How to save Fortescue Metals Group

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From Credit Suisse:

Site visit points to “bankable” 171mt in FY17: Last week’s FMG site visit highlighted a no-capex pathway to a potential 180mtpa output. Rail and port capacity will be at this level by mid CY15. We have assumed 171mt production in FY17 post the start-up of the Solomon detritals plant plus 5mtpa of additional DSO at Chichesters. We stick with our US$30-$31/t cash costs to be conservative but note FMG is targeting cash costs in the mid $20s/tonne range. Higher volume assumptions see our FY15 EPS revised up 4% and FY16-17 EPS up 10%.
■ Valuation metrics compelling: In FY16 we use $80/t China fines pricing and FMG can still generate $1bn off our $30/t cash costs. And with capex at$1.2bn, debt can still be reduced by ~$700m. Even at this earnings and FE price low, FMG trades on FY16 PE of 8.6x, price/cash earnings of 3.9x and FCF yield of ~11% at an EBIT margin of $11/t. Our DCF SOTP is A$6.5/sh.
■ Stress test also supportive: Running $85/t in perpetuity through our models with no change in costs gets a DCF in line with the share price for a steady state EBIT margin of $13/t. At $5/t lower costs, the share price solves for $80/t iron ore. The good news is that at $13/t margin, FMG can still reduce debt and is trading on prospective P/Es at 6-7x and cash P/Es at ~3.5x. At the lower costs, the EBIT break-even Fe price is $72/tonne. Every $4/t increase in the assumed Fe price adds A$1/sh to the DCF.
■ Maintain OUTPERFORM and target price of $5.00. FMG’s shares are down 24% in the last three months, underperforming iron ore peer Rio Tinto by 16%. On a 12-month view, FMG has underperformed Rio by a hefty 28%. Value is apparent and we think our stress-testing points to an attractive risk-reward opportunity.

No, it isn’t. There is only one reason to buy FMG and that is a punt on a year end restock. Beyond those three months none of this makes sense, especially from Credit Suisse whose commodity analysis is very bearish and very good.

The problem is that using prices that are above current values is not a stress test. $60 is needed not $80-85. Moreover, CS sees FMG breakeven at $72 at C1 costs of $32, with possible cost savings over the next three years of $6/tonne. That’s all to the good. But if I’m right and FMG is the emerging marginal cost producer then that won’t matter at all. In a market share battle what matters is not how cheap you are but how cheap versus your competitor. Recall the UBS cost curve:

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Roughly 350mt of new cheap production is coming on stream in the next two years. If Chinese steel output grows by 2% then that’s roughly 50mt in iron ore demand growth over the same period (and I expect less). If China closes 100mt of iron ore production (62% equivalent) then the 100mt or so above FMG on the cost curve will also disappear and that still leaves 100mt of FMG’s production on the wrong side of a balanced market. In that circumstance, any cost cutting by FMG will simply be recycled to China in lower prices.

FMG doesn’t need to get cheaper to survive, it needs to get cheaper than Vale to survive. And remember that Vale has already made a big leap forward with its Valemax ships taking $5 more out of its costs since the UBS chart was printed.

Only three things can save FMG in my view. Chinese steel production grows by more than is hoped or its iron ore production capitulates more than it has and more than I expect, keeping iron ore prices above $70. Or, the Australian dollar must fall radically against the Brazilian real so that FMG can pass the ignominious label of “marginal cost producer” to Brazil.

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If you think I’m being dramatic, try Deutsche via The Oz:

The broker increases its earnings estimates 5%-9% as last week’s site tour revealed increased production at lower costs, but warns that with spot iron ore US$79.5 a ton and AUD/USD at 0.88, its earnings estimates, under the new operating and cost assumptions, would drop by 50% in FY15 and 20-30% from FY16-18. At spot prices, its valuation would drop by around 50% to A$1.85/share and cash would drop below US$500 million unless capex is deferred.

“Even if capex is deferred a short term debt facility would be required as cash would dip below the business critical US$1 billion mark,” analyst Paul Young says.

A much lower dollar is desperately needed to save FMG but I’m afraid it (and the juniors) have joined the ranks of other Australian tradable sectors being hollowed out by Sydney housing speculators.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.