Fortescue Metals’ Rally At Risk

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

-Iron ore prices unsustainable
-But cost reductions are
-Potential for debt reduction
 

By Eva Brocklehurst

A rally in iron ore prices over the March quarter was fortuitous for Fortescue Metals ((FMG)) but many brokers question whether these prices can be maintained into the second half of 2016. Prices achieved for iron ore in the quarter were much better than expected, being US$45.94/dmt, effectively at 95% of the benchmark in absolute terms.

The company shipped 42mt of iron ore, benefitting too from a benign wet season. Production is running ahead of target, brokers observe, with the potential for upside to guidance of 165mt for FY16.

Morgan Stanley doubts the iron ore price can be sustained and has an Underweight rating on the stock, expecting the price will decline in the second half of the year. Support for this view is gained from investors who consider the rapid rebound in iron ore prices untenable, as this could lead to suspended mining operations being re-started.

The broker acknowledges the recovery in the steel price is creating some uncertainty as to how pronounced the decline in the second half will be during the seasonal de-stocking of iron ore inventory. Yet Citi is also bearish, with a Sell rating, convinced that the steel re-starts and re-stocking will come to an end as iron ore supply growth resumes.

If the price decline is indeed more muted, Fortescue Metals could make further inroads on its debt reduction and Morgan Stanley accepts this could be a risk to its view. The broker's calculation centres on each month the iron ore price index is at US$50/t, the company can hike its debt reduction ability by US$160m.

Yet one development that reduces the impact of early debt repayment is that debt is no longer trading at a large discount to face value. Macquarie also notes this fact, and considers Fortescue Metals is a victim of its own success in that debt holders are now more comfortable with the outlook.

On Deutsche Bank's calculations the asset base can now generate free cash flow even at US$35/dmt. The company had US$2.5bn in cash at the end of the quarter while net debt fell to US$5.9bn. Deutsche Bank expects debt levels to be US$5.4bn by the end of FY16 and US$3.1bn by the end of FY18.

Morgan Stanley also points out that the recently announced joint venture blending agreement with Vale, potentially leading to first sales in the second half, could bolster sentiment. On this subject the company has indicated its super special fines would be blended with Vale's Carajas fines and it expects to conduct a bulk trial over the next month with a view for sale in the second half.

The latest rally in iron ore is based on short covering and there is little evidence of an improvement in demand as yet, UBS maintains. Should demand fail to lift then this rally is likely to fade. On the other hand, UBS does not expect prices to revert to the low to mid US$30/t range over any length of time and supply should respond in order to preserve margins. The broker forecasts US$45/dmt in FY16 and US$47/dmt in FY17.

Ord Minnett is in the same camp, expecting a material fall in iron ore prices (25%) over 2016. Should the iron ore price hold up around US$59/t for an extended period then the broker expects Fortescue Metal's share price will continue to rise because of the significant free cash that will be generated and the de-leveraging that will occur.

Macquarie agrees the price premium is unlikely to be maintained but points to the company's success in bringing down costs despite unfavourable currency movements. The broker believes efforts in this regard should be sustainable for the remainder of the decade. Unit costs fell to US$14.8/wmt although the company has signalled that the higher Australian dollar is pressuring its FY16 US$13/wmt exit rate target.

The push down on costs should mean these are maintained in the low to mid teen rates, UBS agrees, provided oil prices stay around US$40/bbl and the Australian dollar around US70c until 2020. At this point Fortescue Metals would need to start investing in its first replacement mines.

FNArena's database shows one Buy (Macquarie), four Hold and two Sell ratings. The consensus target is $2.65, signalling 19.3% downside to the last share price.Targets range from $1.50 (Citi) to $3.30 (Macquarie).
 

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