Fortescue (FMG) has come under significant pressure recently, falling more than 35% from its 12-month highs as softer iron ore prices, operational challenges and increasingly difficult negotiations with China’s centralised iron ore buyer weigh on the stock. We hold FMG in the Income Portfolio, largely for its attractive dividend yield, but recent developments have us questioning whether RIO is now a better option. Both stocks have fallen, but while FMG has traditionally offered a higher yield, RIO provides greater diversification, lower operational risk and arguably better value at current levels.
The immediate issue for FMG is its ongoing negotiations with China Mineral Resources Group (CMRG), the state-backed iron ore purchasing group established to increase China’s bargaining power with major producers. While BHP and RIO have recently reached agreements, FMG remains at loggerheads with CMRG, with the dispute now impacting physical sales. FMG accumulated almost 4Mt of unsold iron ore during the September quarter, with a further 4-5Mt expected in October. Management has warned that production may need to be curtailed if an agreement isn’t reached by year-end, a concerning development for a business heavily reliant on high-volume production and cash generation.
The implications for FMG’s dividends are significant. UBS recently cut its earnings forecasts by 6-10% across FY27-29, with the broker expecting negative free cash flow in FY27 and a sharp reduction in dividends. They now forecast dividends of just 36c per share in FY27, 56c in FY28 and 63c in FY29, implying yields of approximately 2.5%, 3.8% and 4.3% respectively. This compares with Bloomberg consensus expectations of around 4.1% for FY27 and 4.6% for FY28, highlighting the downside risk to FMG’s income appeal if negotiations drag on.
The comparison with RIO is becoming interesting:
- Diversification: FMG remains overwhelmingly exposed to iron ore, particularly lower-grade products that trade at a discount to benchmark prices. RIO has substantial additional exposure to copper, aluminium and lithium, reducing its dependence on a single commodity.
- China exposure: Both companies are heavily exposed to Chinese demand, but RIO has removed an important near-term uncertainty by reaching an agreement with CMRG, while FMG continues to accumulate unsold inventory.
- Valuation: On consensus numbers, RIO trading is on ~12.9x CY27 earnings, compared with FMG on 17.6x FY27 earnings. RIO also trades at a discount on FY28 earnings forecasts, suggesting investors aren’t paying a premium for its greater diversification.
- Income: RIO is expected to yield ~4.5% fully franked in CY27 & CY28, which now compares favourably with FMG, particularly using UBS’s more conservative dividend forecasts.
- Balance sheet: Consensus expects RIO’s net debt to fall materially over coming years, while FMG faces rising debt as elevated capital expenditure and weaker cash generation take their toll.
FMG does have a potential near-term catalyst. An agreement with CMRG would allow inventories to unwind, improve cash flow and potentially trigger a meaningful share price recovery. However, we question whether FMG will ultimately secure better terms than those already accepted by BHP and RIO, particularly as the financial pressure mounts. Longer term, additional iron ore supply from projects such as Simandou in Guinea, where RIO has an ownership interest, also presents a challenge for iron ore prices.
We still see value in FMG following its sharp decline, particularly if the China dispute is resolved sooner rather than later. However, its traditional yield advantage is looking increasingly questionable, while RIO offers greater diversification, more attractive earnings multiples and fewer near-term uncertainties. For our income-focused portfolio, dividend sustainability is critical, and we’re increasingly inclined to favour RIO over FMG on a risk-adjusted basis.
MM now prefers RIO over FMG
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Rio Tinto (RIO) vs Fortescue Metals (FMG)
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Rio Tinto (RIO) vs Fortescue Metals (FMG)
