Fortescue Metals To Peak Soon?

This story features FORTESCUE LIMITED. For more info SHARE ANALYSIS: FMG

Will iron ore prices peak soon? Several brokers ponder the outlook for Fortescue Metals, with the stock heavily leveraged to the fortunes of the commodity.

-Share price could come under pressure when iron ore prices descend
-Record June quarter production, FY20 guidance expected to be met
-Strong price realisation, final dividends expected
 

By Eva Brocklehurst

Speculation over the course of iron ore prices is heating up and the commodity's recent strength could bedevil Fortescue Metals ((FMG)) going forward. Hence, Credit Suisse downgrades to Neutral from Outperform, begrudgingly.

The trigger is the broker's view on the commodity rather than the company, as iron ore prices are expected to peak in the current quarter. In Fortescue Metals' favour, guidance is usually met, volumes are growing and the job of offsetting cost pressures has been accomplished well.

Moreover, the broker calculates that upgrades to the product suite should deliver better margins. Hence, there is no reason to sell the stock. Yet Credit Suisse suspects the share price will come under increasing pressure as iron ore prices descend from lofty heights.

Morgans, yet to update on the quarterly, struggles to justify the share price in value terms, assessing iron ore would need to average US$130/t for the next two years to be supportive. Also, the current earnings upgrade cycle is unlikely to catch up to the share price and so the broker retains a Reduce rating. The main risk, Morgans acknowledges, is an unexpected structural change in the iron ore market.

The broker also believes the company is currently in the ideal position to push into other metals, speculating Fortescue Metals could make a move on a comparatively smaller, mid-cap base metal peer.

UBS, too, is concerned about the sustainability of the iron ore price and maintains a Sell rating. In contrast, Shaw and Partners, not one of the seven brokers monitored daily on the FNArena database, has a Buy rating and $9.98 target and expects the company will stay in a sweet spot for earnings, along with its iron ore peers, for an extended period into 2020.

Change In Sentiment?

Ord Minnett considers the drop in the share price following the quarterly report relates to a change in sentiment towards iron ore markets. This follows slight increases in Vale's production outlook and a minor increase in Chinese port stocks. China's steel production in June was at a another record rate and up 9% year-on-year.

The broker reiterates a Buy rating, assessing the stock offers attractive valuation metrics and strong shareholder returns over the medium term. Ord Minnett expects a record 65% operating earnings (EBITDA) margin next year and a 20% dividend/free cash flow yield based on an achieved price of US$82/t and the spot price around US$100/t.

FY20 guidance is for 170-175mt with costs around US$13.50/t. Processing facilities are expected to be operating more smoothly in FY20 and bottlenecks are now likely to shift to the rail and port, Citi observes. Fortescue Metals is now the lowest cost operator in the Pilbara, the broker adds, and mining strip ratios were a low 1.4x in the quarter.

The company posted record June quarter production and shipped 167mt over FY19. Cash costs were under US$13/t and net debt at the end of the financial year was just US$2.1bn. The next two years will involve heavy capital expenditure but this will leave the business in better shape, Credit Suisse asserts.

Moreover, the company has reiterated its dividend policy and Macquarie suspects there is upside potential for dividends with the FY19 result on August 26. The broker assumes a $0.90 final dividend, $0.60 of which has already been paid. This translates to a 77% payout-out ratio, or 85% including the first half special dividend. Macquarie lifts FY20 and FY21 forecasts for earnings to reflect improved price realisations of 87%.

Seasonality

Iron ore production is typically seasonal, Shaw and Partners adds, with the June quarter invariably the strongest for shipments and the March quarter the most affected by the weather.

The broker is wary of annualising June quarter or June monthly data, noting a recent trend to emphasise a "supply response" in Australia and Brazil and pointing out, yes, there is a supply response – every year. Furthermore, over the next three quarters there will be relatively less iron ore available to customers, as usual, and the "wall of supply" is likely to head into seasonally softer periods.

Citi raises FY19 price realisation estimates and assumes 84% realisation in FY20. The broker assesses 58% iron pricing has moved too high against the benchmark and 62% is now a cheaper iron ore source. In terms of mix, higher grade West Pilbara fines (60% iron) now account for 10% of the company's product mix.

FNArena's database has two Buy, three Hold and two Sell ratings. The consensus target is $8.40, signalling 2.4% upside to the last share price. Targets range from $6.15 (Morgans) to $11.00 (Macquarie).

See also, Will Fortescue Metals Spread More Cash? On May 21 2019

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