Fortescue Metals ((FMG)) has laid out its strategy for growth, with capital expenditure on track and West Pilbara fines scheduled for production from this December. Around 5-10mt is expected to be delivered in the second half of FY19. First ore from the Eliwana mine will commence in December 2020.
West Pilbara fines, 60.1% iron, will commence production at a rate of 10-20mtpa until Eliwana is constructed, at which point the rate will lift to 40mtpa. The company will host a site trip at the end of November to provide more opportunity to assess its new product strategy.
The introduction of West Pilbara fines into the product mix will benefit price realisation in the second half of FY19, UBS calculates, assuming super special and Kings fines remain at current levels and Fortescue blend is reduced. Macquarie, on the other hand, is not factoring West Pilbara fines into models until the commissioning of Eliwana, which provides upside potential to base case assumptions.
Shipments in the September quarter were 40.2mt, down -9% because of maintenance and restocking following the jump in the June quarter. Shipment guidance for FY19 has been maintained at 165-173mt.
Costs were higher, the result of an increase in total material movements as well as maintenance and fuel costs. Pricing achieved, at US$45/dmt, equated to a 67% realisation of the average Platts 62 CFR index price, attributed to higher sales of Fortescue blend relative to FY18 and lower sales of super special fines.
The slightly higher component of Fortescue blend, at 48% versus 45% in FY18, with a reduced super special component, and the greater skew towards premium product, may have been a factor in achieving better pricing. Shaw and Partners re-evaluates the components required to achieve FY19 targets and assesses the business is set up to deliver across production, sales and cost guidance.
Total material movement increased 11% in the September quarter versus the prior quarter with strip ratios of 1.6. Strip ratios are expected to average 1.5 over the year. The broker, not one of the eight monitored daily on the FNArena database, has a Buy rating and $5.60 target.
Value Proposition
Macquarie observes the share price has diverged from historical correlations to the 58% iron index recently and there is significant upside at spot prices. The business is leveraged to its realised iron ore price and valuations can improve substantially, with a 10% increase in spot iron ore prices resulting in a 20-30% increase to the broker’s spot valuation.
Despite the market being fixated on product discounts, Credit Suisse believes Fortescue Metals still has value, as margins are solid and cost performance best in class. Near-term upside is likely to be limited by the broader resources environment and the upcoming winter in China.
Nevertheless, the balance sheet appears sufficient to navigate the uncertainty. Credit Suisse points out the market did not forecast the impact of the 2017 shutdown in China successfully and, whilst the base case is for a similar impact this year, shutdowns may be less stringent.
The broker points to stronger steel margins but remains concerned over sustainability, as demand appears to be moving to medium-grade fines from high-grade because supplies are more readily available. Credit Suisse suggests any softness in steel spreads could mean more demand for lower grade products, particularly from smaller mills with greater sensitivity to price.
Capital Management
Capital management is now in focus as the company has announced a $500m share buyback. The program will be funded out of operating cash flow and remain in place for 12 months.
Macquarie assumes the buyback occurs equally over the second quarter of FY19 and into the first quarter of FY20, expecting Fortescue Metals to buy back 135m shares. The broker believes the buyback is a prudent move and earnings accretive. Citi expects the company to generate around US$700m in free cash flow in FY19, supporting the buyback, as the next major debt repayment is not due until 2022.
FNArena’s database has five Buy ratings, one Hold (Citi) and two Sell. The consensus target is $4.64, suggesting 20.2% upside to the last share price. Targets range from $5.68 (Morgans) to $3.30 (Morgan Stanley). The dividend yield on FY19 and FY20 forecasts is 7.1% and 6.6% respectively.
