UBS: Sell Fortescue, RIO

And here they come. UBS on FMG:

Downgrade to Sell: iron ore fundamentals deteriorating faster than expected

We downgrade FMG to Sell (from Neutral), cutting our target to A$15/sh (from A$18/sh). Since peaking in July, the stock is down 34% while the iron ore price has more than halved. At spot (~$113/t) FMG still generates an attractive FCF yield of ~11%, though we expect iron ore prices to fall below $100/t over the next few months and normalise around the 95th percentile of the value in use cost curve at $70/t-$80/t; at $90/t, FMG generates FCF of ~5.4% incl growth capex (interactive model).

Iron ore prices normalising faster than expected due to weak demand in China

We have been cautious on iron ore over the last 6mths, downgrading RIO to Sell in Jun21 (note) as we expected Chinese demand to soften (with the central govt taking action to deflate commodities) and supply from Brazil/Australia to lift. The correction in iron ore prices has played out faster than expected. Prices have fallen more than 50% since peaking in mid-May. As discussed in our note, this reflects a sharper than expected slowdown in property activity in China thanks to tightening measures/Evergrande risk of default impacting confidence. We have downgraded our iron ore price forecasts. We expect the iron ore market to swing into surplus in 2H21, prices to fall below $100/t over the next few months, before averaging $89/t ($101/t previously) in CY22. We remain cautious medium-term, as supply from the incumbents is set to lift, Guinea is set to add 100-200mt from 2025/26, and as steel scrap in China increasingly displaces iron ore demand.

Catalysts: Iron Bridge, Fe discounts, FFI investments

We expect the iron ore price & China macro (eg stimulus, construction activity etc) to be the key driver of the stock near-term. Other catalysts include: 1) Iron Bridge: we see a risk of a further delay/capex increase if Covid border restrictions persist in Australia. 2) Fe discounts: there is a risk these widen (Jun-Q 84%) if China steel mills focus on productivity. 3) Fortescue Future Industries (FFI): FMG set out its ambition to grow a new energy business to meet its own 2030 carbon-neutral target & generate a new revenue stream; we expect visibility on the spend to improve in 12-18mths.

Valuation: Sell; vulnerable in falling iron ore price environment

Our iron ore price downgrade to US$89/$80/t in CY22/CY23 (from US$101/$85/t previously) drives a 26%/22% fall in EBITDA & 31%/31% fall in EPS in FY22/FY23, and an 18% lower NPV. Our price target is revised to A$15/sh (A$18/sh prior) as a result and is based 50:50 on 1.0x NPV and 4.5x FY23 EV/EBITDA. We estimate FMG discounts a long-term iron ore price ~$95-$105/t, vs UBS’ long-term price of $65/t (real).

Reiterate [RIO] Sell: falling iron ore price undermines cash returns investment case

We downgraded RIO to Sell in Jun-21 (note) as we were cautious on iron ore and we believed the near-term risks for the commodity complex were increasing with the Fed turning more hawkish & China taking action to deflate commodities. The correction in iron ore price is playing out faster than we expected and so we cut our 2021/22 iron ore price forecasts ~10% (note); as a result, we cut RIO’s 2021/22 earnings by 15-20% and our price target by 16% to A$86/sh (from A$102/sh). Our 2022E EBITDA is now 36% below Visible Alpha consensus. RIO still generates significant cash flow at spot (yield ~13% interactive model), but this falls to ~4% at normalised commodity prices (iron ore ~$70/t, aluminium ~$1.00/lb).

Iron ore prices normalising faster than expected due to weak demand in China

The correction in iron ore prices has played out faster than we had expected with prices down 45% since start-July. This is driven mainly by a sharp slowdown in property activity in China with the tightening measures/ Evergrande default impacting confidence; we now expect the iron ore market to be in surplus in 2H21 & prices to fall below $100/t over the next few months. We remain cautious medium-term as supply from the incumbents is set to lift, Guinea is set to add 100-200mt in 2025-30, and as steel scrap in China is set to increasingly displace iron ore demand.

Catalysts & risks: shipments lagging, Oyu Tolgoi issues

We expect the iron ore price & China macro (eg stimulus, construction activity etc) to be the key driver of the stock near-term. Other catalysts include: 1) 3Q production: we see 5-10Mt downside risk to RIO’s 2021 Pilbara shipment guidance of 325Mt with volumes lacklustre in Jul/Aug (note); 2) Oyu Tolgoi: RIO may have to delay the Oyu Tolgoi start-up (Oct-22) & lift capex as it still awaits approvals from the Mongolian govt. Key risks to our cautious view is that China starts to aggressively ease & support the property market given the recent slowdown.

Valuation: Sell; still material downside risk to the spot iron ore price

Our iron ore price downgrade to US$89/$80/t in CY22/CY23 (from US$101/$85/t previously) drives a 17%/11% fall in EBITDA & 22%/15% fall in EPS in FY22/FY23, and an 7% lower NPV. Our price target is revised to A$86/sh (A$102/sh prior) as a result and is based 50:50 on 1x NPV and 6.0x EV/EBITDA. We estimate RIO discounts a long-term iron ore price ~$80-$90/t, vs UBS’ long-term price of $65/t (real).

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Comments

  1. just_the_pipMEMBER

    Well done and thank you for being miles ahead of the curve on this DLS. This has so far been an immensely profitable trade