Australian iron ore producer Fortescue Metals Group ( FMG.AU) has been cut to sector-perform from outperform and its price target slashed 38% by RBC Capital Markets.
While acknowledging the miner's moves to lower costs and cut debt, analyst Paul Hissey is concerned about the prices the miner can get for its iron ore as it is lower grade and sells at a discount to benchmark prices (which are based on 62% iron content). There are several issues, including the growing use of scrap metal in electric arc furnaces (EAF) to produce steel. Here's Hissey in his own words:
In our view, price realisation is now the key issue for FMG (resulting in a discount to its products versus the Platts 62% Fe index), given our perception on the structural changes taking place in China. Whilst we are constructive overall on iron ore, we believe the adage'grade is king' and the trend towards EAF and cleaner, more efficient blast furnaces could potentially drive demand higher for premium products, which in our view will lend itself to higher grade ore demand. As such, we revise our assumption on FMG's price realisation to 80-85% (from the company's guidance of 85-90%).
RBC Capital Markets has also revised its iron ore price assumptions: The broker lowered its average price in 2017 to around $73 a tonne from around $85 a tonne, while prices are expected to average $65 a tonne in 2018.
The weakness in iron ore prices, coupled with lower price realizations based on a grade discount, will also weigh on Fortescue's free cash flow (FCF) generation:
...a lower price realisation (as is assumed in our base case) leads to lower FCF generation in the range of ~US$1.2bn by the end FY20 and ~US$2.8bn by the end of FY24. Additionally,FMG is clearly leveraged to the iron ore price regardless of the price realisation - under spot prices and common price realisation, FCF generation falls by ~US$2.7bn by the end of FY20 and ~US$5.6bn by the end of FY24.
RBC Capital Markets cut its target price to AUD5 a share from AUD8 a share. The stock, which is down 10% this year, last traded at AUD5.28 a share.