Stock in focus – Why Fortescue Metals is a buy

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It is simply nonsense to say that the mining boom has ended, when Australia’s three largest iron ore producers, Fortescue among them, are shipping record tonnages every year.

It is arguably more accurate to say that the investment boom is tailing off and the production boom is really getting underway.

Fortescue Metals Group (FMG) is budgeting for production of 133 million tonnes per annum (mtpa) in FY14 and will reach its headline target of 155mtpa by December 2014.

With a Pilbara land holding that contains 15.6 billion tonnes of resource and 2.2 billion tonnes of reserves, FMG has more ore than it can shake a stick at.

Cost conscious

Importantly, the company’s cash operating costs are at the very low end of the global scale. This does not happen automatically, and the company is demonstrating its capability in this facet by further reducing its costs this year towards US$38 to US$40 per wmt (wet metric tonne). Don’t be surprised to see this number continue to trickle down as the company improves its operational efficiency.

Indeed, despite the very highly publicised decline in iron ore spot prices over the last year as Asian demand (particularly from China) eases back from break neck speed, miners with scale and efficiency will continue to make very good money for investors.

As the company says, the combination of strong production performance, lower costs and declining capital expenditure, will boost FMG’s cash balance towards US$1.7billion – US$2.0 billion for the last financial year.

For some time, the biggest issue for investors has been FMG’s progress towards reducing its considerable pile of debt that has been used to construct the business.

As at 31 December 2012, FMG had gross debt of US$12.7 billion, and with cash of approximately US$2billion, its net debt of US$10.7billion was roughly 2.6 time its shareholders’ equity. Net debt to operating earnings (EBITDA) as at the end of the financial year (30 June 2013) could be around 3.3 times and its interest cover ratio at about 4.0 times.

At first glance, those metrics appear fairly daunting, but the next couple of years for FMG, financially speaking, will look quite dramatic. Its operating cash flow will increase almost as quickly as its capital expenditure reduces.

The corollary is that FMG’s cash will also increase, allowing the company to comfortably repay its debt without any major asset sales.

On this point it should be noted that FMG has no debt repayments due until November 2015 with its peak year of repayments in 2017. The company’s debt is structured so that it can voluntarily make early repayments.

Capacity constraints

Of course, FMG has been investigating a partial sale of its port and rail infrastructure that is housed in its fully-owned subsidiary aptly named, The Pilbara Infrastructure Pty Ltd or ‘TPI’.

TPI includes FMG’s extensive rail network connecting its 700km of railways from its mining hubs to its shipping facilities at Herb Elliot Port in Port Hedland.

It is well known that FMG is considering selling up to 40% of TPI and negotiations with interested parties are likely to conclude a deal by September this year. The terms and price of any such deal will be critical for how the market will perceive the deal because of its strategic importance.

FMG built the rail and port infrastructure to accommodate its expansion to 155mtpa of iron ore. TPI is therefore viewed by FMG as currently configured to only carry iron ore from its operations and not any third party volume.

This is where the story starts to become a little more complex, as there are several so-called junior iron ore mining companies in the Pilbara. Each has its own iron ore resources but lacks the infrastructure to get it to market. As BHP and RIO have locked up their infrastructure, preventing third party access, only FMG has any rail infrastructure of any significance, making it a prime target for the juniors who cannot afford to build their own.

Brockman Mining, for example, has attempted such access and FMG has firmly rejected the proposal on the grounds that it is using all the current capacity and there is none available for Brockman.

The issue becomes more convoluted as transport specialists such as Aurizon (AZJ) and Pacific National (part of Asciano – AIO) seek to establish rail operations in the Pilbara themselves.

Sale opportunities

It is not clear yet how this will play out, but FMG appears to be in a very strong position to negotiate excellent terms for the partial sale of TPI. In exchange for the sale of a big proportion of TPI, FMG will need to achieve an appropriate access price for its own volumes.

If and when FMG achieves a transaction in TPI, it will have a very large amount of money to pay down its debt even more rapidly. Rough estimates value each 10% of TPI at $1 billion.

The apparent slowdown in Chinese economic growth towards 7.5% has crimped commodity prices of key raw materials like iron ore, which is used to make crude steel. But China and other developing nations still need vast amounts of steel to urbanise and modernise their economies, ensuring robust demand for iron ore for many years to come.

The declining Australian dollar also considerably helps exporters such as FMG.

The TPI transaction could be a pivotal event for FMG. Notwithstanding the details of the deal, it should unshackle FMG from the naysayers who have criticised its financial position thus far.

The way things are shaping up for Fortescue, we think it is an excellent buy at the current share price.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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