Morningstar | Fortescue's Fiscal 2018 Adjusted Net Profit Halves on Increased Product Discounts
No-moat-rated Fortescue's fiscal 2018 net profit fell 58% to USD 879 million compared with fiscal 2017. The result was weaker than we had forecast, a function of lower sales revenue and higher costs, including USD 289 million of costs associated with the early repayment of debt. The fall almost entirely reflects the lower realised iron ore price of USD 44 per tonne, down 17% on the average of USD 53 per tonne in fiscal 2017. Fortescue's lower realised price was due to the widening discount for lower-grade iron ore. The average price for the benchmark index 62% grade iron ore was almost flat at USD 69 per tonne versus USD 70 in fiscal 2017. Underlying net profit almost halved to USD 1.08 billion after excluding the USD 202 million of aftertax expenses from early debt repayment.We reiterate our AUD 3.70 per share fair value estimate and the shares remain somewhat overvalued. This reflects our expectation for China's demand for iron ore to decline as steel consumption growth stalls and more is satisfied from scrap as China's stock of steel matures. In addition, we expect the prevailing favourable iron ore price to incentivise new supply. This is evidenced by Hancock Prospecting's acquisition of Atlas Iron and Mineral Resources' plan to build a railway with annual capacity of 50 million tonnes.
We agree with Fortescue the current elevated price discounts for lower-grade iron ore reflects high steel maker margins which are unlikely to persist. Our expectation for a narrowing price discount provides a partial offset to our forecast for a lower midcycle iron ore price of USD 40 per tonne from 2023. By fiscal 2023, we expect Fortescue to realise a price of USD 33 per tonne. This represents a more than halving of the discount relative to the 62% benchmark to 17% per wet metric tonne versus an estimated 40% in fiscal 2018. Our expectation for discounts to normalise means Fortescue is trading at a smaller premium to our fair value estimate than BHP and Rio Tinto.
Fortescue reiterated its fiscal 2019 guidance. The firm expects production of 165 to 173 million tonnes and our forecast remains 170 million tonnes. The ultimate level of production will depend on the mix of products and this will depend on the market. Fortescue will introduce a higher-grade 60% product from fiscal 2019 and will balance output for its various products depending on the price differentials. Unit operating cost guidance remains USD 12 to 13 per tonne, similar to the USD 12.36 per tonne achieved in fiscal 2018. Planned capital expenditure of USD 1.2 billion is about one third higher than fiscal 2018, reflecting early expenditure for development of the new Eliwana mine, which is due to start production in 2022.
The company remains in sound financial shape. Net debt of USD 3.1 billion was up from USD 2.6 billion reflecting the timing of tax and dividend payments. Including customer iron ore prepayments, net debt increased by USD 370 million to USD 3.9 billion. Net debt (including customer prepayments)/EBITDA is 1.2 and EBIT/net interest is 5.5, both relatively comfortable. Tenure is relatively long with the first major debt repayments not due until 2022, when USD 2.15 billion falls due. Free cash flow of USD 720 million was well down on last year's USD 3.5 billion reflecting the lower realised iron ore price and the timing of tax payments. In fiscal 2017, Fortescue only paid USD 375 million for tax versus USD 1.06 billion in fiscal 2018.
Dividends totalled AUD 0.23 per share on a 51% payout ratio of adjusted earnings, down from AUD 0.45 in fiscal 2017, reflecting the lower adjusted net profit. We expect dividends to average AUD 0.17 per year for the next five years with a rising payout ratio, due to improvement in the balance sheet, partly offsetting our expectation for lower earnings due to the forecast iron ore price.
Fortescue Metals Group is an iron ore producer. As of June 30 2016, Co.'s operations had four mine sites in the Pilbara. The Chichester Hub, which includes the Cloudbreak and Christmas Creek mines, is located in the Chichester Ranges and the Solomon Hub, in the Hamersley Ranges, includes the Firetail and Kings Valley mines. Co. owns and operates an integrated supply chain including its Herb Elliott Port in Port Hedland and a heavy haul railway with over 620km of track. As of June 30 2016, Co.'s total hematite ore proved and probable reserves were 2.17 billion tonnes. Also, as of June 30 2016, Co.'s total magnetite ore proved and probable reserves were 705.0 million tonnes.
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