Fortescue Metals Group: worthless or worth holding on to?

Fortescue shares are not worth anything at the current price of iron ore, say analysts. Photo: Nick Cubbin

Fortescue's stock is worthless at current spot iron ore prices, analysts at CBA calculate. Zippo, zilch. That's not as controversial a statement as it sounds. Yet the broker community is, overall, neutral on the stock (for the record, CBA is underweight). Why? It all comes down to assumptions around where iron ore prices and the Australian dollar will trade in the coming years.

In the case of UBS, which has the equivalent of a "hold" recommendation, they assume a long-term iron ore price of $US75 a tonne, well above current levels of around $US55 a tonne.

That means an investor in the miner needs to have faith that the iron ore price in Aussie dollar terms will move higher in the coming years, requiring not only a punt on commodity markets but on currencies as well – two things that are devilishly difficult to predict.

This is also true for BHP Billiton and Rio Tinto, but much less so, as they produce more than just the steel-making ingredient. The two biggest players are also significantly lower geared.

There is $US7.5 billion ($11.5 billion) in net debt squatting on Fortescue's balance sheet. In Aussie dollar terms, that's approaching twice the company's market capitalisation – just a number, sure, but an ugly one.

The combination of a single commodity focus, high debt and skinny margins makes Fortescue a massively leveraged play on the iron ore price, which means minor tweaks in assumptions can result in wildly different earnings expectations and valuations. For example, a 10 per cent move in Morgan Stanley's iron ore forecast for next financial year results in a 303 per cent move in estimated earnings per share. The broker's bull case gives the stock a price target of $4.47. The bear case is for 10¢.

Outlook more bad than good

And with that last number in mind, the outlook for iron ore looks more bad than good.

Goldman Sachs analyst Christian Lelong says the iron ore industry faces a "long war of attrition", one which will last well into 2017. He argues that unprofitable miners will exit the market only slowly, despite marginal costs of production which languish well below the spot price for their product, meaning that the much-needed adjustment in the oversupplied market will take years to eventuate. Lelong points to the precedent of the coal mining industry, where depressed prices have persisted for two years and where mines are only now being mothballed and projects cancelled.

Lelong believes the iron ore price will bump about $US60 a tonne out to 2018, but he acknowledges it's hard to pick how low prices can go in the shorter term. His best guess is 20 per cent below the industry's all-in marginal cost of $US70 – incidentally where iron ore trades now. But that analysis is again based on the recent experience of the coal industry and "iron ore arguably has a bigger problem than coal", he says.

"There is a distinction between tier one and tier-two producers," Lelong continues, turning his mind towards what his forecasts mean for miners. "Tier-one producers just keep doing what they are doing; they still have the potential to carry on with their expansions as they are very low cost.

"For everybody else, the future does look very challenging. A lot of these producers will look to restructure the business and look at potential divestments, bring in joint venture partners, or think about diversification into other commodities and geographies – anything you can do to shore up your balance sheet will buy you time."

But given Fortescue's level of debt, time may be something the miner is running short of. In its defence, the company points out the first $1 billion of debt is not due to be repaid until 2017, and the bulk not due until 2019.

Earlier call on debt

But CBA analyst Andrew Hines in a recent note to clients pointed out a potential fly in the ointment: "Although Fortescue correctly points out that it has no debt due until 2017, the 2017 notes have a first call date in April 2015.

"Bond markets price these notes on the assumption that they will be called on the first callable date. If Fortescue does not redeem the 2017 notes next month, then it may find bond markets demand even higher yields for any future bond issues."

Hines has a 12-month price target of $1 for the stock. His is the lowest, while Bell Potter's at $3.80 (adorned with a buy rating) is one of the highest. That's quite a range.

Penagana Capital global resources fund manager Tim Schroeders reckons a share price of $1.50 looks better value on a risk and reward basis.

"While things look dire at the moment, we still put a low probability of Fortescue going broke," says Schroeders, who doesn't own the stock. But he adds that the company is "not going to be profitable in the near-term; the momentum is clearly negative and it will really test the wherewithal of investors".

All of which may make you think Fortescue is best left to the short-term punter betting on day-to-day commodity and currency price moves.

Not so. Schroeders argues that longer term, contrarian and value investors may be willing to sit out the volatility. And in fact, there is evidence that one such institution is doing just that. And not just any, the world's largest active funds management group.

The gigantic US-based investment house Capital Group, which manages $US1.3 trillion in assets, revealed in early February it had become a substantial shareholder in Fortescue, adding 68 million shares to its pile at an average price of $2.34. It then picked up a further 32 million shares at an average price of $2.45 between February 11 and March 3 to become the miner's third-biggest stakeholder with 6.1 per cent of the issued shares.

Unfortunately, Capital Group has a policy of not talking about individual companies, but the local head of operations did confirm the company invests on a three to five-year basis. They obviously believe Fortescue will survive that long. But it will be a bumpy ride.