fortescue: all systems go

I came across this article in the Eureka Report.

Over the next 12–18 months the stock will track up to the "100 mtpa" trading range of $12.40–15.

Warning. This is a long read but worth while

Fortescue: all systems go
By Charlie Aitken


Where to from here?

To believe that Andrew Forrest and his team would be content as a 55 mtpa iron ore producer would be an error. Once they have proven "practical completion" of stage one by beating a series of production hurdles (to satisfy financiers) I suspect focus will then turn to stage two of the production ramp up.

In a recent note (see Fortescue has arrived) I explored the next leg of the Fortescue production growth, earnings growth, dividend growth, and in turn, share price growth story. I am going to revisit that work below

The debate about Fortescue is no longer whether it will work but what it will earn and what the market will pay for those earnings.

In my view this isn't about discounted cash flows or net present values. This about working out what the potential earnings per share is and then having a shot at what multiple the market will pay for those earnings. This is a simple P/E-based price target scenario analysis.

Before you say that's too basic, remember my very first buy recommendation on Fortescue (at $1.80 with a $5 12 month target) was based on the same methodology. My now somewhat famous "$100" long-term target (adjusted to $10 after the share spilt) was also based on having a shot at estimating earnings over the next five years. So far, that P/E-based price target approach has proved more accurate than any other valuation or price target setting approach. However, my rough "e" estimates have been too low because we underestimated iron ore price rises.


100mtpa by 2010

With the first ore on ship achieved ahead of schedule, the market will now look to the future and start speculating about 100 mtpa production. Let's do some really basic analysis here of what is a really basic business.

Let's assume in 2009-10 that Fortescue produces 100 million tonnes at an average margin of $50 a tonne (conservative). That's EBIT of $5 billion. Fortescue pays some corporate tax (30% conservative) and that leaves net profit after tax of about $3.5 billion. Fortescue has 2,802,393,400 shares on issue, of which an amazing 70% are owned by just five parties and the top 20 shareholders own 92%. Earnings per share works out $1.24 on that scenario and I think the market will pay an absolute minimum of 10 times for that earnings stream (globally unique stock in ultra-politically stable country). That generates a price target of $12.40 per share.

The more likely scenario is that the market pays 12 times for that earnings stream, which generates a price target of $14.88.

I'll be laughed out of town by sceptics for this analysis but I was also laughed out of town when I first speculated about Fortescue earnings-based share price targets 12 months ago. In reality, those initial estimates have proved very conservative.


Moving into a new higher trading range

As the market now comes around to focusing on Fortescue as a 100 mtpa producer, the stock – currently trading at about $9.20 – will trade between $12.40 and $15. That also hasn't assumed Fortescue pays any dividends, which they are likely to do.

Over the next 12–18 months the stock will track up to the "100 mtpa" trading range of $12.40–15. I also suspect during that period the Chinese Government or Anglo American will come on to the register.

So even at just the interim production target of 100 mtpa I can see Fortescue's share price being almost double today's price over the next three years.

Iron ore is the highest economic rent business in all of resources. It is a scaleable logistics game with wonderful margins. Once you have the logistics in place you are in an elite club. Some of the members of that elite club have previously undercut other members of the club, which has led to a multi-decade mispricing of Australian product. BHP is ending that mispricing and Australian producers will be the beneficiaries. Australian producers will get the freight differential one way or another. I also believe iron ore "benchmark" prices will rise again next year.

While many investors will naturally think "I've missed the Fortescue boat", I believe that certainly isn't the case. You have missed the share price all but discount a 55 mtpa producer, but you are still buying a 100 mtpa, 200 mtpa or eventually a 300 mtpa producer very, very cheaply.

Fortescue remains a strong buy and is the great " pure play" winner in all of this. It has done such an admirable job against enormous odds and enormous scepticism. It is now a physical "producer" and from this point domestic investors who need to see cash flow, can buy the stock.

Fortescue is the biggest story in Australian resources and very few Australian institutions own it (yet). If you build it they will come. Today the first ship came and it was great to see it loaded live.