Fortescue Impresses As Costs Head Lower

This story features FORTESCUE LIMITED, and other companies. For more info SHARE ANALYSIS: FMG

-Break even at US$36/t
-Upside risk to prices in June qtr
-Debt levels still high but falling
 

By Eva Brocklehurst

Fortescue Metals ((FMG)) continues to dig deep into its cost curve, impressing brokers with its resourcefulness in the face of a very weak iron ore price.

Credit Suisse took the opportunity provided by the company's December quarter production report to upgrade its rating to Outperform, citing impressive cost control. The company has guided to a break-even iron ore price of US$36/t, but with lower freight, interest and cash costs, the broker estimates this to be more like US$32/t.

Credit Suisse suspects there is upward risk to iron ore prices as the Chinese construction season gets under way and crude steel production lifts. Hence, port stocks may be drawn down and the seaborne iron ore price rise in the June quarter. The broker forecasts a price of US$48/t.

Nevertheless, Credit Suisse is cautious about the second half of 2016 as these positive factors reverse. Brazil’s supply is seasonally weighted to the second half and Chinese steel production weakens from October onwards.

Strip ratios at the company's mines – the volume of waste material to be handled versus the ore extracted — continue to decline, to an average of 1.1:1 in the December quarter. Fortescue expects to maintain this ratio for the remainder of FY16. Credit Suisse has no doubt this efficiency was a key driver in getting costs down. An update is expected at the half year results in February.

Deutsche Bank highlights the change in mining strategy at Chichesters – processing lower grade ore – has been made possible with the upgrades to the optimal power flow (OPF) circuits. These upgrades have not only offset a 0.5-1.0% drop in head grade but actually lifted yields by over 5.0%. The broker suspects yields can increase further when all the upgrades and automation have been completed.

Debt levels surprised JP Morgan, falling another US$500m quarter on quarter to US$6.1bn. This stemmed from the repayment of US$750m in debt in November and lower capital expenditure. JP Morgan expects net debt to remain around current levels for the next 12-18 months. Hence, with iron ore projected to remain weak and gearing still relatively high, the broker sticks by a Hold rating.

Citi remains bearish while conceding that, on an operational basis, the company's performance stands out. The broker expects depressed iron ore prices over the next two years will maintain the pressure on Fortescue and uncertainty centres on how much cash can be generated to pay back the 2019 debt maturities, which total US$5.4bn.

Macquarie notes that the new deposit in the long-term mine plan, Frederick, has many similarities with the waning Firetail, which has the shortest mine life of all Fortescue's operations. Including Frederick in the mine plan should help solve this one reserve issue for Fortescue.

Firetail has been instrumental in Fortescue's ability to create its product blend via high grades and low strip ratios. The broker is confident that the company can pay its debts with the large build up of cash and the debt still trading at heavy discounts.

The company has stated it will continue to use cash flow to opportunistically re-pay additional debt facilities, where liquidity permits, acknowledging that the cash balance at the end of September of US$2.6bn was in excess of its needs.

The de-gearing story is the key for UBS as well. The broker notes capex of US$88m in the first half was well below its estimate of US$172m and the company is now guiding to FY16 capex of US$200m, which implies that sustaining capex has been lowered to US$1.30/t from US$2.00/t previously.

Incorporating the December quarter update, UBS lowers cost assumptions to an average of US$15/wmt over FY17. The broker expects sales to increase in FY17 to reflect guidance that the company is maintaining shipments at 165mtpa, with the absence of tonnage associated with BC Iron ((BCI)). Fortescue shipped 42.1mt in the December quarter, in line with estimates, indicating an annual shipping rate of 167mtpa.

FNArena's database shows three Buy ratings, four Hold and one Sell (Citi). The consensus target is $2.15, suggesting 27.7% upside to the last share price and compares with $2.06 ahead of the update. Targets range from $1.30 (Citi) to $2.70 (UBS).
 

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