Fortescue Metals has done something very difficult, even laudable (although not always in the most laudable fashion). It has successfully challenged the iron ore cartel in Australia of BHP and Rio. That may make it good for competition in the sector, but does it make it a good investment? It is certainly down from some spectacular highs. The stock was over $12 in 2008, it is only just above half that now. As a consequence, the stock is now trading on some reasonable fundamentals. It is predicted to start producing small dividends this financial year, and its earnings multiple for 2011-2012 according to Macquarie is a low 7.6 times. The 2008 euphoria, obviously overdone, may now have been replaced with too much caution.
Brokers are not rushing to advise buys, which may in itself open up buying opportunities. The broker targets are intriguing. Macquarie has a 12 month target of $9.25 with the stock trading at about $6.33. But there is only an outperform recommendation. Macquarie must have considerable scepticism about management or the iron ore price when it is estimating a total shareholder return of 45%. Deutsche Bank has a much lower 12 month price target of $6.20 and is recommending a hold. Merrill Lynch is in the middle with an $8.45 price target and is recommending a buy. That is an unusually wide spread and high level of disparity amongst analysts.
Royal Bank of Scotland is advising going long on the stock, saying it is cheap:
1. FMG is highly leveraged to the buoyant iron ore market, which is leading to strong cash flow. This cash flow is
2. The stock is also trading at a deep discount to our NPV, and at low PEs relative to the sector.
3. We foresee a number of positive news flow events in the medium term, including potential resource expansions.
Merrill believes the financials are strong:
The balance sheet remains robust and revenues continue to trend higher. Cash balance for 3Q ended with ~US$2.15b which was post-capex and all finance payments to end 3Q. Free cash flow was consumed somewhat during the last quarter by the following uses (i) Capex – $323m, (ii) Finance payments – $182m, and (iii) Dividend payment – $93m for a total of $598m. Although no dividend payments are required during 4Q, we expect a similar (if not higher) spend pattern on CAPEX, as growth firms up.
So what is the problem? Deutsche says lower recovery is a negative. Perhaps, but that would seem to be in the price at this stage. What analysts do agree about is the obvious: that the stock is leveraged to the iron ore price. It is a point Macquarie makes:
We rate FMG Outperform with a target price of A$9.25ps. We believe FMG offers leverage to short- to medium-term iron ore price strength, combined with capital-efficient expansion plans. Solomon reserve parameters released today are aligned with / better than our current forecasts for Solomon revenue and opex.
The conclusion seems to be that for investors who like the prospects for the iron ore price, Fortescue is probably a reasonably cheap play. Of course, it all depends on China. And waiting for the correction that is building might be wise. But what doesn’t these days in Australia?
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