Tuesday 21 April 2015 by Alen Golubovic Company updates

Fortescue delivers strong quarterly performance

Latest production report review - challenges remain

Iron ore mine

The quarterly result and improved guidance is positive for the company and demonstrates its continued resilience in the face of a falling iron ore price. However, the company continues to remain exposed to further sustained falls in the iron ore price, which seems to be the general market consensus.  

Following the quarterly report release last week, Moody's downgraded Fortescue Metals Group Ltd's corporate family rating to Ba2 from Ba1. At the same time Moody's has downgraded FMG Resources (August 2006) Pty Ltd's senior unsecured rating to Ba3 from Ba2, and has placed a negative outlook on the company’s ratings. 

All of the Fortescue bonds have rallied on the news, but if there are further falls in iron ore to the low $40’s per dry metric tonne (dmt) and below, the rally may be temporary in the absence of other measures such as debt reduction, asset sales or balance sheet management. We expect the positive quarterly report will drive positive sentiment back to the company as long as iron ore price hovers around $50/dmt or increases. However, given the high volatility in iron ore prices we will continue to see a high degree of volatility in the longer dated (2019 and 2022) bond prices.

On the assumption of a medium term USD35/tonne iron ore price, which has now been suggested by some investment banks, the outlook for Fortescue remains cautious in the absence of further news in relation to the company’s balance sheet position. Even with the company improving its FY16 breakeven guidance to USD39/dmt, Fortescue would be running at a loss at this price. If a USD35 iron ore price forecast does eventuate over the medium term, then the recent rally may be provide an opportunity to exit ahead of even lower bond prices based on continued falls in the iron ore price.

However, if the revised iron ore forecasts have overshot the mark and iron ore prices have found their low point around the $50/dmt level, then the company has a few more years available to work out a debt solution. In this kind of scenario, the later dated Fortescue bonds (particularly the 2019s) look like good value at double-digit yields to maturity, but investors should be aware of the potential downside risks related to iron ore in the current environment.  

March quarter highlights

  • Cash is up from USD1.6bn at 31 December 2014 to USD1.8bn through positive cash margins achieved in the March quarter
  • Shipments for the quarter were 40.4 million tonnes, in line with expected production of 160 million tonnes per annum
  • The company realised a price of USD48/dmt on its iron ore shipments, based on an average contract price of USD55/dmt, in line with the 85%-90% price realisation guidance
  • Direct production (C1) costs in the March quarter of USD25.90/wmt  are in line with previous guidance
  • Net debt at 31 March 2015 was USD7.4 billion has remained steady, with finance leases of USD0.5 billion (inclusive of the recently commissioned USD140 million finance lease on Fortescue River Gas pipeline) and cash on hand of USD1.8 billion

FY16 guidance for improved cost performance

  • Preliminary FY16 shipping guidance is estimated at 165mtpa with C1 cost guidance of US$18/wmt, based on a cost of production exit rate of USD20/wmt in FY15
  • Sustaining capital expenditure, excluding exploration expenditure, is estimated to be USD330 million in FY16 or USD2/wmt
  • USD18/wmt C1 costs would result in total delivered costs to China of USD25/wmt in FY16, and an all-in cash cost of around USD31/wmt
  • Based on this guidance, Fortescue’s breakeven index price in FY16 would be USD39/dmt. This is reflected in the chart below

FY16 Break Even Price 
Source: Fortescue Metals Group

We note that, while the cost guidance for FY16 looks substantially improved, there remains scepticism from the market as to whether this cost guidance is sustainable beyond FY16.

Cash flow forecasts 

Below we provide two forecasts of Fortescue’s cash position, based on two sets of iron ore price forecasts. The analysis below highlights the sensitivity of Fortescue’s earnings to small movements in the iron ore price. At a USD35/tonne iron ore price, the company would completely exhaust its cash balance by end FY16 if it does not roll over prepayments, which would place liquidity pressures on the company. However, if S&P’s revised iron ore price assumptions play out (second scenario below), the cash balance would be USD2.0bn at end FY16.  

Please note that we have also factored in the amortisation of prepayments as an additional cost item, on the conservative assumption they won’t be rolled over. Prepayments are like a form of short-term borrowing for the company, where it negotiates an upfront payment from its customers in exchange for the delivery of future tonnes. Fortescue notes that it has received significant interest from potential and existing customers who are interested in entering into new prepayment contracts or rolling over existing prepayments. If prepayments are rolled over the cash forecasts below would improve. 

  1. At USD35/dmt, which has been the quoted assumption being mulled by the Federal Treasurer and some analysts, the cash burn rate would look as follows.
  • June quarter (assuming breakeven price of USD42): -USD240m cash burn - USD150m prepayment amortisation = (USD390m)
  • FY16: -USD544m cash burn - USD850 prepayment amortisation = (USD1,394m) 

Therefore, at the USD35/dmt assumption, the cash balance of USD1.8bn would likely be fully eroded by the end of FY16, if prepayments are not rolled over and cost guidance is achieved (and no dividends are paid), which would place liquidity pressure on the company. 

  1. At USD45/dmt, which is S&P’s assumed iron ore price for 2015 increasing to USD50/dmt in 2016, Fortescue would be net cash flow positive through FY16 assuming prepayments are not rolled over. The cash position would be expected to move as follows
  • June quarter: +$102m cash flow – $150m prepayment amortisation = -$48m
  • FY16: +$1,156m cash flow – $850m prepayment amortisation = +$306m

Therefore, at S&P’s revised iron ore price assumptions, the cash balance of USD1.8bn would increase to about USD2.0bn by the end of FY16, if prepayments are not rolled over and cost guidance is achieved (and no dividends are paid)

Debt maturity profile

The chart below is a reminder of the current debt position of Fortescue, and goes some way to explaining why the 2019 and 2022 senior unsecured bonds experience significant falls when iron ore prices move down.

The company has USD4.9bn of senior secured debt maturing in 2019, and we understand from media reports that this debt has no maintenance covenants. The 2017’s and 2018’s have traded around par levels on the expectation that the cash balance is sufficient to pay out these bonds, which remains valid if iron ore prices remain at USD50/dmt levels and the company delivers on its cost guidance. From 2019 onwards, the market has discounted the value of the 2019 and 2022 bonds given they rank below senior secured debt in a default scenario, as well as the potential risk of lower iron ore prices  over the long term, eroding the company’s ability to pay its longer term debts.

Debt Maturity Profile Fortescue
Source: Fortescue Metals Group

Disclaimer

The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or  distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.