RBC: Fortescue set to rise on revised iron ore outlook

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Iron ore prices will stay up this year and that makes Fortescue Metals Group (FMG) a buy, say analysts from the Royal Bank of Canada (RBC).

The bank aggressively increased its price target for the miner to $8.50 (from $6.30), based on an upwards revision to its 2017 iron ore forecast from $67.50 to $84.50 a tonne.

The price closed this morning at $88.14 per tonne.

“We see the market as being relatively balanced in 2017 as steel margins in China support iron ore prices following supply side reform. We forecast China’s apparent steel demand to increase by 4.5% in 2017 via infrastructure and property sector consumption, though expect this to soften in the second half,” they said.

The bank expects iron ore prices of US$100 per tonne in the June quarter, decreasing to US$70 per tonne by the end of the year.

The RBC analysts also factored downside risk on the AUD into their revised forecast, as Fortescue benefits from a lower AUD.

“We note that the primary revenue assumption (iron ore price) tends to negatively correlate with the Australian dollar and hence may offset some of the currency effects.”

With a brighter outlook for iron ore and some benefits from expected weakness in the Aussie dollar, RBC now forecasts an additional US$1.5 billion of free cash flow in the second half of 2017.

Having significantly reduced its net debt and with no major capital expenditure on the horizon, RBC expects Fortescue to increase its dividend payout ratio from 40% to 60%. For the 2017 financial year, RBC has forecast the dividend yield at an impressive 11.7%.

RBC’s analysts also highlighted the successful execution of cost efficiency measures across the mining industry.

“All majors have driven significant cost out of their iron ore businesses, primarily through operating improvements and efficiency gains. This has corresponded with impressive margins across the iron ore businesses.

“Whilst FMG has benefited somewhat from economies of scale as it has ramped up its output, the overall transformation of its business in the Pilbara has been significant.”

Shares in Fortescue rose 5.65% today to close at $6.54.

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