Fighting Fortescue shakes off the shackles

Via its decisive response to the dip in iron ore price, Fortescue won the support of surprisingly bold investors and is now back on track as Chinese-led steel demand heads back up.

Fortescue Metals’ successful completion of its re-financing says something about Fortescue, it says something about the iron ore market and it says something about credit markets.

Whether or not the rebound in iron ore markets is sustained, and whether or not credit markets remain more obsessed with yield than risk, the refinancing confirms how adroitly Twiggy Forrest and Nev Power have responded to what could have been a crisis that overwhelmed the self-proclaimed ‘’New Force’’ in iron ore.

Fortescue responded to the accelerating implosion in iron ore prices that developed from mid-year by slashing costs, shelving expansion plans, selling a power station and embarking on a re-financing of the group’s $US3.5 billion of bank debt. It also announced plans to buy back an unsecured note held by Leucadia Capital for $US715 million.

The original refinancing plan was to raise $US4.5 billion of new secured debt to replace the group’s original facilities and pay for the buyback of the Leucadia note. There was an initial expectation that the debt would cost Fortescue around 6 per cent per annum.

Today Fortescue confirmed that it had actually raised $US5 billion after responding to the demand for its paper at a cost of LIBOR (roughly 1 per cent today) plus 4.25 per cent. So it has raised $US500 million more than it originally planned at a materially lower cost than it originally expected.

Had it stuck with the original $US4.5 billion re-financing most of the extra borrowings would have been absorbed by the cost of redeeming the Leucadia note.

That would still have been worthwhile because the Leucadia note represented very expensive funding – it gave Leucadia 4 per cent of the freight on board revenue, net of government royalties, from its Cloudbreak and Christmas Creek mines. As its production scaled up over the next two or three years the effective coupon on the note could have nearly doubled from around $US200 million to around $US400 million.

By buying back the note relatively cheaply – it was valued at nearly $US1 billion a year ago – and funding the buyback with the new bank debt, Fortescue will dramatically lower its effective borrowing costs.

The group’s timing was fortuitous. It was plunged into a near-crisis by the collapse in iron ore prices below $US90 a tonne. Prices have since recovered and are pushing back up towards $US120 a tonne. At $US90 a tonne Fortescue – which suffers a quality discount of roughly $US10 a tonne relative to a Rio Tinto or BHP Billiton, as well as a cost disadvantage – would lose money. At $US120 a tonne it would be profitable.

The recovery in the price would therefore have helped calm its prospective bankers’ nerves and, because of the extra $US500 million raised, has enabled Fortescue to create some headroom in its facilities and potential liquidity either as insurance against another downturn in the iron ore price or to restart the shelved expansion program. The 40 million tonnes a year Kings expansion would, if completed, significantly lower the group’s production costs.

Thus, to some degree, Fortescue has used the crisis as an opportunity to both lower its operating and funding costs and improve its financial flexibility.

The recent stronger tone in the iron ore market may not be sustained – it is dependent on the state of China’s economy and steel production – and almost certainly won’t get back to the aberrational levels of a year ago, when the prices were pushing towards $US200 a tonne.

The bounce back towards $US120 a tonne, however, will be seized on by those who believe that the cost of marginal iron ore production set by the Chinese producers, estimated at around the $US115 to $US120 a tonne level, represents a floor price.

Now that a cycle of de-stocking by Chinese steel mills appears to have run its course, that floor price may be asserting itself, although there may also be an element of seasonality to the firmer demand. In any event it did help Fortescue’s refinancing.

The other take-away from the refinancing is that credit markets are open even to higher-risk borrowers, indeed may even be chasing them for the extra yield.

The coupon on Fortescue’s debt of LIBOR plus 4.5 per cent may not compare favourably with the cost of borrowings for a BHP or Rio – BHP raised $1 billion at 3.75 per cent last week and last month raised about $US5.5 billion of long term debt in the euro markets at a blended cost of around 2.8 per cent – but by historical standards is cheap funding for a company with Fortescue’s risk profile.

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