Can Fortescue Metals Sustain Lofty Heights?

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Can Fortescue Metals sustain record earnings and dividends? It all depends on the iron ore price trajectory.

-Upgrade momentum significant on a spot price scenario
-Fortescue Metals outperformed local iron ore peers in FY20
-Yield on elevated share price dependent on iron ore price sustainability
 

By Eva Brocklehurst

Fortescue Metals ((FMG)) finished FY20 with a flourish, providing a strong dividend and record earnings. However, after a stellar run up in the share price over 2020 to date, several brokers suggest valuation is becoming an issue.

FY21 guidance for 175-180mt has been reiterated along with C1 cash costs of US$13-13.5/wmt. Capital expenditure guidance of US$3-3.4bn is also unchanged. Macquarie highlights a consistent operating performance from Fortescue over the past 3-5 years and is confident in the company's ability to meet guidance.

Meanwhile, the final dividend of $1.00 implies a 77% pay-out ratio against FY20 earnings and Citi would not be surprised if FY21 delivered a similar pay-out, forecasting a base case of $1.22.

Iron Ore Pricing

Revenue realisation lifted as West Pilbara fines product rose to 10% of the mix from 5% in FY19. Moreover, tight market fundamentals and speculative financial operators have driven up the iron ore price, UBS asserts, upgrading its 2020 iron ore price forecast to US$98/dmt.

Upgrade momentum is significant, Macquarie agrees, with a spot price scenario generating earnings for FY21-22 that translate to free cash flow yields of 17-18%.

Citi considers it highly probable that iron ore could average US$85/t in 2021 and US$75/t in 2022. China's economic recovery has meant steel supply is up 2% in the year to date and iron ore imports up 12%.

At the other end of the spectrum Brazil's supply of iron ore has been affected by bad weather and unplanned maintenance. China, therefore, has had to import more from the high-cost producers such as India and Russia.

However, UBS expects the fundamentals will soften in the second half as Brazilian production returns to the table and financial speculators back out.

Valuation

Citi considers the risk/reward ratio is more attractive at Rio Tinto ((RIO)) but concedes a potential dividend yield of 9% in FY21 will underwrite investor interest in Fortescue over the year ahead. Hence, the broker's rating is upgraded to Neutral from Sell.

On the other hand, Ord Minnett notes the stock has risen 74% over the year to date while the iron ore price has risen 37%, and this compares with a relatively flat trajectory over the year for BHP Group ((BHP)) and Rio Tinto.

Hence, the broker opts to retain a Hold rating based on valuation. That said, Ord Minnett continues to like the stock based on its attractive yield and relatively inexpensive multiple. Credit Suisse downgrades to Underperform from Neutral because of the sustained outperformance and emphasises this is a valuation call, noting the healthy yield.

While avoiding "reverse engineering" in terms of the valuation methodology the broker is also watching steel demand in China very closely, not just for where the downside turning point may be but also for whether there is continued tightness.

The stock has had a very strong run in both absolute terms and relative to the sector, Credit Suisse agrees. While a lot of this is justifiable, those that do not hold the stock need to ask just how much more upside is available when iron ore is above US$120/t and earnings are close to peaking.

A moderation in pricing is assumed but the broker acknowledges it was proved wrong by steel demand in 2019, and this appears to be the case again this year. So, the risk to Credit Suisse's rating downgrade is that iron ore holds up longer than expected, which means that the yield on the elevated share price can be maintained for longer.

Meanwhile, Fortescue's growth projects are on schedule and Eliwana is set for first ore to be railed in December. Capital expenditure intentions on Eliwana are US$1.32-1.38bn and the resource estimate at Eliwana declined to 1.8mt. First ore will be shipped from Iron Bridge in mid 2022.

Macquarie was disappointed with a -2% decline in reserves, implying just modest growth following mine depletion.

Further growth projects are being explored, with the focus on commodities that support the de-carbonisation and electrification of the transport sector. Fortescue aims to be net zero emissions by 2040, with a -26% reduction by 2030. The company has budgeted US$300-400m in FY21 and US$250-350m in FY22 for solar-gas hybrid energy and transmission infrastructure.

FNArena's database has two Buy ratings, four Hold and one Sell (Credit Suisse). The consensus target is $16.21, suggesting -13.6% downside to the last share price. Targets range from $12.65 (Morgan Stanley) to $19.00 (Macquarie). The dividend yield on FY21 and FY22 forecasts, on present FX values, is 13.7% and 9.5%, respectively.

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