We expect iron ore prices to stabilise above US$85/t.
We forecast debt reduction and increased dividends on this basis. EBITDA is flat on our base case, but we identify upside elements that could contribute inforward years. We upgrade Fortescue to OW.
Equity price decline has created the upside: Our valuation and forecasts are largely unchanged. The equity is trading below a spot price scenario valuation, A$3.95/sh, and our base valuation of A$4.69/sh. We still allow for a bear side skew in our PT, but at A$4.30/sh there is sufficient upside to warrant the rating upgrade.
The view is not without risk: It is based on our house view that 62% iron ore price index will be at, or above, US$85/t for the next several years. However, if this is the case, then Fortescue can reduce its gearing below 40% in FY17 and increase the dividend. The 4-5% yield we forecast also suggests the equity is under-priced.
Upside factors still to flow: We estimate the potential expansion to ~175Mtpa (shipped) and gas conversion of the truck fleet could add A$1.25/sh to our base case NAV and 20% to EBITDA in four years. These are elements that could support the equity in future years.
New price deck carried through: There is a 14% EPS reduction in FY15e as a result of the recent revisions to the MS price deck, but from FY17 forward there are EPS upgrades as we have reduced the moisture factor to 8%.
Returns to the top pick list: As with RIO, which we recently upgraded to OW, FMG is once more a large cap mining top pick. We prefer RIO for its larger, lower-cost iron ore business, but both offer leverage to our view that iron ore prices will stabilise above current levels.
This is a trade recommendation, really. For the longer term, the first line is all that matters. I see $65 within eighteen months…
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.
