Fortescue Metals: Setting a Price Target for 2010 and Beyond

by: Rohan C. Pease

Big players are tossing around large stakes of Fortescue Metals Group (OTCQX:FSUMF), the Aussie-based miner controlled by Mr. Forrest and the third largest iron ore producer in the land of Oz. Reports out of Australia today indicated that Phillip Falcone of Harbinger Capital in New York had unloaded a portion of his stake (now less than 5%, approximately half of his original position), Mr. Falcone has been one of Mr. Forrest's longest supporters. Leucadia has joined the selling as well, unloading a stake they acquired in 2006. Many take this as a sign that FMG might dissapoint in the near term, however RBS upgraded the stock yesterday from "Hold" to "Buy" citing rising iron ore prices. RBS has a target of $5.80 adjusted for currency conversions. Which side is right, Hedge Funds or Institutions? Neither, I side with RBS. However, I believe their target price is way too low, my year end target is $8.00.

I wanted to update my pro forma income statement for Fortescue Metals Group to reflect increased iron ore prices and slower expansion growth for the company. Back in August, FMG was anticipating $6B of fresh financing from China, funds that were diverted from Rio Tinto (RTP) when they announced a joint venture with BHP Billiton (NYSE:BHP). The terms were supposed to be disclosed as of the end of September, though the deal eventually fell through and FMG didn't secure the financing. Originally I had put together a pro forma income statement for the rapidly expanding FMG, which had stated that it would like to see annual production exceed 100 Million tonnes starting around 2012. Obviously, the timeline has been extended as FMG now must fund expansion thru internal cashflow. Flipside is that they have good cashflows and with benchmark prices about to reset much higher (reports indicate 40% - 80%) this will provide a nice boost for infrastructure spending.

So what adjustments need to be made to the income statement? First is to decrease the rate of production of iron ore whereby we should see production around 85 million tonnes by 2012. Funding expansion using cashflow will hurt margins, which are currently around 28%. This will taper off during expansion to an estimated 23% in 2012. A downward spiral will emerge as lower EPS numbers yield a lower P/E multiple. A blend of Vale (NYSE:VALE), BHP, and RTP multiples gives us a current multiple of 18x earnings; this should reduce until 12x in 2012 with the initial year starting @ 16x in 2010. All of this can be weathered, however, due to surging spot prices for iron ore, currently at $138/ tonne. I will use $100/ tonne for 2010, a 60% increase from the current benchmark pricing which expires at the start of April.

When looking at the pro forma income statement assume fiscal years start in April, as this is when annual contracts readjust.

2010 2011 2012
Production (MM tonnes) 60 70 85
$/ tonne 100 108 126
Operating Income 6.0B 7.56B 10.710B
Operating Margin 27% 25% 23%
Net Income 1.62B 1.89B 2.464B
EPS 0.52 0.61 0.80
P/E x 16x 15x 12x

EPS multiplied by the P/E will yield stock prices of $8.32, $9.15 and $9.60 for 2010, 2011 and 2012, respectively. (All units in USD, share prices for FSUMF.PK)

Currently, Fortescue is trading around $4.40 USD.

Disclosure: Long FSUMF.PK, VALE Shares