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Fortescue faces uphill climb

Lex Hall  |  12 Feb 2020Text size  Decrease  Increase  |  
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The near-term outlook for Fortescue Metals Group is strong but the twin tailwinds of high iron ore prices and buoyant Chinese demand may fade, says Morningstar.

Fortescue (ASX: FMG) shipped an impressive 89 million tonnes in the first half and is well on track to meet full-year guidance to ship 170 to 175 million tonnes of iron ore in 2020, says Morningstar director of equity research Mathew Hodge.

At 1pm Fortescue was up 0.4 per cent at $11.16 – a more than 60 per cent premium to Hodge’s fair value estimate of $6.80.

Fortescue is the world's fourth-largest iron ore exporter. Its margins trail those of industry leaders BHP Group (ASX: BHP) and Rio Tinto (ASX: RIO), and some way behind Vale (NYS: VALE). As such, Fortescue sits in the highest half of the cost curve. This is chiefly why it has no moat or long-term competitive advantage, Hodge says.

It also relies on a lower grade of iron ore, which it ships almost exclusively to China.

2019 was a good year for Fortescue as high iron prices and supply disruptions at rival Vale boosted demand.

However, the current iron ore price of more than US$80 is double Hodge’s long-term forecast and he expects prices to decline as China reduces its steel consumption and Vale’s production recovers. The coronavirus is also a near-term headwind, he says.

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“With all revenue from iron ore, and operating costs in the highest half of the industry curve, after adjusting for product discounts, we expect Fortescue to be hardest hit by a lower iron ore price.”

Fortescue has grown almost exclusively on debt. Highly favourable iron ore prices, aggressive management, and low corporate interest rates have also combined to fuel its rapid growth.

The high ore price has also allowed Fortescue to strengthen its balance sheet and clear debt.

However, given its vulnerability to Chinese demand, a fall in the iron ore price and the cyclical nature of its capital requirements, Fortescue is wise to run with a conservative balance sheet, Hodge says.

“Fortescue could again benefit if China supports further high levels of fixed-asset investment, as it did in 2016, but in the long term, we see demand growth for steel in China declining,” Hodge says.

“Fortescue has relied on cheap debt and inflated Chinese economic growth to fuel rapid expansion in what is a cyclical industry. If conditions are less favourable than the peaks of 2010-19, Fortescue's earnings and returns are likely to be substantially lower.”

On the dividend front, Hodge forecasts Fortescue’s dividend payout ratio to fall from 79 per cent to 50 per cent because of higher capital spending.

is senior editor for Morningstar Australia

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