Market confidence in Fortescue is improving, driven by higher iron ore prices and continued progress reducing costs. The company is weighing up options for its USD1.5 billion cash pile that ranges from refinancing to fresh bond buybacks
Fortescue recently published its March quarterly production report which was positively received by the market. A link to the report is available here.
Key points from the report are as follows:
- Shipments are running ahead of target despite bad weather experienced during the March quarter, with potential upside to full year production guidance (subject to weather)
- The company achieved a 6% reduction in direct (C1) costs to USD14.79/wet metric tonne (wmt) on the prior quarter, which also represents a 43% cost reduction on the prior corresponding March quarter
- Fortescue’s cash balance increased by USD200m to USD2.5bn over the quarter, resulting in net debt reducing to USD5.9bn. An extra USD200m of additional cash will flow into the June 2016 quarter as timing adjustments associated with provisional pricing are released
- The company’s guided USD13/wmt cost exit rate is looking harder to achieve at the higher exchange rate, however we note the margins have improved with the rebound in iron ore prices
The company has also stated that of the USD2.5bn cash on hand, around USD1.5bn is available as a ‘war chest’ for further debt reduction. The company is remaining coy around how it will apply the cash, and whether it will buy back bonds, call bonds or refinance debt. It has a number of options at its disposal.
Confidence in the company’s credit profile has improved as a function of a rebound in iron ore prices to nearly USD60 per dry metric tonne (dmt), as well as continued progress on the cost front. As a result, we have seen continued rallying in the Fortescue bonds across all lines since the lows reached in February, as reflected in the figure below:
If iron ore prices remain at the current levels of near USD60/dmt, our expectation is that the company will look to pay down debt to a level which achieves its stated 40% gearing target. Net gearing is currently at around 43%-44% and we estimate the company needs to reduce its net debt position by a further USD800m to achieve the 40% target, assuming no change to the company’s asset position.
We expect it will look to repay the remainder of the 2019 unsecured bond first, and to the extent the unsecured 2022 bond trades sufficiently below par (in the USD80s), it would also tender these bonds and realise a gain on their repurchase. We note that the 2019 bonds can be called by the company at any time (current call level is USD102.063) and the positive trajectory of the 2019 bond prices suggests an increasing likelihood that an early call will come into play.
As gearing and net debt levels reduce, we would anticipate that Fortescue’s credit rating would be upgraded over time and it would be able to raise debt at far cheaper levels than present (and as a result, further rallying in the remaining 2022 bond prices). Upon a re-rating of the credit, it would make sense to refinance the 2022 secured bond with a cheaper tranche of debt. No doubt 9.75%pa is a hefty interest rate to be paying on secured debt, noting it was previously able to issue a 6.875% unsecured bond during the peak times in the iron ore boom. We think it’s perhaps premature for the company to be considering raising new debt because we still think that the cost of funding looks relatively expensive for the company and through further gearing reduction it can achieve an improved outcome on the refinancing cost of debt at a later stage.
If iron ore prices fall (which many market analysts are expecting), then we believe the company has created sufficient headroom in its cost profile to manage a price fall. Its direct costs of production are converging to BHP and Rio’s direct costs and as such the majors cannot rely on a strategy of flooding the market with production to knock out Fortescue – it would be too damaging for their own bottom lines and restrict their ability to pay dividends. Based on its exit rate cost guidance for FY16, Fortescue’s guided breakeven iron ore price would be USD29/dmt. In other words, iron ore prices would have to halve from today’s levels for Fortescue to be producing at levels which do not generate positive free cashflow. In the context of commodities business, it’s a meaningful buffer of protection for the iron ore producer.
Its guided breakeven price for the end of FY16 is USD29/dmt, but note this is based on an exchange rate of 0.71 which is looking increasingly unlikely. However, a stronger AUD is correlated to a higher iron ore price which would still suggest a favourable operating environment and healthy margins for the company.
Fortescue bond prices are exhibiting volatility and prices fluctuate daily. The following bond prices (and yields to maturity) ranges are indicative and we expect will change daily:
- Fortescue 2019 unsecured bond – USD98 to USD101 (8.92% to 7.54%)
- Fortescue 22 unsecured bond – USD83 to USD86 (10.83% to 10.06%)
- Fortescue 22 secured bond – USD103 to USD106 (8.97% to 8.22%)
With a relatively stronger position in the capital structure, high running yield, and attractive spread differential to the unsecured lines we believe the 2022 secured bond represents good relative value at current levels. In addition, we expect to see relatively greater capital price stability in the 2022 secured bond versus the unsecured bond if iron ore prices fall from current levels, which may be attractive to some investors.
Please contact your FIIG representative for further details on the Fortescue USD bonds. Available to wholesale investors only.