Treasure Chest: Turning Negative On Fortescue

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By Greg Peel

Last night the spot iron ore price fell to a new six-year low at US$54.20/t. Only a year ago iron ore was trading over US$120/t.

For the Big Two Australian iron ore producers, this is not an issue. BHP Billiton ((BHP)) and Rio Tinto ((RIO)) are part of the problem for the iron ore industry, not its victims, as they have chosen to increase production in the face of falling Chinese demand, expanding their high-grade, low-cost legacy operations. It’s not malicious, it’s just business.

The “victims” of the reduced demand/increased supply global equation are the junior pure-play miners, many of whom operate lower grade, higher cost operations, with several funded by material gearing. They have been burning cash at prevailing iron ore prices for some time now and if there is no relief before too long, their future is in doubt. BHP and Rio continue to generate positive cash flow at current prices.

In between sits Fortescue Metals ((FMG)) – far smaller than the Big Two but too big to be counted alongside the “juniors”. At current iron ore prices, Fortescue is still generating positive cash flow operationally, but is running below breakeven if one assumes no rebound in pricing ahead of the company’s debt repayment obligations. The first repayment is not due until FY17, but Fortescue has clearly decided it’s best to be prepared. With global interest rates trending ever lower, the obvious solution is to restructure existing debt. The cost of restructure can be offset by a lower interest rate, and an extended maturity buys time.

Fortescue attempted a debt restructure last week by offering a $2.5bn senior secured convertible note issue. A day later the company withdrew the offer, likely red-faced, but undoubtedly surprised. Fortescue could not restructure at a favourable price, being the interest rate required, implying lenders required a greater risk spread built into the coupon to warrant their risking such an investment.

And that leads us back to the iron ore price, and outlooks thereupon. For some time commodities analysts had been expecting a fall in the iron ore price, to reflect increasing seaborne supply (See: BHP, Rio and Fortescue itself, notwithstanding juniors). However consensus had the price settling at a lower but stable level based on the demand side of the equation – ostensibly Chinese steel production. But in recent months, one by one said analysts have been changing their views on the strength, or more importantly lack thereof, of Chinese steel demand.

This has led to some significant iron ore price forecast downgrades, not just for spot but across the time curve. The falling Aussie dollar has provided some offset on an earnings basis, but not enough.

Morgan Stanley has become the latest broking house to reassess its iron ore outlook, the result being a forecast average price downgrade of 28% for 2015 and 13% for 2016. Until today MS was carrying an Overweight recommendation on Fortescue, predicated on a combination of an assumed rebound in the iron ore price and Fortescue’s ability to refinance at a lower interest rate cost.

The broker now no longer forecasts a price bounce, and Fortescue’ own withdrawal of its convertible offer rather discounts the second factor. As a result, Morgan Stanley has now double-downgraded its recommendation to Underweight, or a “Sell” equivalent.

The impact of the MS commodity analysts’ downgrades of 28% and 13% for the iron ore price in 2015-16 translates into 66% and 83% earnings forecast downgrades over the same period. On the broker’s new “price deck” (forecasts out into time) Fortescue’s earnings deteriorate through 2016, implying an earnings trough is ahead of the company, not behind it.

The new price deck implies to the broker that Fortescue has three months to issue new secured debt before the price would be too unfavourable, but given last week’s withdrawn offer that time may already have come, the broker notes. Issuing high coupon debt would just add margin pressure. The company could direct its still-positive operating cash flow towards early debt repayments but these would be just a stop-gap, the broker points out, not a solution.

To do so would also require suspending dividend payments which, in the current market, could potentially be share price suicide.

On that score, brokers were somewhat surprised Fortescue stuck with a 3c interim dividend at the recent result release. JP Morgan (Neutral) summed up the feeling by suggesting, under the circumstances, the board was being “a bit free with its cash”.

Morgan Stanley suggests asset sales and/or a capital raising may be the only solution(s). Indeed, fresh press reports suggest the company is considering selling off stakes in some or all of its Pilbara iron ore assets as an option.

Last week Macquarie (Neutral) was content to believe another debt restructuring opportunity will arise down the track – that track leading to 2017 and to further repayment obligations beyond. The broker calculates Fortescue’s operating-plus-debt-obligation breakeven iron ore price is US$65/t. The iron ore price has fallen further since last week, but given the depth of the fall in recent months a short-covering bounce and general shake-up is always a possibility.

Fortescue shares themselves are also prone to a potential short-covering scramble, given FMG stock was as of last week the fourth most shorted on the ASX (11.5% according to ASIC).

UBS (Neutral) is not, at this stage, suggesting a capital raising is nigh given the broker believes the company’s near term liquidity remains “sound”, but refinancing risk only builds if the iron ore price remains below US$60/t, on the broker’s calculation. Citi suggests Fortescue could go down the aforementioned early debt repayment path by looking to increased customer pre-payments, but the broker has a bearish stance on iron ore prices and retains a Sell recommendation on the stock.

In downgrading its earnings forecasts, Morgan Stanley has cut its share price target to $1.65 from $2.60, to be the new low-marker on the FNArena database, by a margin. Morgans (as opposed to Morgan Stanley) is one of four brokers having last updated their views following Fortescue’s February result release, and currently has the high-mark target in the FNArena database of $3.55. The consensus average is $2.52, with two Buy (or equivalent) ratings meeting four Holds and, now, two Sells.
 

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