Metals & Mining: Iron ore could re-test US$120/t

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
21 May 2020, 11:30 AM
Sectors Covered:
Mining, Energy

  • Already positive iron ore fundamentals continue to improve, gaining support from global supply that is failing to keep pace with resilient consumption.
  • Weekly iron ore exports from Brazil, home to the world’s second-largest seaborne producer Vale SA, are materially under-performing guidance and could see added tightness.
  • Running flat iron ore prices through our RIO/BHP/FMG models to backsolve current share prices implies RIO is trading on US$61/t, BHP US$75/t, and FMG US$76/t.
  • BHP and FMG multiples appear reasonable, while RIO’s relative leverage to iron ore looks like it could be more heavily rewarded.
  • We upgrade FMG to Hold (from Reduce); and retain Add ratings on BHP/RIO.

Listen to the podcast:

Morgans Senior Analyst Adrian Prendergast provides an update on the Iron Ore sector, including the macro plays causing disruption and his top two sector picks.

Good times set to keep rolling

Brazil iron ore major Vale SA recently cut CY20 guidance by 35-40mt to 310-330mt, a big step down from the 340-355mt it was guiding to. However, a new issue is emerging: government restrictions and Covid-19 spread in Brazil has continued to drag on Vale’s ability to ship tonnes. As a result, Brazil iron ore exports are sitting at their slowest start to a year for the last five years. Having shipped just 91mt, we estimate Vale will have to average c.7mt per week for the remainder of 2020 to achieve the low end of its already- downgraded guidance. This is a significant issue considering Brazil exports currently sit at just 4.2mt/w (having averaged 4.8mt/w YTD), made worse by the fact that Covid-19 is starting to spread in Brazil’s key mining districts, potentially further hampering shipments. Add this to steadily declining iron ore stockpiles in China, and potential new stimulus measures that could be announced in China later this week.

Value could be further overwhelmed by high earnings

Running flat iron ore prices through our RIO/BHP/FMG models to backsolve current share prices (while applying spot prices for other commodities (ex-iron ore) for the diversified miners) implies RIO is trading on US$61/t, BHP US$75/t, and FMG US$76/t. FMG’s premium makes sense given current commodity market conditions have left diversification at a disadvantage. Meanwhile we can also appreciate that BHP is trading with a partial oil price recovery priced in. While RIO’s share price has outperformed the wider market, we have not seen it rewarded on par with what we would expect given its tremendous sensitivity to iron ore. This, combined with RIO’s potential to pay high cash dividends, leaves the big miner looking particularly attractive.

FMG has a special place in the seaborne market

FMG remains the largest beneficiary of strong iron ore market conditions, as a mass-scale low-grade iron ore producer. While trade tensions between China and Australia could (immaterially) appear in iron ore, we expect FMG would be well supported by the Chinese in this scenario given its market position as a decentralising force against the market dominance of RIO, Vale and BHP. A point we expect would see FMG well supported by its seaborne customers in the downside scenario of broader trade and geopolitical instability. Current EV against FY21F EBITDA consensus sits at 4.8x (well above usual bull-market multiple of 3.7x) although with spot sitting 35% above consensus this appears reasonable.

Retain Add ratings on RIO/BHP

We maintain conviction and Add ratings on BHP and RIO. Recent share price strength justified by robust fundamentals. High-quality earnings, balance sheets and dividends (especially vs other Australian large caps). We have further marked-to-market our 2020 iron ore price forecasts (+5%) and other metals, leading to increased target prices for BHP (was A$36) and RIO (was A$99).

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Upgrade FMG to Hold

We have made a number of changes. Small bump in benchmark prices, plus lowering the discount on FMG’s low/mid-grade products to 17-20% (from 25%) reflecting market conditions. We have adjusted FY21/22 strip ratio forecasts to ~1.9 (from 2.2). Net of these changes our FMG NPV climbs to A$10.34 (from A$8.51). Given FMG’s large sensitivity to short-term earnings strength we have also moved to 50:50 NPV:EV/EBITDA blend for our target price, applying an upcycle multiple of 3.7x to spot EBITDA (US$7.6bn) giving us a blended price target for FMG (login to view target price). On a TSR basis this leaves FMG appearing fair value. As a result we upgrade our recommendation to Hold (from Reduce).

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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