Fortescue’s Need For Capital The Major Negative

This story features FORTESCUE LIMITED. For more info SHARE ANALYSIS: FMG

By Chris Shaw

Earlier this week FNArena noted Credit Suisse initiated coverage on Fortescue Metals ((FMG)) with an Underperform rating (see More Coverage, Another Sell On Fortescue ), joining the majority of analysts in the market with a negative view on the stock.

As Morgan Stanley points out in a note on the stock today, there is a good reason the FNArena database shows a total of seven Sells compared to one Hold rating and that is the company is likely to require additional capital sometime in the coming year and this raising will be dilutive to existing shareholders.

The broker points out the group’s accounts show financial liabilities maturing in the next six months of US$554 million and in the following six months of US$178 million, meaning a total of US$732 million maturing in FY10. Offsetting this is US$655 million cash on hand, though this is before an estimated US$140 million in capex requirements during what it expected to be a break-even result in terms of cash from operations.

When currently unpaid Leucadia royalty payments of US$71 million are added in, along with the broker’s expectation long lead time items related to phase two expansions previously ordered could be delivered this year, it sees scope for the company’s capital requirements to rise significantly.

Further support to its view comes from the fact when the company ships its 100 millionth tonne of iron ore it is required to detail a proposal to build an iron agglomeration plant, and on shipping its 150 millionth tonne it is required to have the plant running within three years, which the broker suggests shows a clear need for new capital, which would account for the US$6 billion the company is currently attempting to secure from Chinese backers.

In Morgan Stanley’s view, even if the raising were to take the form of hybrid securities, such securities would ultimately be converted into equity and so would be dilutive to existing shareholders, particularly as any deal appears to be exclusive to the Chinese backers and not available to existing shareholders.

Credit Suisse offered a similar argument earlier in the week, noting while higher production and higher iron ore prices are potential positives for earnings the group’s highly geared capital structure is a major concern. Similarly Deutsche Bank suggested while the capital raising would help address cash flow issues the stock remains expensive relative to its valuation, while RBS Australia offered a similar argument. 

Morgan Stanley expects an announcement on a capital raising by the end of this month and given this it retains its Underweight rating on the stock, with a price target of $2.15. This compares to an average price target according to the FNArena database of $3.10.

Shares in Fortescue today are slightly weaker and as at 11.05am the stock was down 4c at $4.11.

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