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Is the share price of Fortescue Metals Group Limited (ASX:FMG) about to break its downtrend?

The worst performing major iron ore producer on the ASX may be at a turning point as the market isn’t put off by the 58% drop in net profit from Fortescue Metals Group Limited (ASX: FMG) or the halving of its final dividend.

The results were below what consensus was expecting but that hasn’t stopped the stock from jumping 1.1% to $4.26 in morning trade when the S&P/ASX 200 (Index:^AXJO) (ASX: XJO) index is only a touch above breakeven.

Fortescue is also outperforming its larger rivals BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) with both stocks up less than 1% at the time of writing.

Embattled shareholders of Fortescue will be hoping that negative sentiment towards the stock is easing as supporters have long argued that all the bad news is already in its share price as the stock has crashed 27% over the past year compared to BHP’s 29% rise and Rio Tinto’s 15% gain.

Fortescue has been unable to find love despite the mining sector going gangbusters on the back of strong commodity prices as the discount on its lower-grade iron ore has been increasing through FY18 with Chinese buyers gravitating towards the higher quality ore due to the government’s pollution controls.

That is the key reason behind the big drop in net profit to just US$878 million for the last financial year as revenue fell 18% to US$6.9 billion. Its high fixed-cost is driving the disproportionate decline in its bottom-line.

Management has cut its final dividend to 12 cents a share from last year’s 25 cents payout, which takes its total dividend in FY18 to 23 cents a share. This puts the stock on a respectable yield of nearly 8% if you count franking credits, although this only works if you assume the miner can sustain its dividend.

Here’s where things get a little more complicated. If the discount for Fortescue’s iron ore with 58% content closes (compared to the standard 62% content), there will be no doubt the stock will re-rate sharply.

But supporters think that closing the gap may not matter as Fortescue is going to start selling higher quality ore with 60% content in 2HFY19 by blending higher grade ore from its small Firetail mine before its Eliwana mine (which has an ore body with 60.1% content) can be commissioned.

Fortescue is going to start selling a mid-quality product in a few months to help close the price discount gap.

On the flipside, sceptics aren’t sure what discount the mid-tier product, which Fortescue is calling West Pilbara Fines (WPF), will fetch. Further, even if the discount was favourable, Fortescue will have limited quantities of WPF to sell until Eliwana comes to life.

There are also worries about Fortescue’s cost. The miner has done a good job in lowering its C1 cost (the net cost at each stage of processing) by 4% to US$12.36 per wet metric tonne (wmt) but is forecasting C1 cost of US$12 to US$13 wmt for FY19.

Production is also tipped to stay largely flat with guidance of 165 million to 173 million tonnes in the current financial year when Fortescue shipped 170 million tonnes in FY18.

There is a valuation argument for Fortescue but this is no re-rating event. What this means is that while the stock may not test new lows (unless the macro environment turns for the worse), it is unlikely to be heading materially higher.

I am feeling a little less bearish on Fortescue but I would be sticking to BHP and Rio Tinto for now.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited and Rio Tinto Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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