Treasure Chest: Fortescue Oversold

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

FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. Morgans upgrades Fortescue Metals to Add, suggesting headwinds hitting the stock recently have now abated.

– Coal price spike now over
– Low grade discount to retreat
– Chinese conditions improving
 

By Greg Peel

The prices of iron ore and coal recently retreated from their highs earlier in the year, that is until Cyclone Debbie came along. Disruption to production and transport sent coal prices spiking again. With steel prices falling, and liquidity apparently declining in China, stockbroker Morgans foresaw a double-whammy impact on Fortescue Metals ((FMG)).

As a pure-play producer, Fortescue’s share price is inevitably highly beholden to the iron ore price. But as a low grade producer, compared to BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Brazil’s Vale, Fortescue also has to wear the discount steel producers apply to lower grade iron ore prices.

As coal prices blew out with steel prices still falling, that discount widened out to -25% below the price of high grade fines. Fortescue’s share price took a beating.

As expected, the impact of Debbie proved only temporary and coal prices have fallen back again, with iron ore and steel prices remaining under pressure. This means, Morgans suggests, steelmakers will no longer seek to minimise coke use and instead will increase low grade iron ore use to prop up their margins in the face of falling steel prices.

To that end, Morgans foresees the low grade discount retreating into its more normal range of -13-17%. The broker also notes feedback now suggests liquidity conditions are improving again in China. This in turn should support steel demand and iron ore prices.

While further falls in the iron ore price benchmark remain a risk, particularly if Chinese domestic supply rises and/or BHP/Rio/Vale production rises, all things being equal Morgans believes Fortescue has crossed into oversold territory.

Having set a target price of $5.95, the broker upgrades to Add from Hold, which is the broker’s equivalent of Buy.

The upgrade takes the number of Buy or equivalent ratings on Fortescue to four from eight database brokers, with the other four on Hold. Morgans' target is at the low end of the pack, with a $6.34 consensus target reflecting a range from $5.80 (Citi, Neutral) to $7.30 (Ord Minnett, Accumulate).

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