demand but after a long battle, BHP has managed to destroy the royal and ancient rules of annual contract pricing and bring seaborne sales prices closer to spot via quarterly deals. By default, Fortescue is also a winner.

Yet the recent move toward a 100% or more increase in the iron ore price has focused the market's attention once again on bulk materials and junior miners, but not so much on Fortescue. In the last six months, Fortescue's share price has rallied 30% but stocks such as Mount Gibson Iron ((MGX)) and Atlas Iron ((AGO)) have rallied 60%.

[By comparison, BHP has rallied 10% but it is a diversified miner with a finger in every pie, while Rio, in its diversity slightly more leveraged to iron ore, has managed 20%.]

It is not obvious why Fortescue has gone out of favour but a simple explanation is that the stock had already re-rated. Investors had heard Twiggy talk the talk, and responded accordingly, and now they need to see him walk the walk. Infrastructure seemed the main hurdle first up but things have progressed on that front. Funding then became a life threatening issue at the depths of the GFC but the Chinese have stepped in with bit of help there. So all that really remains is for Fortescue to deliver on its ambitious production targets. Investors have been cautious on this issue recently as share price underperformance would suggest.

So yesterday's March quarter production report from the miner was pretty important. The iron ore price might be going through the roof but can Fortescue actually capitalise?

The first thing an investor must appreciate is that mining company analysis involves a lot of dart boards. Within the production report were figures for ore produced, ore processed, ore shipped, the realised price of ore shipped and the cost of getting to that point, as well as guidance for ongoing mine-life, infrastructure progress, capital expenditure estimates and operational expenditure estimates.

For each of those figures, analysts must come up with a forecast. Suffice to say a spread of forecasts is the result. So for each number announced yesterday, analysts found them either in-line, above or below forecast which informs their subsequent changes to earnings forecasts and valuation.

No more is the dart board effect evident than in the range of target prices in the FNArena database. For an average of $5.74, targets range from $4.35 to $7.31.

Here are the real numbers: Fortescue mined 10.4Mt of ore, up 14% for the quarter. It processed 9.0Mt (down 4%) and shipped 9.4Mt (up 4%). While the production level shows Fortescue is averaging around the planned 40Mtpa at present, the low processing figure is a result of hitting denser ore which is full of manganese. This slows things down, and at present the company only has small crushers when a big one is needed, although a big one is on the way.

The hard ore is a set-back because it means an increase to operating expenses over the “life of mine”. In the meantime, FMG's cash cost increased by 7% over the period to US$29.40/t. Management suggests costs will exceed US$30/t in the second half of 2010. Citi analysts are expecting US$37/t in 2011.

The good news is that the realised price FMG attained for its ore was US$67/t, up 19% from the US$56/t achieved in the previous quarter. This surprised brokers because management had warned, as the spot iron ore price was spiralling upwards, that contracts prevented the company from selling much ore on the spot market. This is another likely reason Fortescue's share price has been held back.

Fortescue also confirmed that it would be moving to a quarterly-based contract pricing arrangement, a la BHP, which means analysts are now free to assume significant price rises which should first be apparent from the June quarter.

The bad news is that forecast capital expenditure to get to the intended interim production target of 55Mtpa in 2011 has increased by 75% to $500m. That expansion has been delayed, and analysts are assuming it is 3-6 months behind schedule. Most analysts had nevertheless already assumed an increase as an inevitable flow-on from commodity price increases, and delays are always assumed by conservative analysts.

Because Fortescue's realised iron ore price is set to jump so sharply in coming quarters, analysts are now happy to suggest the company will generate enough cash to deal with capex increases and also to reduce the lingering problem of high gearing on the balance sheet – another share price inhibitor. What's more, iron ore prices don't look like plunging again any time soon so the ultimate goal of a 95Mt production level is also more realistic now.

So weighing up all the pros and cons, the general feeling was that this was a solid result. But is it one that should render FMG's share price cheap at this point?

Four out of eight brokers in the FNArena database covering FMG believe so. That $7.31 high-marker target price belongs to RBS (Buy) and this is what the analysts had to say:

“FMG has been left behind in the recent rally in mining stocks, and has also underperformed iron ore spot prices. The stock is trading 46% below our NPV for a 95Mtpa rate, which will soon form the base case for the company, in our view. The company offers strong production growth, along with considerable value and remains one of our key picks in the sector.”

Credit Suisse (Outperform, $6.00) sees the investment case as:

“Proven ability to discover, finance, develop, mine and market iron ore, with a ground position and iron ore endowment to support long-term production and earnings growth, subject to market demand.”

Such a view from CS is in stark contrast to the initial doubts many analysts had about Twiggy's bold claims a few years ago, operationally speaking.

Citi (Buy, $6.30) is also positive, as is UBS (Buy, $6.00).

The other four brokers all have Hold ratings. They believe that iron ore price rises aside, the market has already priced a successful expansion to production of 95Mt. Yet as this production report shows, there are ever present risks of delays and ominously rising costs and capital expenditure requirements as well as an increasing operational expense from reaching harder ore.

In this group are Deutsche Bank (Hold, $5.20), Macquarie (Neutral, $5.00), and low-market JP Morgan (Neutral, $4.35). JPM took the biggest knife to its target following the production report, dropping it from $4.95. Interestingly, GSJB Were has a Hold rating if for no other reason than “we see no reason to be underweight”. But at $6.87, Were's target is the second highest in the database.

So it's a difficult one for prospective investors. On the one hand, RBS suggests FMG is trading at a 46% discount to an achievable 95Mtpa target. On the other, Macquarie, for one, suggests the market is already pricing in 95Mtpa and ignoring inevitable risks. What is probably certain is that FMG had run a lot of its race prior to the GFC and so the onus is on the company to match expectations let alone produce surprises.

It will be a game played in quarters.

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