The dust cloud over Fortescue

A warning for investors is that analysts are so divided over the iron ore miner.

Summary: The iron ore stock has rocketed ahead in recent months, with investors effectively doubling their money since mid-year. But concerns over the future direction of iron ore prices, especially as competitors such as BHP and Rio Tinto ramp up their production, mean the growth outlook for Fortescue is under a red dust cloud.
Key take-out: The differences of opinion among the professional analysts is a warning sign that the stock could go either way.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Underperform (under review). 

All good things come to an end, and in the case of Australia’s leading pure-play iron ore producer, Fortescue Metals Group, the time has come to sell.

That’s largely because its share price has doubled in five months and because the iron ore outlook is cloudy.

The stronger-than-expected iron ore price has helped FMG make welcome early debt repayments, bolstered its balance sheet, and propelled its shares from a mid-year low of $2.87 to its recent $5.73.

The challenge now is to deliver another upward share-price spurt, an unlikely event given the sluggish pace of global growth, subdued demand for steel and strongly rising iron ore production.

Investment bank analysts are split over FMG. Some have harshly negative views and some have extremely positive views, with the differences perhaps the most extreme seen for some time in any ASX-listed stock.

Future price forecasts range from a 33% drop to $3.80, and a 30% rise to $7.50.

The consensus is for a future share price of $6.14, potentially up 7%, but only at some time over the next 12-months, which is not a compelling reason to invest in a stock with the high-risk profile of FMG.

Professionals, it seems, either love FMG, or hate it, and while both sides of the divide have their arguments for or against the stock there are two factors which point to sell.

They are the challenges facing any company to keep rising after doubling in five months, and the overdue, but inevitable, impact on the iron ore price of strongly rising production as the world’s economy struggles to grow rapidly.

A factor possibly offsetting next year’s widely expected fall in the iron ore price (which some observers expected to arrive this year) is the benefit of a lower Australian dollar.

As an exporter selling a US dollar-traded product, and with a cost base in Australian dollars, FMG is already enjoying a modest uplift from the currency effect with an iron ore price of $US135 a tonne converting into $A147/t at the current exchange rate. Earlier this year that same $US135/t converted to A$128/t.

The currency effect and the higher-than-forecast US dollar iron ore price is helping FMG repair its stretched balance sheet. Management recently opted to make an early repayment of $US1 billion in a form of debt (senior unsecured notes), and announce plans to repay early another $US1 billion.

Shrinking the company’s heavy debt commitments, which totalled close to $US12 billion at one stage, is a positive development, as is restructuring debt schedules to enjoy the benefits of lower interest rates.

However, the financial engineering underway in FMG could also be part of an early move in the resurrection of a plan to expand from the recently achieved annual export target of 155 million tonnes a year to shoot for the stretch target of 355 million tonnes a year.

Never knowing quite what FMG’s mercurial founder and chairman, Andrew Forrest, will do is a reason to keep a watchful eye on the stock, because just when it seems to have its obligations under control, Forrest has a habit of doubling up on debt.

A few opinions and numbers illustrate the challenge of investing in FMG.

Goldman Sachs has a sell rating on the stock and the lowest 12-month price target of any big investment bank at $3.80, or $1.93 (34%) less than its recent price of $5.73.

Credit Suisse, an equally reputable investment bank, disagrees with Goldman Sachs. It reckons FMG is heading for a share price of $7.50, an increase of $1.74 (30%), over the next 12 months and is a stock to buy.

Both can’t be right, but rarely do you see such widely-spaced future price forecasts.

Other big name banks sit on either side of the divide. UBS says buy, with a price target of $6.50. Deutsche says sell, with a price target of $4.20. Macquarie says outperform, with $6 the target, and CIMB says $5.95 and hold.

Also read Adam Carr's analysis on iron ore prices today: Iron story is ore inspiring.

For the average investor, the differences of opinion among the professional analysts is a warning sign that the stock could go either way and should not be bought by anyone looking for a degree of stability and comfort in their investments.

On balance, FMG is a sell. Here are six reasons why:

  1. It will be hard for the stock to keep rising after its 100% gain over the past five months.
  2. The iron ore price, despite its refusal to fall this year, is trading close to an all-time high with most analysts forecasting lower prices next year.
  3. Continued expansion by most big iron ore miners, including a fresh $US301 million investment this week by BHP Billiton in new ship loaders at Port Hedland.
  4. The inability of FMG to keep pace with Rio Tinto and BHP Billiton in the drive for lower costs, especially given FMG’s lower-grade ore.
  5. Concern about the future level of demand for steel in China, the world’s biggest steel producer.
  6. Uncertainty about the ambitions of the chairman and major shareholder, Andrew Forrest, and whether he will dust off a plan to “double up” (again!).

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