Fortescue Metals Outlook Impresses Brokers

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

-Achieved iron ore prices better than expected
-Costs plunge, driving attractive valuation metrics
-Productivity improves with automation, in-house contracts
 

By Eva Brocklehurst

Brokers are impressed with the ability of Fortescue Metals ((FMG)) to exert downward pressure on costs and its agility in obtaining maximum productivity from its suite of iron ore assets in Western Australia's Pilbara.

The company has guided to FY17 iron ore shipments of $165-170mt with a cost target of US$12-13/wmt based on an Australian dollar average of US75c and an oil price of US$50/bbl. Additionally, the company has flagged US$1.0-1.5bn in capital expenditure from FY19 to replace the 25mtpa Firetail operation, its only mine with a life span short of 20 years.

The step-down in costs is notable and creates upside to market expectations, Morgan Stanley maintains. Lower strip ratios – the volume of material to be removed versus the ore extracted – are the likely driver. Fortescue expects to reach its gearing target of 40% in FY17, a level the broker notes was previously flagged for allowing an increase in the dividend.

Meanwhile, the company is still hoping to do a deal on blending with Vale by year end and has flagged the potential of diversification, by looking at early stage investment in copper-gold targets and lithium opportunities on its Pilbara tenements.

The stock has some of the most attractive valuation metrics in the mining sector, Ord Minnett proclaims. At US$50/t, FY17 estimates suggest the free cash flow yield is 16% and enterprise value to operating earnings ratio is 4.5, undervaluing the stock in the broker's view.

Ord Minnett undertakes a detailed review of the company's long-term mine plan, extending operations to 2050 from 2036 and including capex for replacement mines as other operations are depleted. The broker believes it is now fair to assume Fortescue will be able to leverage its port and rail infrastructure over the long term.

Deutsche Bank envisages that over the next five years, mining costs can fall a further 15% given several initiatives. These include an increase in productivity at Solomon as result of more automated trucks, bringing the mining contract in house and moving to ultra class trucks. Also feeding into the efficiency strategy is full excavator mining at Christmas Creek, with in-pit dumping, shortening of haulage routes and processing more lower grade channel iron deposits at Kings.

Macquarie agrees with this analysis, noting that despite a stronger Australian dollar and higher oil prices, the company achieved its goal of finishing FY16 with costs at US$13/wmt. An average of US$15.43/wmt was achieved in FY16, which is almost half that of FY15. Moreover, despite lower grade material from elsewhere re-entering the seaborne market, Fortescue was also able to achieve better pricing than the broker expected, at US$48.79/t versus estimates of US$45.61/t.

As a result, Macquarie would not be surprised if Fortescue was able to surpass its larger rivals on a C1 cost basis. The broker expects the balance sheet to rapidly de-gear, despite the capital needed for the replacement of Firetail, and calculates that if spot prices are maintained, the company could generate US$2.4bn in free cash flow in FY17.

Credit Suisse was impressed with cost guidance, noting the planning underway to replace Firetail involves developing satellite ore bodies which will require the extension of rail infrastructure. Depending on the preferred strategy, the capital for this development is likely  to be deployed from FY19-21. The broker revises up its earnings estimates for FY16 and FY17 by 9% and 3% respectively and FY16 operating cash flow is revised up 12%.

UBS also makes some significant changes to mid to long-term assumptions. Cash cost forecasts are lowered, capex adjusted and a pay-out ratio of 35% of earnings is slated from FY18. This reflects the broker's expectations that Fortescue will achieve its gearing target of under 40% by the end of FY17. Yet, with the iron ore price in the mid to high US$50/dmt range, the broker believes the risks for that price and thus the stock are to the downside in the near term, with additional iron ore tonnage coming on line with the price at this level.

FNArena's database shows two Buy ratings, three Hold and two Sell. The consensus target is $3.99, signalling 12.9% downside to the last share price. This compares with $3.46 ahead of the production report. Targets range from $2.40 (Citi, yet to update on the report) to $5.00 (Macquarie).
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms