Fortescue Metals Group: Pressure building
About the author:
- Author name:
- By Adrian Prendergast
- Job title:
- Senior Analyst
- Date posted:
- 07 June 2021, 10:30 AM
- Sectors Covered:
- Mining, Energy
- After a remarkable run, and hefty shareholder returns, we see the risk/reward balance for Fortescue Metal Group (ASX:FMG) finally skewed to the downside.
- A mass-scale low-grade pure iron ore producer, and fledgling energy aspirant, we see FMG as being particularly sensitive to a maturing iron ore cycle.
- Adding to risks, cost pressures are surging in WA which could lead to a softer Q4 sales/cost performance and potential further Iron Bridge downgrades.
- We have upgraded short-term iron ore forecasts, while also increasing operating cost assumptions and reducing FMG’s multiple closer to its peak cycle level.
- We pull back our rating to REDUCE (from HOLD) with a revised target (login to view).
Cost pressure rampant
Surging cost pressures are an industry-wide issue in WA, but we expect it is particularly painful in the Pilbara, especially for FMG who has an extensive production network and project under construction.
This has already been evident with the 16% increase in C1 costs reported in the March quarter, and this week’s material capex blowout at Iron Bridge, but anecdotal reports and sector news point to continuing pressure.
We expect FMG’s C1 costs to continue to escalate/inflate beyond the US$14.9/wmt reported in the March quarter. Attempting to minimize costs we see potential for FMG to trim back production volumes in Q4, although unlikely to impact Q4 shipments given FMG will run down stockpiles.
Meanwhile further downgrades for Iron Bridge also cannot be ruled out.
As good as it gets for iron ore?
The immediate outlook for spot iron ore is a critical question given it remains the dominant driver for FMG fundamentals.
In the short-term we see:
- Flat iron ore stockpiles at Chinese ports year-to-date (suggesting lack of real tightness)
- Early signs Chinese infrastructure and property markets may moderate heading into 2H
- Brazilian iron ore supply recovery continuing and approaching seasonally higher 2H
- Chinese domestic iron ore supply rising
- Scrap steel usage surging (eating into iron ore demand growth).
Further adding to these factors, we expect support from speculators (who have been adding to tightness) will likely reverse against a backdrop of slowing fundamentals.
Moving down to peak multiple
In reality, we find that multiples for cyclicals work inversely to industrials, where peak cycle multiples tend to be low while floor cycle multiples tend to be high.
We attribute this to the cycle look-through equity markets make when valuing resources (i.e. investors unwilling to value iron ore miners on US$200/t into perpetuity, leading to gains in spot earnings outpacing share prices). As a result, low multiples in resources have at times more accurately signalled selling opportunities.
If the iron ore cycle does turn, we expect market focus to shift to earnings direction rather than earnings momentum. With this in mind, we lower our EBITDA multiple on FMG to 4.0x (from 5.5x) in line with its long-term average.
Downgrade rating to REDUCE
FMG is a phenomenal business, and despite our concerns 2H steel demand could still beat expectations. But weighing the scenarios we see the risk/reward skewed to the downside, overcoming its impressive dividend profile.
Net of changes to iron ore prices, opex assumptions and EBITDA multiple, our blended target price (DCF:EBITDA) has declined (login to view) and as a result we downgrade our rating to REDUCE (from HOLD). The key risk to our call is iron ore price risk.
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