Fortescue Metals Group Limited (ASX: FMG) started 2016 at $1.90 per share. It now trades at $4.90, which is a gain of 158%. A key reason for this is an iron ore price which has increased from US$42 per dry ton in January to its latest price of US$57 per dry ton. This has benefitted iron ore miners such as Fortescue and Rio Tinto Limited (ASX: RIO). However, in my view, Fortescue faces a difficult outlook which could see its share price decline.
Falling demand
The outlook for iron ore is uncertain. The world's largest importer of iron ore, China, is attempting to cool its housing market which has surged in recent months. The average new home price in 70 major Chinese cities increased at an annualised rate of 9.2% in August. This is up from the 7.9% annualised gains which were recorded in July.
One way China is attempting to cool the housing market is to restrict home purchases. The latest city to do so is Nanjing. In the medium to long term this policy is likely to reduce the incentive for developers to build new houses. This could reduce demand for steel and in turn, for iron ore.
Increasing supply
Alongside an uncertain outlook for demand is a forecast increase in supply of iron ore. The world's two largest exporters of iron ore, Brazil and Australia, are forecast to increase their production by a combined 17.2% over the next four years. This means that the current imbalance between demand and supply is likely to widen. The current surplus of iron ore across the globe is 20 million tons. This is expected to increase to 56 million tons by 2018.
Cost cutting
Fortescue has been successful in reducing costs. Its C1 operating costs averaged US$15.43 per wet metric ton in financial year 2016. This is a fall of 43% from financial year 2015 and Fortescue expects its C1 figure to drop further in financial year 2017.
Fortescue's free cash flow has improved due to a reduction in capital expenditure. It fell from US$626 million in financial year 2015 to US$304 million in financial year 2016. Improved operating cash flow has helped to reduce Fortescue's total debt to US$5.2 billion having repaid US$2.9 billion of debt in financial year 2016.
Outlook
However, the combined effect of falling demand and rising supply is likely to be a lower iron ore price. Although Fortescue has become more efficient in recent years, its profitability is set to be hurt by a lower realised price for iron ore.
Fortescue's P/E ratio of 11.5 indicates that it is cheap, while miners such as Rio Tinto and Newcrest Mining Limited (ASX: NCM) have P/E ratios of 16 and 34 respectively. Therefore, a price fall to $1.90 per share may not take place. However, in my view Fortescue's valuation will decline over the medium term.
With that in mind, I believe that these three blue-chips are better places to invest.
