Material Matters: Iron Ore Value, Steel And Fertliser

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

By Chris Shaw

Share price outperformance is expected is in the Australian iron ore plays according to RBS Australia. The broker suggests the sector in general has been oversold on concerns over the global growth outlook and uncertainties surrounding the proposed resources super tax (RSPT).

RBS Australia points out while spot iron ore prices have fallen 27% to US$120 per tonne over the past month, the decline comes despite still strong Chinese imports. Chinese iron ore imports are running about the same rate of 631 million tonnes annually as in 2009, while steel production in China this year is running at an annualised rate of about 640 million tonnes. This is up 14% on 2009 levels.

With iron ore prices having come back of late RBS suggests Chinese buyers may start to show increased interest in higher quality imports over domestic production, a trend it suggests would support prices around current levels.

This implies ongoing strong margins in the mining industry, as forecast cash costs on the broker's numbers are around US$20 per tonne for BHP Billiton ((BHP)) and Rio Tinto ((RIO)), about US$30 per tonne for Fortescue Metals ((FMG)) and US$45-$55 per tonne for Mount Gibson ((MGX)) and Atlas Iron ((AGO)).

The iron ore price falls have been matched by share price falls in the sector, with some stocks having fallen by more than 30% from recent highs. Even allowing for the proposed RSPT, RBS estimates BHP, Rio Tinto, Fortescue and Mount Gibson are all currently trading at a greater than 20% discount to net present value.

This value, plus signs the Australian dollar is holding around US82-83c and with commodity prices stabilising, leads RBS to suggest there is an increasing chance confidence returns and buyers re-enter some stocks.

RBS's preferred exposure is Fortescue given the combination of 35% upside to net present value and forecast strong production growth. While both BHP and Rio Tinto are also rated as Buys the broker suggests their diversified nature means the more leveraged plays such as Fortescue may outperform.

RBS also rates Mount Gibson as a Buy and is its preferred exposure among the juniors, while it has a Hold rating on Atlas Iron. Overall, the FNArena database shows Sentiment Indicator readings of 0.5 for Fortescue, 0.8 for BHP Billiton, 0.9 for Rio Tinto, 0.4 for Mount Gibson and 0.0 for Atlas Iron.

As UBS notes, world steel production is important for raw material markets as it directly influences demand for the likes of iron ore, coking coal, nickel, manganese and chromium. Higher than expected steel capacity and production are positives for the raw material producers such as iron ore and coking coal, while there are corresponding negative implications for the steel producers according to the broker.

With this in mind UBS paid close attention to April World Steel Association data for April, which showed global steel production of 121.65 million tonnes for the month. Steel capacity utilisation for the same month was 83.4%, which implies global capacity of around 1,775 million tonnes.

This implies global capacity growth has been rising by more than 5% in year-on-year terms for the last seven months, while UBS estimates global steel production has grown 31% in year-on-year terms so far this year. This is well above its forecast of around 12% growth.

Some of the near-term production increase may be the result of seasonal factors in UBS's view, as historical figures show production growth tends to be stronger in the first half of the calendar year than in the second.

UBS notes longer-term that China continues to reveal policies aimed at shutting down some steel production capacity. To date these efforts have had limited success however, so UBS's review of global steel output appears to add weight to the RBS Australia view there is some value in Australian iron ore producers at current levels.

Moving from hard commodities to soft, key US fertiliser group Monsanto has reduced gross profit and earnings per share guidance for FY10 by about 50% and 22% respectively. The company has indicated the changes to guidance reflect overcapacity in China in particular, which is pressuring volume and prices in global glyphosate markets.

In the view of Credit Suisse, the update by Monsanto is acknowledgement of a structural decline in glyphosate markets as the volume and price pressures being experienced are resulting in margin compression.

As Credit Suisse points out, this has implications for Australian fertiliser play Nufarm ((NUF)) as the company is the second largest global distributor of glyphosate behind Monsanto. With Monsanto moving to cut branded price premiums to near to the level of generic suppliers, both Credit Suisse and UBS suggest the market is likely to face an extended period of price competition.

While Nufarm management has reiterated FY10 earnings guidance on the back of the Monsanto announcement, Credit Suisse has been more conservative and cut its earnings per share (EPS) forecasts. The broker now expects EPS of 40.3c this year and 52.5c in FY11, which implies cuts of 9% and almost 6% respectively to its previous numbers.

UBS has similarly cut its forecasts to 37c and 60c in FY10 and FY11, while consensus EPS forecasts according to the FNArena database stand at 41.8c and 60.2c respectively. The database shows Nufarm is rated as Buy once, Hold four times and Sell four times.

Deutsche Bank is one to rate the stock a Sell, pointing out its forecasts remain well below earnings guidance for this year. This downside risk to earnings suggests little chance of share price outperformance for Nufarm in the shorter-term.

By contrast, Credit Suisse notes North American feriliser inventory levels fell in April in both urea and diammonium phosphate (DAP) due to favourable weather, restocking, and a return to normal feriliser application rates. DAP inventories remain 32% below the five-year average. Credi Suisse continues to see upside risk to its US$390/t FY10 average DAP price assumption.

This is positive for Incitec Pivot ((IPL)), to which the broker remains "favourably disposed". Incitec currently draws five Buy ratings in the FNArena database against two Holds and a Sell, with an average target price of $3.62.

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