Fortescue’s Deal With Vale Piques Interest

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-Could improve product reliability
-How are rehandling costs offset?
-Steel price expected to fade
-So, too, iron ore
 

By Eva Brocklehurst

An intriguing deal has been negotiated between Fortescue Metals ((FMG)) and global number one iron ore producer, Vale. The two intend to partner on blending their ores. The joint venture is is non-binding and expected to take six months to finalise. Fortescue has indicated the venture would allow it to reduce cut-off grades at the Chichester mines and, therefore, reduce costs. Blending is intended to take place at at Chinese ports, with no capital expenditure requirement of Fortescue.

There is also an option in the deal for Vale to buy Fortescue shares on market, taking a 5-15% stake, and/or invest directly in Fortescue's mining operations. Brokers, based on current information, can find value in the deal for Fortescue but remain less clear on where it benefits Vale.

Morgan Stanley finds some logic in the mixing of Vale's 66% ore with Fortescue's 58% ore, if both can achieve a better realised price for the tonnage that is blended, but more detail is needed before assuming the deal can deliver better value for customers, as well as confirmation the plans will be implemented.

In relation to the stated intention to increase supply chain efficiency, the broker wants to know how costs from re-handling during the blending can be offset. The potential for direct asset investment by Vale may be a risk to an Equal-weight rating if it leads to accelerated debt reduction, but Morgan Stanley also notes the company has previously said such transactions would only occur it they represent long-term value.

Value creation is predicated on how the proceeds are split, Credit Suisse contends, and agrees there is an extra cost as the proposal requires port space and some double handling. The broker estimates there is around $2/dmt in benefit to be gained and, if that is shared equally between Vale and Fortescue, it suggests around US$90m per annum in additional revenue for the latter. Running this through models the broker calculates its base cash valuation would rise to $3.26 from $3.06 per share.

China's steel mills are running on very tight margins and sentiment and procurement is affected by day-to-day moves in prices of rebar and Tangshan billet. When the mood turns bullish, all mills want to re-stock at once to beat price rises. Credit Suisse notes this happened last weekend when the price of Tangshan billet shot up to US$53/t. Nevertheless, without a driver in terms of Chinese steel demand, the broker expects a steel surplus and sagging prices by the end of the second quarter.

As steel demand fades, the iron ore price is expected to come down and Credit Suisse forecasts US$35/t in the second half of 2016. Given Fortescue's shares have moved sharply higher on the iron ore rally the broker downgrades to Neutral from Outperform. Credit Suisse does not believe iron ore prices can hold onto current levels through 2017.

Several positives for Fortescue come into view for Deutsche Bank. This venture may lift the company's price realisation from a current 85-90% and it has potential to strengthen relationships with large Chinese steel mills as the country rationalises its industry. Lower costs can be obtained by a further reduction in cut-off grades at the Chichester hub.

It may also provide Fortescue with a new source of capital. Still, such an agreement may meet some regulatory hurdles in China, Deutsche Bank contends, although advance discussions were likely to have been held. The broker envisages few benefits for the Chinese steel industry, other than a more reliable and consistent product that may support blast furnace efficiencies.

Details noted by UBS include an intention by Vale, as it ramps up 90mt of high-grade 65% ore in coming years, to blend part of this down to an average 61.5%. The JV does not envisage additional ore would be mined but rather than around 80-100mtpa of volume would be blended. The broker note the announcement follows Vale's strategy to increase Carajas blending with Southern System supply, as high-grade iron ore price premiums have declined in recent years alongside Chinese steel profitability.

The pricing benefits for Vale, for now, remain unclear to UBS as well. The broker does not believe Vale would exercise its options for an equity investment in Fortescue at present, either in shares or operations, given its current financial state.

The deal may provide Fortescue with the means to re-work its mine plans, Ord Minnett suspects, and Vale's interest in potentially taking a stake is a vote of confidence in the assets. Overall, the market is likely to view the deal positively, the broker asserts and, following significant cost cutting and the recent rally in the iron ore price, short covering in the stock may produce upside risk in the near term.

Nonetheless, Ord Minnett is also of the opinion that the recent rally will fade as the market remains in oversupply, and this in turn may mean the stock faces downside risk again. Current prices may also motivate some marginal production to come back on line.

Macquarie concludes that improved pricing is the key to the deal. Blending Fortescue's lowest quality product from Cloudbreak with Vale's highest quality product from Carajas could combine to produce a similar product to Rio Tinto's ((RIO)) Pilbara blend. This would mean Fortescue's quality discount on its super special fines is removed. While acknowledging the deal is in its infancy, the broker lifts longer-term value assumptions for Cloudbreak and Fortescue's undeveloped resource base.

FNArena's database contains two Buy ratings for Fortescue, four Hold and one Sell (Citi). The consensus target is $2.47, suggesting 5.7% downside to the last share price. Targets range from $1.40 (Citi) to $3.20 (Macquarie).
 

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