Will Fortescue Metals Spread More Cash?

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Unusually, Fortescue Metals decided to pay a dividend outside of the standard reporting season and most brokers expect there will be plenty more.

-A demonstration of just how much cash the company is generating
-Credit Suisse suggests iron ore prices are likely to peak in the September quarter
-But is the stock trading ahead of fair value
 

By Eva Brocklehurst

A surprise early dividend payment from Fortescue Metals ((FMG)) has put the focus on the bumper profits expected from the sector when iron ore companies report in August. Amid upgrades a-plenty to the iron ore price outlook, Fortescue Metals declared a $0.60 dividend, payable June 14, outside the standard February and August announcements that typically come with results.

Brokers suggest the dividend is a pulling forward of part, or all of, the dividend that otherwise would have been announced in August. Deutsche Bank asserts timing made this payment unique, rather than the quantum.

A large dividend in FY19 was always expected from an iron ore company. The broker does not envisage any other candidates in the mining/oil coverage will make an early dividend payment and the move also reflects Fortescue Metals' nimble culture.

For larger peers Rio Tinto ((RIO)) and BHP Group ((BHP)) Deutsche Bank considers there is more potential for downward pressure on the iron ore price to weigh on these stocks, rather than increased dividend potential.

Citi points out the company may have acted early because of concerns around possible changes to Australian dividend imputation ahead of the election but, most certainly, it was about increased confidence in 2019 cash flow. Credit Suisse agrees, at the very least, this is further demonstration of just how much cash the company is generating.

Macquarie believes an extra $0.20 dividend is possible at the FY19 results should iron ore prices remain at current levels. Including the $0.19 interim dividend and $0.11 special dividend announced in February the company has so far paid out $0.90, equating to a fully franked yield of 11% for FY19.

The company has stated it will return to a March/April interim dividend and September/October final dividend going forward, which signals to the broker that this is actually an early payment. A pay-out ratio of 50-80% of net profit has been reiterated. Macquarie expects a further $0.20 special dividend with the FY19 result, assuming a pay-out ratio of 80%.

Ord Minnett expects such returns to be a feature of FY20. Iron ore markets are tight and the company's achieved price estimate is at recent highs of US$82/t. The broker does not expect a further dividend payment at the August results, although accepts the company did not rule one out. Ord Minnett expects an FY20 dividend of $1.09 a share, implying a 14% returned to shareholders.

Iron Ore Peak?

Iron ore prices have rallied significantly this year in response to a supply shock caused by the Brucutu dam failure in Brazil. Credit Suisse expects iron ore prices to peak at US$110/t in the September quarter, when China's port inventory is likely to be at its tightest. The broker expects an iron ore deficit over 2019.

By lifting forecasts by 21% and 33% over 2019 and 2020 respectively, this substantially affects the broker's forecasts for Fortescue earnings. Credit Suisse acknowledges it has gone to almost the highest iron ore price deck from the lowest, which has driven an increase in the target price to $8.20 and pushed its rating back up to Outperform from Neutral.

The broker believes the investment case for Fortescue is compelling for at least six months, given the limited global supply responses to the iron ore market tightness and continued strength in China's crude steel production. Specific to the company are the Eliwana and Iron Bridge developments as well as further capital management.

Outlook

Exceptional strength in the iron ore price has particularly helped lower grade products and meant the company's profitability doubled in the second half of FY19. While a large quantity of Brazilian supply has been suspended and Chinese stimulus is supporting demand, Morgans is concerned.

The stock is understandably trading higher on the news of the extra dividend, but the broker does not change its view that Fortescue Metals is trading beyond fair value on a 12-month basis. History has taught Morgans to be fearful when iron ore is trading at 45% above its long-term sustainable levels, also when the market focuses on spot fundamentals and relies on an upgrade cycle.

UBS suggests recent momentum in the stock can be attributed to the confirmation that Vale's 30mtpa Brucutu mine will not re-start as anticipated. The broker also notes the Fortescue Metals' weighted average discount narrowed to 8% in April/May from around 21% in February.

As a result of the trends, the broker has lifted the June quarter realised iron ore price estimate to US$80.40/dmt. UBS maintains a Sell rating on the stock, nonetheless, believing the current iron ore price is not sustainable.

At spot prices, if maintained for three years, the broker acknowledges, with a 100% pay-out ratio, the company could declare around $2.50 a share in dividends, or deliver an implied yield of 31%, fully franked. UBS suspects that Fortescue Metals intends to pay out 100% of earnings while the iron ore price is elevated.

FNArena's database shows three Buy ratings, three Hold and two Sell. The consensus target is $7.42, signalling -17.1% downside to the last share price. The consensus target has risen from $4.75 at the start of 2019. Targets range from $5.94 (Morgans) to $8.70 (Macquarie). The dividend yield on FY19 forecasts, on present FX values, is 13.0% and 12.1% on FY20 forecasts.

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