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Treasure Chest: Time to Sell Fortescue?

Treasure Chest | Jan 16 2018

RBC Capital Markets suspects Fortescue Metals will find it hard to achieve a broad uplift in iron ore grades and cost savings will also be difficult to obtain.

-Widening discount for low-grade iron ore a critical issue
-FY21 before a meaningful uplift in product grade can be maintained?
-Robust Chinese growth and supply-side reform should be supportive


By Eva Brocklehurst

Fortescue Metals ((FMG)) has made progress in reducing its costs and debt, but should investors be wary of the impact of iron ore price realisation on cash flow and earnings? The company has provided consistent production and cost management from its iron ore assets in Western Australia's Pilbara but now RBC Capital Markets believes further cost savings will be more difficult to achieve. This view stems from increasing strip ratios and the need for sustaining capital expenditure across the asset base.

Also, the market has witnessed a widening discount for low-grade iron ore, which Fortescue markets, and this has become a critical issue for the company, RBC declares, estimating a -1% decline in price realisation would require a further -5% in cost savings.

The analysts also warn investors not to use the Platts 62% index as a proxy for the stock, noting increases to this benchmark index are not necessarily reflected in the prices that Fortescue receives for its product. This observation is based on the shift in demand towards higher quality products.

The company has signalled it would like the majority of its iron ore product to be greater than 60% iron and whatever project replaces Firetail should provide the majority of an uplift in grade. The analysts suggest achieving this will be difficult, given a mineral resource of 875mt at 58.8% iron. Either an increase in cut-off grade is required or additional upgrading.

The analysts believe that, given the early nature of the preferred option at Eliwana, it may be after FY21 before a meaningful uplift in product grade can be maintained.

The company is also diversifying its product base and exploring for copper and gold opportunities. Again, the analysts suggest such a move may require M&A and an expansion of the exploration budget, as well as adding complexity to a simple investment proposition. RBC warns this portfolio expansion may lead to a de-rating of the stock and considers the balance of risks weighted to the downside, downgrading its investment rating to Underperform.

RBC Capital Markets, not one of the eight stockbrokers monitored daily on the FNArena database, has a revised price target of $4.25. CLSA, also not one of the eight, is on the same page and advises selling iron ore exposure on an expected pullback in the market.

The broker considers Fortescue Metals the obvious way to play the theme. CLSA remains constructive regarding steel prices in China but finds it hard from a trading perspective to envisage how iron ore prices can hold up in the near term.

Several other brokers are more positive, maintaining or upgrading to Buy in the last few weeks. UBS upgraded to Buy from Neutral in December as part of a broader update on its commodities outlook for 2018. The broker remains attracted to the elevated price levels in iron ore and findsvalue in the stock amid prospects of surplus cash being generated.

Citi also believes that better-than-expected Chinese growth and supply-side reforms provide the support for bulk commodities, upgrading Fortescue to Buy from Neutral last month. Macquarie, in maintaining an Outperform rating, suggests, even if softer demand emerges this year, unlike the previous downturn in 2011, the supply-side response, generally, is likely to be more subdued.

The broker acknowledges low-grade discounting continues to affect Fortescue but believes its price target of $6.00 factors in a realised price of US$50/t that is broadly in line with the average for the September quarter. Macquarie remains positive on the pure-play iron ore stocks. Deutsche Bank, with a Hold rating, prefers base metal commodities to the bulks.

There are five Buy ratings on FNArena's database, two Hold and one Sell (Morgan Stanley). The consensus target is $5.50, suggesting 3.7% upside to the last share price. The dividend yield on FY18 and FY19 forecasts is 6.1% and 5.4% respectively.

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