positive view on fmg

A contrarian view for the downrampers. Just seems to be so many of them so I thought i would post this.

Fortescue: what is it discounting?
We thought the best way to approach the big end of resources was to attempt to "backsolve" what a given share price is currently discounting and then consider if we agree/disagree with that view.

Clearly FMG has been hit very hard for a variety of reasons, the vast bulk of which have been out of FMG's control. FMG shares have fallen -65% from the high ($13.15), but clearly they are not alone in being de-rated. For example, the under takeover Rio Tinto is now -46% below its high ($157.45) despite an aggressive takeover defence. Interestingly, RIO has been "unshortable" in Australia since the BHP bid was announced and that most likely explains the excess underperformance of FMG vs. RIO. As we have written, there is no doubt FMG has been a shorters favourite in recent times.

The shorters of FMG have a consistent view. They believe the company will be unable to secure the funding for further expansions, their cashflow will be below expectations, iron ore contract prices will fall sharply, and of course the usual stuff about FMG's mining techniques and infrastructure not working (there is a site visit coming up in late October). More recently, market concerns about large shareholder Harbinger have weighed on the share price.

So we know why the FMG share price has corrected but what is it discounting? FMG pretty much comes down to two variables; production and price (margin). This is not a complicated company. The chart below shows our FMG valuation matrix. Production volume is shown on the X axis while Brockman fines iron ore contract prices are shown across the top.



On our model the current FMG share price of around $4.65 is discounting FMG as a 60mtpa producer and iron ore contract prices for fines falling from 144usc%fe to around 110usc%fe. For consistency we are using a "steady state" Australian Dollar/USD cross rate of 85usc, but clearly any sustained cross rate decline below that price would increase our valuations.

We currently forecast fines contract prices to rise by +12% for JFY09. We see fines prices peaking at 213usc%fe in JFY 2012. However, our backsolving suggests the FMG share price is discounting iron ore fines prices to fall by -23% in JFY09 to around 110usc%fe and then stay there. That's a pretty wide price expectation arbitrage if you remain a believer in the structural undersupply of steel making raw materials.

The market seems to be contradicting itself here. They have de-rated FMG on concerns about funding for further expansions, yet they have concurrently de-rated product price expectations. If the credit crisis is having serious ramifications for iron ore company expansions and therefore future supply of iron ore, it would seem odd that the price of existing iron ore production would fall -23% under those circumstances particularly given hedge funds aren't involved in the pricing of iron ore.

Personally, I think the markets concerns about FMG's ability to fund further expansions beyond 60mtpa are over-stated. The market is only looking at the credit and equity markets and coming to the conclusion FMG will find it difficult to get funding. Right now, those investment markets are shut but the corporate market for funding in this sector is not shut for the right large companies.

There is obviously a window of opportunity for a "big brother" to turn up and provide funding for FMG's expansion. Clearly, the world's steel mills want a genuine competitor to BHP/RIO/VALE and it wouldn't be surprising to see a group of steel mills finance FMG's expansion. And while most of you will dismiss this, do not underestimate Australia's Future Fund turning up to play a role either. I am told the Future Fund is a little surprised how few Australian companies with funding issues have knocked on their door.

I am not as concerned about FMG's funding as the market is. The company is one of Australia's most entrepreneurial and creative. They will find a sensible solution to the issue and the market in my view is too pessimistic in discounting FMG as only ever producing 60mtpa of iron ore. That's just too pessimistic and implies funding markets will never open up again or FMG will be able to access corporate or sovereign funding.

I suspect FMG's share price will be highly correlated to credit markets in the short-term. If I am right and we are at the absolute nadir of credit market activity and counterparty risk, then we are also at the nadir of FMG's share price. In a more rational short-term funding environment FMG shares should be closer to $7.50. We continue to recommend accumulating FMG at these low levels.

There is capitulation everywhere and fear has never been higher. Yet there is the clear possibility the very worst of credit market activity is occurring right now. That says to me there will be opportunities during this equity market capitulation event. However, we have to acknowledge this is downright ugly now and all we can hope for in the shorter-term is the occasional tradeable relief rally. It does give me hope, however, that radio DJ's are now asking whether they should sell their shares!

Let's see what tomorrow brings.

Go Australia


Charlie Aitken
Director
Head of Institutional Dealing
Southern Cross Equities