Fortescue At The Mercy Of China’s Steel Mills

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Chinese steel mill profitability has surged, signalling to Morgan Stanley why the iron ore price achieved by Fortescue Metals has remained relatively flat.

-Morgan Stanley suspects an extended period of wider low-grade discounts is likely
-Improvement in product grade unlikely to come without reversal of cost reductions
-Iron ore prices not keeping up with steel prices, which are at seven-year highs
 

By Eva Brocklehurst

The iron ore price achieved by Fortescue Metals ((FMG)) continues to perplex. China's stimulus program and reform agenda has driven the 62% iron ore price index to US$69.50/t in September, from US$56/t in March. During this period, the discount for Fortescue's 58% iron ore has risen to -43% from -17%.

This means the price Fortescue Metals has received is relatively flat, at the mercy of the elevated profitability of Chinese steel mills. Morgan Stanley continues to expect these steel margins will be well supported because of the shutdown of China's outdated capacity and enforcing of the winter steel production cuts.

China's iron ore is typically low-grade and production has been curtailed by -3% over 2018 because of environmental restrictions, while imports remain strong.

Morgan Stanley believes it is important to understand what is causing the recent spike in iron ore discounts in order to appropriately value Fortescue Metals. The broker finds limited evidence that metallurgical coal prices are driving the widening discount, rather it is supply-side reforms by China and the elevated profitability of steel mills.

This elevated profitability has altered the incremental value placed on each unit of grade. Based on the broker's channel checks, when steel margins dropped towards RMB300/t back in March, the Chinese mills started to use more low-grade iron ore.

Shipping

The latest shipping data from Australia's ports signals shipments in the September quarter are down significantly. The average shipping rate for Fortescue Metals in the quarter was -11% lower than Macquarie expected. The company hit its 170mtpa target for FY18 because of a record 200mtpa in June. Hence, Macquarie is not surprised that the shipping rate has fallen back, as maintenance is undertaken at the mines as well as the port and rail network.

Even so the decline has been larger than expected and July's shipment rate was the weakest in three years. Macquarie has reduced shipment forecasts for the first quarter of FY19 by -11% to reflect this weak start. The broker also notes that while the shipping rates from Australia's ports have declined from the peak achieved in June, Fortescue's low-grade price has been stable, trading in a tight range of US$40-46/dmt since April.

Cost Savings

Morgan Stanley expects an extended period of wider low-grade discounts is likely and, while Fortescue may be able to ameliorate this by changes in product mix, it will not be without some cost savings being reversed.

Over the past five years the company has achieved cost savings through low average product grades, and production costs have dropped -70% since FY12 because of product blending and wet processing. This allowed for a reduction in cut-off grades and strip ratios at its Chichester hub while keeping the end product unchanged.

Morgan Stanley has reinstated coverage of Fortescue Metals with an Underweight rating, suspecting there will be negative revisions to consensus earnings estimates as high discounts persist until FY21.

Deutsche Bank downgraded to Sell from Buy recently, suggesting the whole steel complex may turn before the discount for iron ore narrows. The broker also recognises steel prices are at seven-year highs and iron ore prices are not keeping up, despite the weaker supply.

Fortescue Metals is the fourth-largest supplier of iron ore in the global seaborne market. FNArena's database shows five Buy ratings, one Hold and two Sell. The consensus target is $4.62, suggesting 23.6% upside to the last share price. On present FX values, the dividend yield on FY19 and FY20 forecasts is 8.5% and 7.6% respectively.

See also Capex Plans To Feature For Fortescue Metals on Jul 30, 2018.

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