The Stars Align

In Ord Minnett’s view, the iron ore market is tighter than initially expected. It appears the stars have aligned, with China demand strength, Brazilian supply issues, low port inventory, and lack of marginal supply response. The China stimulus program was also larger than we expected.

 

Iron ore prices have risen more than 10% in the year to date and have pushed above US$100/t. Our price deck sees spot iron ore trading lower into 2H20, although this is based on a recovery in Brazilian supply. Should the impact from COVID-19 last longer, there is a realistic proposition that prices will continue to trade higher.

 

We have raised our iron ore price forecasts by 11% in 2020 to US$91/t and 10% in 2021 to US$80/t, which has boosted our target prices for BHP Group (BHP), Rio Tinto (RIO) and Fortescue Metals Group (FMG).

 

Our Accumulate rating on all three iron ore miners is unchanged. In a forced ranking, we believe the two diversified majors are more attractive from a balance-of-risks perspective – that is, if iron ore is softer than we expect, we still see strong valuation support. Fortescue has a higher risk-reward ratio should issues ramping up Brazilian exports continue, which could see markets remain strong through much of 2020. We have increased target prices for BHP to $40.00 from $38.00, Rio Tinto to $108.00 from $99.00 and Fortescue to $15.10 from $12.90.

 

We remain positive on the iron ore miners, despite the strong run in share prices. We see more valuation support from a net present value (NPV) perspective in BHP and Rio Tinto than in Fortescue, although based on our estimates Fortescue should provide higher free cash flow and dividend yields over the coming years, and lower enterprise value to operating earnings (EV/EBITDA) multiples.

 

  • BHP and Rio Tinto – We have a marginal preference for Rio Tinto over BHP. Rio Tinto’s greater iron ore leverage has seen it trade at a discount to BHP based on a near-term EV/EBITDA multiple of 5.5x FY21E, a price to earnings ratio of 13.6x and free cash flow yield of 6%. However, their price to NPV ratios (0.9x) and dividend yields (about 3% based on a 50% EPS payout ratio) are similar. Overall, there isn’t much to separate the two from an investment perspective – both look appealing – but on a forced ranking Rio Tinto comes out in front. We also highlight Rio Tinto’s greater potential upside to mark-to-market EBITDA of 26% compared to 8% for BHP under a spot scenario.

  • Fortescue Metals – Fortescue’s spot EBITDA is about 33% above consensus and in our new price deck the stock yields 7% in FY21E (the peak capital expenditure year). We note low steel spreads are also seeing modest discounts of 15–20% remaining in place for its weighted average product. Overall, the material increase in our valuation reflects less conservative cost, capital expenditure and reserve life assumptions in the long term. Fortescue’s valuation metrics have a high sensitivity to iron ore prices, however, which continue to beat consensus estimates. The scenario of Brazilian exports remaining subdued continues to present potential upside for the stock.

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