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Morningstar | Shrinking Discounts and Higher Iron Ore Price Benefit Fortescue; FVE Raised to AUD 4.50 Per Share. See Updated Analyst Note from 20 Feb 2019

We raise our fair value estimate for no-moat rated Fortescue to AUD 4.50 per share from AUD 4.20 previously. The increase reflects higher near- and medium-term earnings. A faster-than-expected convergence in iron ore price discounts for Fortescue’s lower grade product, compared with the benchmark 62% index, is the primary driver. At its worst in 2018, Fortescue’s ore received an approximate 50% discount relative to the 62% index. This has subsequently shrunk to around 15%, slightly better than our unchanged 17% long-term assumption.

Despite our higher fair value estimate, Fortescue shares have risen sharply with the Vale disaster and the higher iron ore price and screen as overvalued. We think the upside from iron ore supply disruption is likely temporary, and the benefit is more than factored into the share price. Higher near-term prices raise the chance of an eventual supply response. We see additional iron ore supply coming from Vale as it recovers, Anglo American in Brazil, and Samarco once it restarts, though the timing is uncertain. Mineral Resources also looks keen to enter. China’s steel demand should decline, and scrap should account for a greater proportion of consumption. Iron ore is well above the marginal cost and required incentive price, a key reason we see the shares as overvalued.

Fortescue’s first half fiscal 2019 net profit after tax declined 5% to USD 644 million versus the same period a year ago. However, that comparison masks a significant sequential lift. Adjusted profit was up 66% against the second half of fiscal 2018, reflecting lower product discounts. The better realised iron ore price saw Fortescue’s EBITDA margin expand 24% to USD 21 per metric ton versus the last half. Unit costs were challenged, a function of lower volumes. We expect unit costs to improve with much stronger volumes expected in the second half of fiscal 2019. But we’ve lifted our overall near- and medium-term cost assumptions with the recent half’s actuals.

Reduced discounts for lower grade ore reflect a renewed focus on raw material input costs for steel makers. Lower steel maker margins have again seen those firms focus on minimising unit costs through lower cost inputs, rather than maximising steel volumes with higher grade raw materials.

We’ve consequently lowered our assumed discounts for Fortescue’s ore relative to the 62% benchmark. In fiscal 2019, it’s now 30% versus 35% previously and 40% in fiscal 2018. For fiscal 2020 to fiscal 2022, we now assume an average 21% discount down from 25% previously. A modest increase in near- to medium-term unit costs is a partial offset, but longer term, we still expect incremental cost efficiencies through innovations such as automation. As a result of the cost and price discount changes, we raised our earnings forecasts by 15% to USD 0.58 per share in fiscal 2019 and by 18% to USD 0.52 per share in fiscal 2020.

Dividends were a feature of the result with Fortescue declaring a AUD 0.19 per share interim and AUD 0.11 per share special, both fully franked. This was up from AUD 0.11 per share in the first half of fiscal 2018. The increased payout reflected the much stronger financial position and the improved outlook given the higher iron ore price and lower discounts. Net debt sits at USD 3.0 billion, down from USD 3.3 billion a year ago. EBIT interest cover is a comfortable 7.9 and annualised net debt/EBITDA sits at 0.9.

We see scope for further modest debt reduction, but a relatively limited call for capital investment from the core business. Rather than undertaking another round of large-scale investment, Fortescue says it remains focused on extracting efficiencies and volumes from the current asset base. In addition, the firm’s exploits outside iron ore are long-dated and limited to early stage exploration. These are relatively modest investments. Therefore, we expect excess cash, particularly from the most recent unexpected spike in the iron ore price, to most likely be returned to shareholders.