Could Eliwana Reduce Fortescue’s Discount?

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Development of the higher-grade Eliwana mine should allow Fortescue Metals to transition to a premium iron ore product, which could lift earnings and valuation.

-Eliwana should enable iron grades of 60% ore more
-Price realisation remains the key driver of the share price
-Eliwana rail spur could open up more potential in Western Hub
 

By Eva Brocklehurst

Fortescue Metals ((FMG)) is exploring an alternative product strategy in a move to obtain better margins for its discounted iron ore product. To this end, the company has recently approved the Eliwana mine.

The company is also aiming to introduce a new 60% iron product, called Fortescue Premium. This will be sold from the second half of FY19 and sourced from higher grade ore at Firetail and other operations to test the market and potential price premiums, versus the existing blended 58.2% product.

Fortescue has a record for achieving ambitious goals, UBS points out. Leveraging Eliwana to enable a 60% or better iron grade product the broker suspects will be no different. Saleable production of 170 mtpa is expected to be maintained and not require a material lift in operating expenditure or a reduction in the mine life of the assets.

The company will batch process its mined ore to split what is currently a blended product into a higher quality Premium product and increase the tonnage of its Super Special Fines. Adopting this strategy could mean the overall average discount received for its iron ore reduces to around -28% from -34% against the Platts 62% index.

Furthermore, UBS calculates, assuming Eliwana comes on line by FY21 the blending strategy could be expected to lift earnings per share by US$0.14 and valuation by $1.65, relative to a spot scenario.

Eliwana, being of a higher reserve grade at around 59% iron and a lower strip ratio compared to existing operations, should support the transition once production starts late in 2020.

The capital cost of developing the 30mtpa mine is US$1.28bn. Macquarie had already incorporated the mine into its forecasts and makes only modest adjustments, but agrees development should allow the company to improve its product mix over time, although to what level remains uncertain.

Price Realisation

Price realisation remains the key driver for the share price, the broker points out, down currently to 65%, having fallen from 90% in 2015, although, while realisation has remained volatile over the past eight months, the actual realised price has remained stable, at around US$40-45/t.

While iron grade is an important driver, the levels of silica, alumina and phosphorus are also major inputs to price realisation. To date the company has not released product specifications for its Premium product and, therefore, the broker does not incorporate improved price realisation at this stage.

Citi accepts the discounts for lower grade ores are more structural than cyclical but also expects iron ore prices to fade over the next couple of years, towards a long-term price of US$55/t.

The broker emphasises the fact there is no clarity on how much of the future production will be increased to a 60% iron grade or the full operating and capital cost implications of the new strategy.

Capital expenditure for Eliwana is higher than some of the other mine replacement projects currently underway in the Pilbara, Citi notes, as it requires 143km of new rail.

Ord Minnett does not consider the project approval contains any major positives or negatives, although bringing it to fruition will allow other assets in the Western Hub to be exploited, given the addition of the rail line.

The broker believes the rail spur could accommodate significantly more than 30mtpa, noting that Fortescue will build a dry processing facility that appears to be a like-for-like match to Firetail.

Credit Suisse suspects, if discounts normalise back to levels closer to 2016, the company may make a decision to revert back to its existing blend as the primary product, given sensitivities around strip ratios, the life of mines and revenue realisation.

Background

Environmental concerns prevailing in China have affected steel mills, resulting in increased demand for higher grade iron ore. The spread between high and low-grade ore is structural because of this drive for higher productivity at the mills.

Discounts for lower grade products are, therefore, the highest in many years. UBS notes, in the case of Fortescue, the discount to the Platts 62% index was -23% in the March quarter 2015, had reduced to -6% by the March quarter of 2016 and then steadily increased. It is now at -38%.

While Fortescue has pure exposure to the iron ore market, and is considered the lowest-cost iron ore producer globally, its assets are slightly lower grade compared to Vale, Rio Tinto ((RIO)) and BHP Billiton ((BHP)).

FNArena's database shows six Buy ratings and one Sell (Citi). The consensus target is $5.40, suggesting 12.5% upside to the last share price. Targets range from $4.00 (Citi) to $6.10 (Morgans, yet to comment on the Eliwana approval). The dividend yield on FY18 forecasts is 5.2% and 5.4% respectively.

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