Fortescue Share Price: Is ASX: FMG Undervalued or Overvalued?
Fortescue (ASX: FMG) shares are benefiting from high iron ore prices and discounts on its lower-grade ore that are toward the lower end of their historical averages.
Mentioned: Fortescue Ltd (FMG)
Key Morningstar Metrics for Fortescue (ASX:FMG)
Data from Morningstar Direct as of 26 February 2024
What we think of Fortescue’s Shares
After first ore in 2008, Fortescue has significantly expanded production to become the world's fourth-largest iron ore miner. Fortescue built its assets during the iron ore boom, meaning the unit cost of its installed capital base is generally higher than the established majors, who benefit from investments made when industry capital costs were much lower. Operating leverage is high, with margins well below those of peers BHP, Rio Tinto, and Vale, mainly due to the production of lower-grade iron ore, which attracts a material discount to the 62% benchmark. Considerable debt repayment in recent years has lowered financial leverage and the balance sheet is strong. Development of the 22 million metric tons a year Iron Bridge magnetite mine should add a higher-cost but higher-value 67% grade iron product. More recently, Fortescue is pursuing ambitions in green energy though its plans are at an early stage.Â
Fortescue Share Price (ASX: FMG)
Source: Morningstar Direct. Data as of 26 February 2024
Fortescue Economic Moat Rating
We assign Fortescue a no-moat rating. The iron ore produced by its mines generally has less iron content than the 62% iron ore benchmark while also having higher percentages of impurities such as sulphur, alumina and phosphorous. As a result, Fortescue’s iron ore is lower quality than that produced by its major competitors such as BHP, Rio Tinto and Vale. This competitive disadvantage results in its iron ore tending to sell at a material discount to the 62% benchmark price, with the average discount over the 10 years to fiscal 2023 being about 23%. The exception is Iron Bridge, which will produce a 67% product. As it is a magnetite deposit, once mined the ore requires beneficiation (where the mined material is crushed into smaller particles and then the valuable ore is separated from the waste). This means cash operating costs for Iron Bridge are materially higher than for the company’s other conventional mines. Moreover, Iron Bridge will only account for around 10% of total production on a 100% basis once fully ramped up.
As a commodity producer, Fortescue is a price-taker and needs low-cost mines with long lives and a low installed capital base to support the longer-term excess returns needed to justify an economic moat. We forecast midcycle returns on invested capital of around 8% based on an assumed iron ore price of roughly USD 60 per metric ton and Fortescue receiving a 20% discount to the benchmark price. We would have to assume a midcycle iron ore price of around USD 67 per metric ton for Fortescue’s return on invested capital to equal its weighted average cost of capital. This pricing level would imply the iron ore industry almost as a whole has a moat. Once product discounts are taken into account, and assuming Vale’s costs normalize, Fortescue sits around the 75th percentile of the industry cost curve.
Access our full research report to continue reading about Fortescue’s (ASX: FMG) moat rating.
Fortescue Risk and Uncertainty
We rate Fortescue's Morningstar Uncertainty Rating as High. The price of iron ore and unit costs are the primary drivers of our fair value estimate. The key risk to cash flow is a slowdown in Chinese fixed-asset investment and the consequential impact of steel demand, iron ore demand and ultimately the iron ore price. The expansion of low-cost iron ore supply is another key risk, namely the recovery in output from Brazil, after the Vale tailings dam disaster in 2019, and in the longer term from the likely development of iron ore mines in Africa. Fortescue's cash margins are lower than the low-cost industry majors and so it will be most affected if iron ore prices fall materially.
In the global financial crisis, demand for steel declined rapidly, affecting iron ore prices. Industry pricing power will be tested if Chinese demand for steel slows and total consumption eventually shrinks as we expect. The company wisely focused on debt repayment and financial risk is now low. Provided Fortescue does not embark on another large debt-fueled expansion, or substantial green energy acquisitions, the balance sheet is strong and maintainable.
