In Ord Minnett’s view, the iron ore market is tighter than we had initially expected. This is based on solid Chinese steel output, lacklustre Brazilian exports and declining port stocks. We have raised our iron ore price forecasts by 11 per cent in 2020 to $US91 a tonne and 10 per cent in 2021 to $US80 a tonne, which has boosted our target prices for BHP Group (BHP), Rio Tinto (RIO) and Fortescue Metals Group (FMG).
On this basis, 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.
Our Accumulate rating on all three 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, there is 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 from $38, Rio Tinto to $108 from $99 and Fortescue to $15.10 from $12.90.
Iron ore prices have risen more than 10 per cent in the year to date, and have pushed above $US100 a tonne. It appears the stars have aligned, with China demand strong, COVID-19-related Brazilian supply issues, low port inventories and only a marginal supply response. The China stimulus program was also larger than we expected. We assume that spot iron ore prices will be lower in the December half, 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.
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 near-term earnings multiples. However, their price to NPV ratios (0.9x) and dividend yields (about three per cent based on a 50 per cent 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.
Fortescue Metals – Fortescue’s spot earnings (EBITDA) is about 33 per cent above consensus and in our new price deck the stock yields seven per cent in FY21E (the peak capital expenditure year). Overall, the material increase in our valuation to $15 per share 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.