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The investment case for our recent foray into Fortescue Metals was all about stories. The dominant narrative at the time of our upgrade was that the gap between high grade and low-grade iron ore had permanently expanded.
China, the arbiter of all things iron ore, had tightened environmental standards and that was thought to have caused a large – and permanent – shift in the price gap between high and low-grade ore.
We argued ignorance. Perhaps there had been a permanent change, perhaps not. We weren't sure and neither was anyone else, but Fortescue's shares were priced with certainty.
The grade discount turned out to be largely cyclical and Fortescue’s share price has soared. With our investment case having played out, we banked a rapid 60% gain and moved on. Then the iron ore price surged.
We were arguably so preoccupied with grade discounts that we didn’t consider the iron ore price itself. Yet something has changed. In Brazil, the world’s largest supplier of iron ore, Vale, is in trouble for the state of its tailings dams.
A review recently found that many of Vale’s 50-odd dams were below standard but about 17 were in such bad condition their stability couldn’t be guaranteed. The company has halted operations on at least 10 dam sites and many more are at risk; an important part of the world's iron ore supply is now under threat.
The world's other great iron ore basin, the Pilbara, is unlikely to be able to replenish Brazilian supply. Iron ore prices, which are touching US$100 a ton, could stay elevated for years while the dam situation in Brazil is sorted out.
In this environment, Fortescue has announced a new high-grade project. The Iron Bridge magnetite project will produce modest free cash flow at budgeted iron ore prices but sensational returned at spot prices.
It also lowers overall risk as higher grades from the deposit offer blending potential that could raise margins across the business and reduce vulnerability to lower grade iron ore.
Yet it is the potential deficit from Brazil that has propelled the share price.
At spot prices, Fortescue could be worth about $14 a share, about twice the market price. The large gap between theoretical value and market price suggests market scepticism that current iron ore prices will hold. With widespread and intractable infrastructure woes in Brazil, today’s prices could, in our view, hold for years.
Of course, this is one outcome among many, but we judge it to have a reasonably high probability. Even after doubling, Fortescue could still be cheap – not cheap enough to buy, but it does warrant a change in our price guide.
We’re raising our Buy price from $4 to $5 and our sell price from $6 to $9. The possibility of a larger than expected gain is now present. Our recommendation moves from Sell to Hold but we still suggest reducing your exposure and holding less than our maximum portfolio limits.
Thinking about stories in terms of probabilities unveiled the original opportunity in Fortescue. Doing the same now may eek a little more from that idea. HOLD.
Note: The author holds Fortescue Metals after selling half his holding. Staff members may own securities mentioned in this article.
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