Fortescue Plans To Beat On Costs, Again

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This story features FORTESCUE LIMITED.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

Fortescue Metals beat expectations on iron ore production and sales in the June quarter but what really flummoxed brokers were record low costs. And there's more.

-Cost guidance sets a new benchmark for Pilbara producers
-Lower costs and current iron ore prices expected to offset headwinds
-Main headwind is price realisation as significant discounting likely to continue
 

By Eva Brocklehurst

Fortescue Metals ((FMG)) beat expectations on production and sales in the June quarter but what really flummoxed brokers were record low costs of US$12.84/t, This was assisted by a lower strip ratio.

The company has guided to FY18 costs of US $11-12/wmt which implies another record year, despite the strip ratio rising to 1.4 from 1.0, as productivity and efficiency projects such as autonomous haulage technology and conveyor systems are expected to deliver savings. Most brokers considers this an extraordinary outcome and testament to the company's strong management of its operations.

Macquarie observes the company continues to lead the way in operating efficiency for the iron ore industry, as its FY18 cost guidance has set a new benchmark for Pilbara producers. The broker pushes through the implied lower mining costs into forecasts for FY19 and beyond, while acknowledging discounting of iron ore prices continues to be a negative for the stock.

Fortescue shifted 44.7mt in the June quarter and guides to FY18 shipments of 170mt. Deutsche Bank believes shipment guidance is conservative and suspects the company will do better, raising earnings estimates by 3-4% and valuation by 13%, given the lower cost estimates and the inclusion of the Firetail replacement project. The broker is also impressed with the performance on net debt, which was reduced to US$2.7bn. Deutsche Bank retains a Hold rating on valuation.

Shaw and Partners believes the business has a lot more potential, given the record daily shipment rate and the down-trend in costs. The broker, not one of the eight monitored daily on the FNArena database, has a Buy rating and $5.50 target.

Shaw and Partners would really like to buy the stock below $5 a share but cannot envisage it returning to this level for a while, not with the iron ore price at a healthy US$70/t and costs heading below US$12/t. Macquarie also considers the stock cheap, but acknowledges assumed iron ore prices of US$70/t and an AUD exchange rate of US$0.80.

Price Realisation

Price realisation was around 73% of the benchmark in the quarter. Realised revenue of US$37.82/t was a -40% discount to the June quarter average Platts 62 CFR index price, when taking into account the impact of quarterly pricing and timing adjustments. The company has guided to 75-80% average discounted pricing for FY18.

Price realisation headwinds are expected to be weighted to the first half, while the second half is expected to return to more normal levels. Nevertheless, Credit Suisse believes the risk is for pricing weakness to continue into 2018 for longer than many expect. The broker assumes 85% price realisation in FY19 and beyond. Credit Suisse struggles to identify an immediate catalyst for the stock but remains a happy holder.

Ord Minnett also believes the stock is attractive, based on its high dividend yield potential, a reduced debt profile and solid operations. The broker predicts a -23% discount to the benchmark next year and a long-term discount of -17%.

Shaw and Partners suspects the maximum discount to the benchmark is now behind the company, although this is still averaging -24% in the year-to-date. Historically, the discount averages around -12%. The broker expects that when steel mill and capacity utilisation rates ease the discount should normalise to a more typical 85-90% price realisation.

Currency and realised pricing remain headwinds but cost reductions and the strength in the current iron ore price are expected to be offsetting factors. Yet UBS believes the market is right to be concerned about the level of discounting for low-grade iron ore.

The company's guidance assumes the discount narrows over FY18, in line with the broker's expectation. Nevertheless, UBS points out that higher utilisation and the abundance of low-grade ore is in the market, with the absence of high-grade to blend, remain structural issues. UBS expects the company to deliver earnings in FY17 of around $2.13bn and pay a $0.15 final dividend, taking the full year dividend to $0.35.

There are four Buy ratings, three Hold and one Sell (Citi, yet to comment on the production report) on FNArena's database. The consensus target is $5.64, suggesting 7.7% upside to the last share price. Targets range from $3.90 (Citi) to $6.50 (Credit Suisse). The dividend yield on FY17 and FY18 forecasts is 6.8% and 4.3% respectively.
 

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