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Iron ore miners reap cash bonanza

Nicki Bourlioufas  |  25 Jan 2021Text size  Decrease  Increase  |  
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Analysts from several research houses have upgraded their earnings forecasts and price targets for iron ore miners after a surge in the price of the bulk commodity. However, some say the fallout from Juukan Gorge disaster could plague Rio Tinto’s growth and favour investments in BHP Billiton and Fortescue Metals Group.

Iron ore prices are trading at around 10-year highs at around US$170/tonne and the current spot price is well above most analysts’ long-term forecasts. Iron ore prices have rallied more than any other bulk commodity over the past year based on expectations of ongoing strong demand from China, which accounts for over half of the world's steel production.

“Buoyant iron ore prices and positive leading indicators (such as relatively low port stocks and positive steel margins) underpin our bullish stance on iron-ore exposure,” Macquaire analysts said in a research note. This has pushed up the prices of iron ore miners, many to record highs, in recent weeks, including Fortescue Metals Group (ASX: FMG), BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO), Mineral Resources (ASX: MIN) (which has also gained with lithium prices) and Champion Iron (ASX: CIA).

Iron Ore US/tonne (NJYMEX)

Iron Ore Price

Source: MarketIndex.com.au

Morningstar mining analyst Mathew Hodge has recently lifted his near- to medium-term outlook for several commodities and fair value estimates for iron ore miners.

“Over the next three years, on average we’ve lifted our forecasts for iron ore prices by 34 per cent, copper 12 per cent, gold 8 per cent, thermal coal and aluminium 6 per cent and alumina 4 per cent. We’ve also factored in higher spot prices for zinc, nickel and lead, up 22 per cent, 15 per cent and 10 per cent, respectively,” he says.

For Fortescue, Hodge has raised his fair value estimate by 30 per cent to $10, compared to its price of $24.32 as at 22 January, as the miner reaps in cash from higher iron ore prices. Last week Fortescue said it reaped a net profit after tax of more than $US940 million just for the month of December 2020. The company told investors it expects to record a net profit of between $US4.0 billion ($5.17 billion) and $US4.1 billion ($5.3 billion) for the first half of its 2020-21 to 30 December, based on preliminary unaudited management accounts. That would be a jump from $US2.45 billion a year earlier. Fortescue’s half-year results are due on February 18.

For the more diversified miner Rio Tinto, Hodge has raised his fair value estimate by 15 per cent to $79 – a smaller increase than for Fortescue given less exposure to iron ore. For BHP Billiton, Hodge has raised his fair value estimate by 5 per cent to $33, with both companies in overvalued territory, with BHP Billiton trading at $46.13 and Rio at $119.32 on 22 January.

“Rio Tinto and BHP have the lowest operating costs of the iron ore players, but despite this being the bulk of company earnings, adjusted excess returns were destroyed by procyclical overinvestment during the China boom,” says Hodge.

MORE ON THIS TOPIC: Bargains hard to come by as commodity prices buoy miners' earnings and share prices ($)

Earnings upgrades, price gains expected

The strong demand for iron ore is likely to continue this year and further price rises for the miners are expected, according to US investment bank Goldman Sachs.

“Five years of mining sector deleveraging and capital discipline from 2015-2020 and a lack of high-quality greenfield projects across most commodities sets this next cycle up as more of a supply-side driven rally as global demand recovers from the COVID-19 pandemic,” analysts Paul Young and Matt Greene say.

“We see consensus earnings per share (EPS) upgrades for the sector over the first half of 2021 and expectations for strong capital returns in February to continue to support share prices in the near term, particularly for the iron ore and copper companies."

Analysts vary on their preferred iron ore miners, with some preferring BHP Billiton over Rio Tinto and others preferring Fortescue.

“Fortescue Metals Group is preferred in large caps and Mineral Resources, Deterra Royalties, Champion Iron and Mount Gibson Iron preferred for smaller caps,” Macquarie Research said in a note to clients. However, Rio Tinto, BHP and fellow iron ore miner Salt Lake Potash are still expected to outperform.

Ord Minnett likes all three big miners. “We expect commodity market conditions to remain strong heading into 2021 and remain attracted to valuations for the diversified miners BHP Group, Rio Tinto, Fortescue Metals and [diversified miner] South32.

“Strong dividends will likely be a feature of the February results. We believe excess cash will be generated throughout 2021, which should also support further capital management initiatives as the year progresses. We upgrade our recommendation on Fortescue Metals to Buy from Accumulate, based on valuation.”

Goldman Sachs prefers BHP Billiton with a $48.70 target price and an appealing valuation. “BHP’s portfolio is in a very strong position, and we forecast a 65 per cent increase in earnings before interest, taxes, depreciation, and amortisation (EBITDA) and doubling of free cash flow (FCF) in FY21. Longer term, we are positive on BHP’s organic growth options, particularly in oil where we see possible 50 per cent volume growth.”

Goldman Sachs has pushed up its target price to Rio Tinto to $117. While Rio Tinto’s cash flow looks attractive, the investment bank sees risk for its iron ore business given the events at Juukan Gorge in the Pilbara, “with possible impacts to future Pilbara approvals, production and capital expending".

For Fortescue, it has a price target of $19.80. The company “is on track for another strong quarterly production result and strong dividends in February”, with Fortescue having the greatest sensitivity to an increase in the iron ore price of the big miners, as the chart below shows.

EBITDA Sensitivities 2021E

Source: Goldman Sachs

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