Price Discounts The Key Risk For Fortescue

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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

Despite increased discounts for its iron ore product in the December quarter, Fortescue Metals maintains FY18 guidance.

-Price realisation expected to settle in guidance range of 70-75%
-Overburden removal costs offset despite rise in strip ratios
-Eliwana the key to a lift in iron ore grade
 

By Eva Brocklehurst

Brokers continue to be preoccupied with price realisation for Fortescue Metals' ((FMG)) low-grade iron ore. In the December quarter, realised prices were lower than the market expected, related to the achieved price discount and shipment volumes.

The discount to the benchmark on iron ore sales grew to -34% from -29% in the preceding quarter. Shipments were -8% lower quarter on quarter. Yet FY18 guidance is unchanged, and includes costs at $11-12/t and a full year discount of -25-30%. No information was provided on the new product strategy and the underperformance of shipments was attributed to maintenance.

Ord Minnett had expected a larger impact from a reduction in low-grade ore demand but notes costs provided another record quarterly outcome despite a rise in the strip ratio. The broker, maintaining a Hold rating, would look to become more positive on the stock at a lower entry point, or when more information about the revised product strategy is released.

Cost Controls

Deutsche Bank was impressed with what the company achieved on costs, considering an increase in strip ratio and the fall in shipments. A further reduction in costs is expected in FY19 with the new autonomous fleet at Chichesters and overland conveyor systems at Cloud Break.

Shaw and Partners notes, importantly, overburden removal, one of the largest cost components, has been offset despite the rising trend in strip ratios.

Cost reductions impressed UBS as well, given the low volumes in the quarter, and productivity initiatives appear to have more than offset higher strip ratios, exchange rates and fuel prices.

The broker retains a Buy rating with a view that the market is already pricing in high discounts for the longer term and there is potential upside as the company embarks on a change in its mine plan that could mean over 50% of its volumes achieve an iron grade of over 60%.

Key to lifting grade will be the development of Eliwana and a decision on this is expected before the end of FY18.

Price Realisation

Credit Suisse considers price realisation to have a far bigger impact on margins and value in the near term. The broker sides with the view that discounting is a cyclical dynamic. As steel margins have recently eased, anecdotally at least, the broker notes a greater interest in lower quality iron ore.

This has not played out materially in the iron ore indices to date, although it is starting to have an impact on the market, as Credit Suisse points to reports that Cliff Resources is looking to close Australian operations.

Credit Suisse assumes price realisation slowly returns to 85% in FY21 from 75% in FY19. If discounting is indeed cyclical, the broker believes there is a strong valuation case, as well as the opportunity to take a decent dividend on the way through.

The new product strategy is still to be explained and there are headwinds for price and discounting so the road ahead could well be bumpy, but the broker considers this may present good entry opportunities.

Macquarie assumes discounts remain around current levels before price realisation rises towards the 70-75% guidance in the June quarter. Shaw and Partners agrees that discounts should ease in the second half and land prices within the guidance range.

To meet the company's target would require a second half price realisation of at least 72%. The broker, not one of the eight monitored daily on the FNArena database, has a Buy rating and $5.16 target.

CLSA continues to envisage risks around guidance for the full year yet retains a price realisation estimate just shy of guidance, at 69%. This could be reduced in the next quarter if discounts persist, which underscores the broker's base case.

Sales in the quarter were also lower than CLSA anticipated and the increase in low-grade stockpiles at Chinese ports are considered an early sign that volumes may not be placed so readily in steel mills. CLSA prefers to await the third quarter volume data.

The broker suspects steel mills may have more bargaining power at present and can push back on prices when margins narrow. Lower grade iron ore demand is expected to remain elevated over the current quarter, albeit a temporary situation.

As pricing risk remains in focus, and the quarterly missed CLSA's forecasts on all aspects except costs, an Underperform rating is maintained. The broker, also not one of the eight, has a $5.10 target.

FNArena's database shows four Buy ratings, three Hold and one Sell (Morgan Stanley, yet to update on the quarterly). The consensus target is $5.45, suggesting 7.5% upside to the last share price. The dividend yield on current FX values for FY18 is 6.2% and 5.1% for FY19.

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