Fortescue At Whim Of Iron Ore Price

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

-Cost sustainability uncertain
-Capex outlays also queried
-Will strip targets affect grade?
 

By Eva Brocklehurst

Fortescue Metals ((FMG)) may have honed its strategy in terms of digging up the dirt but its fortunes, or otherwise, remain predicated on the outlook for iron ore prices. The more bearish the forecasts for the iron ore price the more bearish the broker on the stock.

June quarter production numbers were strong, with shipments of 42.4m tonnes. FY15 shipments of 165.4mt met guidance, while costs were around US$27/wmt. The realised iron ore price in the quarter was US$53/dmt. Guidance was maintained at 165mtpa for FY16. Nevertheless, of most interest was the ability of the company to continue to reduce its strip ratios and, hence, lower its costs.

The strip ratio refers to the amount of waste rock the miner has to remove before getting to the ore. Fortescue Metals has revised life-of-mine strip ratios and expects over the next 20 years the Chichester hub can average 2.3 tonnes and Solomon hub 1.7 tonnes. That is 2.3 and 1.7 tonnes of waste respectively for every 1.0 tonne of ore extracted.

Credit Suisse emphasises that 85% of product is beneficiated and blended across operations, a fundamentally different prospect to that which Fortescue originally operated. The broker is convinced Fortescue Metals can sustain cost savings. What is less convincing is whether it can sustain capital expenditure at $2/t for any extended period. Credit Suisse upgrades to Outperform from Underperform because the share price has corrected by 25% in the past month.

The production report may be a positive in the face of weak iron ore prices but Morgans remains cautious, given the risk for prolonged price weakness. The broker accepts the company is doing all it can to reduce costs and maintain a competitive edge but, as costs drop so does the iron ore price, and the net gain appears largely negated at present. At US$55/t for iron ore the broker considers the company’s operating margin is heavily restricted.

Strip ratios may be dropping but Morgans is not sure whether the market believes in the improvements. Or maybe the issue is more about how the longer-term mine plan will be affected. Either way, the broker considers it prudent to retain a Hold rating. Deutsche Bank notes the strip ratio is now below rival Rio Tinto’s ((RIO)) and, while the company does not expect a material impact on reserves, assumes this means tonnage and not product grade.

Deutsche Bank continues to believe that over time product grade will suffer as a result of lowering the cut-off grade at Chichester and chasing lower strip, near-surface deposits along strike such as the Kangaroo pit at Cloudbreak. Deutsche Bank remains in the Sell camp, given the current valuation and still-high debt levels.

Citi is bearish on the iron ore price, expecting it to fall below US$40/t by the end of the year. No surprise the broker remains in the Sell camp too, while acknowledging the company is controlling what it can. Citi expects costs to fall in FY16 and FY17 driven by an Australian dollar forecast of US71c.

The break-even, all-in cost target for Fortescue is US$39/t, effectively where the broker believes the iron ore price will be. Hence, a small cash burn of around US$400m is expected over the next two years assuming no pre-payments are rolled over.

There is a similar view over at JP Morgan. Margin benefits from falling costs are likely to be eroded by continuing price pressure. Moreover, while backing the company to achieve on its cost targets in the short term, the broker does not consider these sustainable at the life-of-mine strip ratios. UBS, in contrast, appears more comfortable with the company’s strategy, selective mining and focus on costs.

At present, while there are more marginal players on the cost curve the company may be able to make margin and pay down debt, but UBS acknowledges this expectation is based on an assumption iron ore prices stay above US$50/dmt. The broker follows a similar path to Credit Suisse, upgrading its rating to Neutral from Sell because of the correction in the share price.

There is just one Buy rating on FNArena’s database, Credit Suisse. There are four Hold ratings and three Sell. The consensus target is $1.84, suggesting 9.7% upside to the last share price.
 

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