We feel that the market is becoming increasingly bearish on iron ore, but expect Chinese demand to remain strong.
As a pure-play low-cost iron ore producer, we expect Fortescue Metals to profit greatly.
We see significant upside potential should iron ore remain north of $80 a tonne.
Fortescue Metals (OTCQX:FSUMF) is an iron-ore producer based in the rich soils of the Pilbara in Western Australia. While it is a relatively new company, making its first shipment in 2008, it has rapidly made a name for itself with its low costs and tantalizing dividend yield. Although iron ore price projections are currently up for debate and the general consensus seems to be that it's only a matter of time before things take a downward turn, we think the insatiable demand of Chinese steel producers can sustain the current demand far longer than the market expects. With this in mind we think it could be a good time to dig deep on this diamond in the rough.
Source: Company presentation
Like a phoenix from the flames the iron ore price roared back to life in 2016. As the chart below shows, prices fell below $40 a tonne at the start of last year on the back of oversupply and a slowdown in demand from China following its proposed shift to a consumer-driven economy. Few expected the world's second-largest economy to make a successful transition and they appear to have been spot on. At least for now. With China's steel mills firing up, demand for the steel-making ingredient has soared, catching many in the market by surprise.
Although for a long time the market was calling the iron ore price a speculative bubble, it turns out that there was more to it than just Chinese speculators chasing riches. So much so RBC Capital has been forced into revising its iron ore price forecasts by 20% and now expects an average iron ore price of $84.50 a tonne in 2017 thanks to China's massive demand for steel. At present, RBC Capital has forecast a 4.5% increase in demand, which we feel places Fortescue in an excellent position to capitalize. Especially given that it became the world's lowest cost seaborne supplier of iron ore in 2016, enjoying high margins and bumper profits. As of its most recent half-year report, Fortescue delivered C1 cash costs (operating costs of mining, processing, rail and port on a per tonne basis, including allocation of direct administration charges and production overheads) of $13.06 per wet metric tonne. As you can see below, Fortescue has managed to reduce its C1 cash costs all the way from $48 a tonne to between $12 and $13 a tonne this year.
Unlike BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO), the mining and supply of iron ore is Fortescue's sole focus. While this lack of diversification means that the miner comes with significant downside risk in the event of a downturn to prices, whilst prices are high we feel the miner is arguably the best way to gain exposure to the industry. Whilst we expect iron ore prices to remain above $84 a tonne, due to the vast improvements in its C1 cash costs, it wouldn't be too detrimental to the miner if prices were to fall a touch lower than this. In fact, even if the iron ore price only averages as much as US$73 a tonne, as some have predicted, there's still good bang for your buck.
Source: copyright link
Not only has favorable iron ore prices meant that Fortescue has been able to pay down a substantial amount of its debt, see above, but it has also given the company the ability to return money to shareholders through its dividend. At present the company pays out approximately 38% of its earnings, but we believe there is significant room for improvement in this regard. In fact, Fortescue chief Nev Power has recently been on record saying that the iron ore producer will consider increasing its payout ratio this year. We think this could mean that its policy of returning 30% to 40% of profits to shareholders is thrown out of the window, possibly opening the door up to a payout ratio of up to 60%. Especially now its debt is under control, its credit status is much improved, its chairman and largest shareholder Andrew Forrest is known to be a big fan of dividends.
But it's not just the dividend that should get investors excited. We see significant share price gains ahead if the iron ore price is maintained. Based on an average iron ore price of $84 a tonne and EBITDA of A$5.432 billion we have an EV/EBITDA-based 12-month price target of A$8.20 ($6.35) on its shares - approximately 34% higher than the current share price.
But as with every investment there are risks to consider. The biggest risk with Fortescue is of course the iron ore price and the impact it has on both the company and its share price performance. HSBC has predicted a bomb in prices this year as supply catches up with demand, potentially to the point of saturation. Whilst we acknowledge that an increase in supply is likely to come this year, as long as Chinese consumption continues to remain strong, as we expect it will, then we think prices will remain favorable.
Despite this risk, in our opinion an investment in Fortescue over the next 12 months provides investors with a compelling risk/reward. We class the Australian iron ore producer as a buy. Disclosure: I am/we are long FSUMF.
FMG Price at posting:
$6.10 Sentiment: Buy Disclosure: Held
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