Fortescue has provided guidance for a USD28.80 per tonne breakeven price by the end of FY16, which represents continued improvement on its cost position. We look at what this means for the company and the bonds going forward
Fortescue’s 1H16 result was more interesting for the guidance that the company provided, rather than the half year performance itself (announcement to the results here
). The company continues to make substantial progress on costs, and its guidance for an exit breakeven price for FY16 is USD28.80 per tonne. To put this into context, if iron ore prices were to average USD40 per tonne, Fortescue would generate around USD1.7bn in cash flow annually at the guided breakeven price. This compares to USD6.1bn of remaining net debt outstanding. If iron ore prices remained at the current level of around USD50 per tonne, annual cash flow generation would increase to almost USD3bn annually.
The reconciliation from cost to a breakeven price is reflected in the figure below. We note that the breakeven calculation also factors in the discount to index (~13%) Fortescue achieves on its iron ore sales:
Source: Fortescue
The company is now in a position where its breakeven price is converging towards the two majors, which are understood to be producing at breakeven prices of around USD25-26/tonne. At these cost levels, BHP and Rio cannot simply rely on increasing supply and falling iron ore prices to knock Fortescue out of the game. They too need to generate free cash flow on their iron ore operations, and with the breakeven prices converging they will understand that any pain to Fortescue’s bottom line will result in a similar pain to theirs.
This is an important milestone for Fortescue. Not long ago we were all contemplating the survival of this company. Now we are increasingly confident in the company’s ability to successfully deleverage and roll over the secured USD4.8bn term loan in 2018. Concern around this debt maturity is keeping the price on the 2022 lines relatively low and presents a value opportunity.
For those with a high risk appetite/ tolerance for risk, now would be a good time to turn reassess the 2022 lines which are both trading below par value. We expect the 2019 line will become increasingly difficult to source as existing holders wait and see what the company does in relation to a bond buyback, which we believe is a very high chance of occurring. Management have reiterated their commitment to a gearing ratio target of 40% through debt reduction. Gearing is currently at 52% and we expect around USD3bn of further debt reduction will be needed to achieve the 40% target, holding equity value constant at current levels.
We think the secured 2022 US dollar bond is particularly interesting. Fortescue owns all of its mine, port and rail assets valued at USD17.2bn at 1H16 and the bond is fully secured against these. The coupon is at a very high 9.75% and the bond is currently trading below par offering an indicative yield to maturity of 10.45%.
We expect Fortescue will look to pay off the unsecured 2019 and 2022 lines first. The reason we believe the unsecured 2022 line will be repaid first is because it is trading at a much greater discount to par than the 2022 secured line. While the 2022 secured bond has a higher coupon, the company stands to make a larger gain from buying back the 2022 unsecured line because its market price is trading at a much greater discount to par. Once the unsecured bond maturities have been addressed, we expect the company would use any surplus cash flow to progressively reduce the expensive secured 2022 line. The lesson from the reporting season is that the big end of the mining town has substantial dry powder at its disposal to manage its way out of a down cycle. Fortescue’s main lever has been its continued and substantial progress on cost reduction. The company has consistently delivered on cost guidance which means its expectation of USD28.80 per tonne breakeven price by the end of 2016 is credible.
Fortescue’s corporate credit rating is BB with a negative outlook from S&P (rating affirmed 3rd February), and Ba2 by Moody’s with its rating placed under review for downgrade on the 22nd January.
A list of the Fortescue bonds and their indicative yields to maturity are outlined below. We note that the secured 2022 bond ranks 2 notches above the unsecured bonds.
| Bond | Bond rating | Capital price | Coupon | Running yield | Yield to maturity* |
|
2019 Unsecured Bond
|
B+/B1
|
$91.00
|
8.25%
|
9.07%
|
11.31%
|
|
2022 Secured Bond
|
BB+/Ba1
|
$96.95
|
9.75%
|
10.06%
|
10.45%
|
|
2022 Unsecured Bond
|
B+/B1
|
$73.25
|
6.875%
|
9.39%
|
13.45%
|
*Yields indicative based on pricing as at 25 February 2016
Please contact your FIIG representative for further information and current pricing levels on the Fortescue bonds. Available to wholesale investors only.