Iron Ore: Recovering faster than fundamentals

About the author:

Adrian Prendergast
Author name:
By Adrian Prendergast
Job title:
Senior Analyst
Date posted:
08 December 2022, 8:00 AM
Sectors Covered:
Mining, Energy

  • While hopeful of a China growth recovery, which would be positive for steel/iron ore demand, we are less comfortable with the equity market already moving to price in the recovery before it unfolds.
  • This has undermined our conviction in the upside on offer in BHP/RIO, while FMG briefly traded in line with our target price before returning to a premium to our target.
  • It is encouraging to see iron ore benchmark prices sustaining healthy levels (>US$100/t) on rising sentiment.
  • China’s steel market remains under pressure, although margins appear stable.
  • Despite stable fundamentals, reduced value upside leaves us neutral on the large iron ore miners. We downgrade BHP Group (ASX:BHP) and Rio Tinto (ASX:RIO) to Hold. We maintain a Reduce rating on Fortescue Metals Group Limited (ASX:FMG) and Speculative Buy rating on Genmin Ltd (ASX:GEN).

Iron ore and share prices rebound hard

Shaking off weak Q4 data from China/global demand, and the prospect of US/EU recession, instead market sentiment has been rising over the last month on the back of China signalling a shift in its COVID policy (easing restrictions) while adding further stimulus policies (supporting property).

Over the last month iron ore price (+27%) and share prices for BHP (+16%), RIO (+20%) and FMG (+27%) have bounced hard off their November lows. We agree that the developments are likely to see improved demand conditions in early 2023, but the issue is how fast the equity market has moved to price in this recovery. 

This is reflected in the current FCF yields on offer in our iron ore miners, which even at spot prices are a modest 6%/6%/9% for BHP/RIO/FMG respectively, which is well below their average levels over recent years.

Chinese steel market still on the backfoot

The health of China’s steel market remains mixed. Weekly data suggests that steel output was still declining through November, while in early December we have seen some improvement in Chinese steel prices (HRC and rebar).

Unfortunately, this price increase has been offset by rising raw material costs but overall likely contributing to a stabilisation of steel margins.

To gain conviction on the China recovery, in early 2023 we will be on the look out for how reactive demand drivers respond to both the relaxation of COVID-19 restrictions and the added stimulus measures (monitoring indicators like new housing starts and blast/EA furnace utilisation rates).

Changes to estimates

We have applied updated Morgans house inflation and WACC input assumptions to our models for the iron ore miners. This includes increasing our risk free rate to 3.6% (from 3.0%) and maintaining our equity risk premium at 6%.

For inflation we have increased our 2023 forecast to an average of 4.7% (from 3.0%), 2024 to 3.2% (from 2.0%) and long-term assumption to 2.5% (from 1.5%). 

We have also slightly increased our Q4 estimate for iron ore benchmark (62% Fe fines CFR) to US$105/t (from US$102/t), while also applying updated coal assumptions (only relating to BHP), after a mark-to-market.

The key risk to our TPs are related to key steel demand drivers (i.e. China macro).

How to play the space

We can certainly see the potential green shoots for a recovery in demand drivers for steel, but it is also not hard to see a fresh bout of volatility before that recovery takes hold.

We view current share prices on our large-cap iron ore miners as suggesting we have to ‘pay up front’ for that potential recovery, leaving us with lower conviction. As a result we downgrade our rating on BHP and RIO to HOLD (from ADD), while maintaining a REDUCE on FMG. 

Our valuation-based target price on iron ore explorer/developer GEN, who is planning to reach FID in 2Q23 on its Baniaka project, is unchanged at (login to view).

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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