A Big Tick In A Big Box For Fortescue

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

By Greg Peel

One is reminded of an old ad campaign back in the eighties for Swan Lager – WA's preferred tipple – centred around celebrities and featuring the theme song “They said you'd never make it”. Were the campaign to be revived today, Twiggy would have to be a hot contender for the first round.

Not that Andrew Forrest can say in all honestly he, or at least his iron ore company Fortescue Metals ((FMG)), has actually “made it” just yet. Not in terms of actually delivering on ambitious expansion plans. But those analysts which scoffed a few years ago have now had to meekly admit that so far FMG is ticking the boxes along the path, albeit softly-softly.

Yesterday's announcement was nevertheless not quite so softly-softly. UBS calls it a “positive step”, RBS Australia is more effusive with “major breakthrough”, while once sceptical Macquarie is happy enough to call it a “game changer”.

Fortescue has been carrying a debt burden of some US$2bn representing a senior secured note issue with a coupon of 10.5%. Not only is the coupon stiff, the issue placed various restrictive covenants on the company which included an inability to sell down assets and an inability to use cashflow to finance any project outside the Chichesters. Most specifically, this left the company's new greenfield project at Solomon hanging out to dry. And Fortescue's cashflows have been growing considerably.

Now, however, FMG has refinanced the notes via a corporate bank facility on a interest rate linked to the London Interbank Offer Rate (Libor), beginning at 7.5%. Not only will the new deal at the lower rate save FMG some US$50-60m a year, it comes with none of the previous covenants. As more than one broker commented this morning, FMG has been “unshackled”.

Not that this “Get out of jail” card comes with the “free”part. Buying back the senior notes will cost FMG an up-front US$650m, which wipes off about a quarter of broker earnings per share forecasts for FY11. Fortescue, however, is not a short-term story.

Aside from reducing the company's weighted average cost of capital, the deal goes a long way to de-risking the Solomon project as far as analysts are concerned. It's one thing to have lots of iron ore in the ground, it is another to have the money to be able to exploit it. Deutsche Bank also notes that by securing the corporate facility, FMG has now “opened the door” to seek financing in the US corporate bond market which will come in handy when the company is ready to push through the initial 55Mtpa production target and on to its far grander goals.

Yet Deutsche is, among the brokers in the FNArena database, the least convinced. All along, the Fortescue story has been one of whether Twiggy could actually “do it” or whether the ebullient West coast ranga had more rocks in his head than in his tenements. For one thing, his rocks were stuck out in the back of the Pilbara with no rail access and no port facility even if a railway were built. But those infrastructure boxes have also been ticked over the past few years. There will still be some reliance on new port facilities planned on the coast and access being purchased from other players, and this is still a risk as Citi notes, but it is not the greatest concern.

For Deutsche, the greatest concern remains one of whether project delivery schedules are realistic, and whether capital and operational expenditure can be kept within targets. With the share price running solidly this past month, Deutsche has decided to downgrade from Hold to Sell. There Deutsche would have met Macquarie, but for the fact the Macquarie analysts have decided to upgrade from Sell to Hold (Underperform to Neutral) post the re-fi news.

Macquarie acknowledges the risk FMG faces and the fact the Chichesters has been beset by delays and production downgrades even before we move on to Solomon. And Solomon still faces permit hurdles and a government agreement on a spur line. But it was the funding issue mostly holding the analysts back, and that has been greatly resolved.

Indeed it has been resolved enough for Macquarie to effectively de-risk a dollar's worth of value, taking its FMG target price up from $5.72 to $6.75. This moves Macquarie up towards the higher end of the target price spread among database brokers, which ranges from UBS at $7.50 down to Deutsche at $4.30 (down from $4.40 post re-fi).

Investors should take note that while the database now shows an average target of $5.91, up from $5.57, the range of targets is a very good indication of the risks Fortescue exhibits. There are a lot of moving parts and sheer assumptions to make in a valuation, and if the brokers all threw a dart at a dartboard with a blindfold on the spread of values would probably be tighter.

And it does depend on where an analyst pitches iron ore price forecasts, from next quarter to next decade. Macquarie, for example, backs up its FMG upgrade by noting the analysts have just raised their iron ore price forecasts and are becoming “increasingly bullish”.

Citi notes that while the $2bn re-fi is a bonus, pushing Chichester and Solomon projects to target production levels will still require conservatively about another US$4bn, although this could be reduced to US$2bn if iron ore prices are maintained.

Which begs the question of how Fortescue will be looking if, as the federal government assumes, iron ore prices go up forever.

There are a couple of brokers still mulling over the FMG announcement but currently the database shows a Buy/Hold/Sell ratio of 4/2/2, representative of that very wide spread of targets around the current trading price of just over $6.

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