Does Fortescue Have A New Funding Issue?

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

By Chris Shaw

Back in 2006, US-based Leucadia invested $400 million in Fortescue ((FMG)) via the way of a share placement and US$100 million in a subordinated loan note. The company now holds an 8% stake in Fortescue and receives a royalty payment of 4% of revenues on the loan note.

As Fortescue needs additional capital to fund its planned expansion in production, it has proposed issuing additional subordinated loan notes. The additional funding would mean the current 4% royalty would be split among Leucadia and other parties, something Leucadia is not willing to accept.

Leucadia has issued a summons to prevent any dilution of its royalties, which could impact on Fortescue's significant funding requirements. Macquarie estimates Fortescue's ramp-up schedule implies peak funding of around US$2 billion, while senior debt repayments falling due over the next three years adds a further US$950 million to this total.

One possible consequence in Macquarie's view is any potential souring of the Leucadia-Fortescue relationship could mean Leucadia looks to sell its stake, which implies a stock overhang. As well, Leucadia could also look to take legal action against the prospect of a diminishing royalty stream from its loan note.

As Macquarie offers as an example, the Chichesters project was envisaged to be a 160 million tonnes yer year project by the end of this year but now is set to be only a 90 million tonne per year project by June 2014. This suggests Leucadia may not receive the royalties it had previously expected.

As it transpires, Leucadia has today issued a Writ of Summons against Fortescue.

While Fortescue may be able to find alternative sources of funds the Leucadia action means these are likely to be more expensive according to Macquarie, so the dispute has the potential to have a negative earnings impact as well.

Of course, as JP Morgan notes, if Fortescue is successful in this case it would be a positive for earnings as the implication is the company could effectively raise additional principal at 0% real interest. This is because of the terms of the existing notes.

The fact payment on the notes is a pro-rata amount of 4% of revenue means if new notes could be issued the interest payment per note would effectively fall. As an example, JP Morgan suggests the issuance of one additional US$100 million note would halve the interest payment per note to 2% of net revenue.

Success would thus effectively amount to an additional US$800m of cash for Fortescue, says JP Morgan, or some 5% of market capitalisation.

Given this issue is likely to take some time to be resolved both brokers have retained their views on Fortescue, JP Morgan rating the stock as Neutral and Macquarie as Underperform. Overall the FNArena database shows Fortescue is rated as Buy five times, Hold three times and Underperform twice.

The average price target on Fortescue according to the FNArena database is $5.22, while the stock today is down 2c at $4.87 as at 11.55am. Over the past year the stock has traded in a range of $3.28 to $5.57, while the current price implies upside of around 5% to the average price target in the database.

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