On Part I and Part II I reviewed the current demand and supply conditions in the iron ore market. We saw that the market is about to be oversupplied with iron ore over the next to year and that should take a toll on the miners financial performance going forward. On top of that, I showed that powerful stakeholders such as the Chinese government, have strong interest in low iron ore prices and are taking actions towards that end. Now, it is time to see what scenarios are baked into the valuations of the miners and a see if we can identify any opportunities to bet against them. Here is the usual Twitter version (137 characters): “Market participants are overly optimistic about iron ore miners’ future performance and this optimism is reflected in their share prices.”
The Street’s View
I went on Bloomberg to see what the “leading steers” have to say about the iron ore market. Their (JPM, Deutsche etc.) analysis carries a lot of weight in the market. Surprisingly, their forecasts do not vary too much — that could be attributed to anchoring bias or to the institutional imperative. Here is what one had to say about the prices that RIO is expected to realize over the next two years:
We can see prices of $125 and $116 for 2014 and 2015, respectively. These prices are “CIF”, which means that they exclude the shipping costs from Australia to the destination (~$10/ton). I think that by now it is very easy to see that these expectations will not materialize but this report is from this month so go figure.
JPM is not only optimistic, but also confused. Here is a link to one of their reports that is publicly available. Look at that:
The upper table in the picture above is taken from a JPM report on Fortescue, the high-cost-low-quality Australian iron ore miner. In order to justify their valuation they had no choice but be very optimistic and use $126 as the unit price and $113 for next year. The table below, also from JPM (written by another analyst) where he predicts a price of $118 and $110 for 2014 and 2015, respectively. Not sure how many people read the disclosures on these reports, but it says that BHP, Rio and Fortescue are all clients of JPM’s investment banking unit, that also helps to explain the optimism. No wonder why VALE is not mentioned in that report…
Also, in the upper picture JPM predicts a price of $114/t for FMG (upper picture below the red circle), let’s see how the prices that FMG gets behaved recently:
Good luck with getting this one right, JPM.
Another thing the analysts did not relate to is the volumes sold. What if both prices and volumes go down? This is not at all unlikely. One can think of a scenario in which Chinese demand is cut by 30% and the prices are falling. Then companies like VALE (high shipping costs) and Fortescue (low realized prices due to low quality ore) will sit on a lot of unsold inventory and may even see losses.
To sum it up, the Street expects iron ore prices and volumes to go up. I don’t. So there you go, there is a disagreement and there are different views. Now a few words about each company…
Rio Tinto has good quality ore and it gets most of it in Australia, which makes shipping to China cheap and easy compared with VALE. However, analysts expect it to post an EPS of ~$5.5 in 2014 and $6 in 2015. Based on my analysis this is near impossible even without a catastrophe in China. Even if it happens, Rio trades near X10 these values and these are peak-of-the-cycle earnings so even if I’m wrong, the damage by betting against Rio can’t be huge but it will most likely not meet these expectations and it’s current valuation is too high.
Fortescue is the ugly duck in the mining business: it has a lot of debt, low quality iron ore but its valuation is really cheap right now compared with last year’s earnings. However, should things in China slow down this company can easily go bankrupt and its equity value might go down to zero. Fortescue sells almost all of its iron ore to China and if Chinese demand slows down Fortescue will be the first one to lose business because of it’s high costs and low grade iron ore. However, if it survives the next few years, there can be a sharp improvement in its valuation, therefore if you don’t have a very strong conviction that a terrible bear case is highly probable, I would be cautious. Given the situation in the spot market for iron ore grade 58 It is very hard to see how can Fortescue earn the $1.05/share that the Street expects.
Vale has a distance problem and it puts it at a cost disadvantage versus those who mine in Australia. It costs about $24/t to ship iron from Brazil to China while it costs only about $10/t to send it from Australia. As such, in order to sell it’s ore, Vale will have to compromise on a very low selling prices and may also get hit hard. Analysts expect it to make $2/share this year but I think it’s nearly impossible (given current conditions in the iron ore market) and it’s earnings will suffer badly in the coming years.
The next two years will reveal who was right and who got it wrong. One of the most important aspects of learning and improving oneself is to get feedback so I prepared the following table that contains the stock prices of the miners on the date I wrote Part I and the target prices that analysts have set for them. While I don’t set a concrete number, my prediction is that we will see much lower prices for these shares 1-2 years down the road. I set myself a reminder to come back and check it, here is the table:
Disclosure: I hold a short position on RIO and VALE. Each investor should do his/her own due-dilligence.