Fortescue (ASX:FMG) share price tumbles on broker downgrade

The Fortescue Metals Group Limited (ASX:FMG) share price has come under pressure on Wednesday after being downgraded by a leading broker…

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The Fortescue Metals Group Limited (ASX: FMG) share price has come under pressure on Wednesday.

In morning trade, the iron ore producer’s shares are down 2% to $19.98.

Why is the Fortescue share price tumbling lower?

Investors have been selling Fortescue’s shares this morning after it was the subject of a broker note out of Goldman Sachs.

According to the note, the broker has downgraded the company’s shares to a sell rating and cut the price target on them to $18.90.

This price target implies potential downside of 5.5% over the next 12 months.

Why did Goldman downgrade Fortescue’s shares?

There were a number of factors that led to Goldman Sachs downgrading the Fortescue share price this morning.

One of the main ones was its relative valuation. It notes that Fortescue’s shares are changing hands at 1.4x net asset value (NAV). This compares unfavourably to BHP Group Ltd (ASX: BHP) and Rio Tinto Limited (ASX: RIO), which are trading at 0.95x NAV.

Goldman also estimates that its shares will be trading at 8x estimated FY 2023 operating earnings when iron ore prices retreat to the US$80 per tonne to US$90 per tonne level. Whereas BHP and Rio Tinto’s shares will be trading at 4.5x to 5x operating earnings.

Why else is Goldman bearish?

The broker also has concerns over the widening of lower grade iron ore prices in comparison to benchmark iron ore.

It is expecting low grade 58% iron ore product discounts or realisations to widen from the current c~87%-90% level to 80% by the year-end. Combined with an expected ~35% drop in the benchmark 62% Index price, this doesn’t bode well for Fortescue.

Goldman explained: “China steel curtailments which could drive the steel price and margins higher making higher grade iron ore more favourable on a Value-in-Use (VIU) basis. We assume FMG’s realisations drop 10% from 91% achieved in Dec Q in 2020 to 81% by the end of 2021. We have already started to see steel mills switching to higher grade iron ore since Chinese steel mill gross profit margins have climbed above RMB500/t.”

All in all, Goldman doesn’t see enough value in the Fortescue share price now and recommends investors look elsewhere in the sector.

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Motley Fool contributor James Mickleboro has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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