Forrest digs his way out from between a rock and a hard place

Fortescue Metals was selling iron ore at a loss a year ago; today it is well placed to service its many billions of dollars in debt obligations, writes Peter Ker.

This time last year, Andrew "Twiggy" Forrest was nursing a broken heart.

His iron ore empire had momentarily lurched into crisis, and scores of his loyal lieutenants had been retrenched on the spot.

"My heart breaks for the people we have had to let go. They are paying a high personal price for something that is necessary," he told Fairfax Media, almost exactly a year ago.

With iron ore prices sliding far beyond expectations, Fortescue was temporarily selling iron ore at a loss, forcing its share price down by 30 per cent in the space of two weeks. As liquidity dried up, billions of dollars worth of expansion plans were deferred, and the deathly silence of a four-day trading halt allowed rumours of Fortescue's demise to run rampant.

But if Forrest's heart was broken at that moment, it certainly wasn't defeated. "We have to emerge from this with a company that is fitter and stronger to make sure that we really have built a multi-generational business," he said at the height of last year's storm.

A year on from that spectacular liquidity crisis, and Forrest's first wish already seems to have been achieved. Fortescue is enjoying an Indian summer of sorts on the back of unexpected strength in the iron ore price.

The company is leaner in terms of total iron ore production costs, which are already about 25 per cent lower than the same time last year thanks to some new low-cost mines bringing down the average across the company.

Fortescue's export volumes are 40 per cent stronger, growing the revenue pile by 21 per cent in the 2013 financial year.

All expansion projects have resumed, and the spend on growing iron ore production rates from 55 million tonnes to 155 million tonnes annually will be complete by December, a year earlier than originally planned.

"All those things in combination have given us a lot more strength," said Fortescue boss Nev Power this week. "We are definitely a fitter and stronger company today than we were 12 months ago."

But Forrest's second wish - to turn Fortescue into a "multi-generational business" - remains unfulfilled, and if it is to be achieved, the iron ore miner will have to thrive between a rock and a hard place. Fortescue has about $US12 billion of gross debt sitting just beyond the horizon, and will have to repay that over a nine-year period in which iron ore prices are universally tipped to decline.

Fortescue's highest-profile critic, New York hedge fund manager Jim Chanos, believes that combination of factors could create a "witches' brew" that brings Fortescue to its knees.

"This is a company that has made a one-way bet on one commodity," he told Fairfax Media this month in a rare interview. "The iron ore miners have made a big bet that demand is going to continue increasing meaningfully in China."

Arranged by JPMorgan and Credit Suisse during the height of last year's crisis, Fortescue's debt was structured to give the company a three-year repayment holiday before the first $US2 billion worth of unsecured notes fall due around November 2015.

But once the repayments start, things get rather hectic for the company that calls itself the "third force" in iron ore; more than $US9 billion falls due in a three-year period ending in June 2018.

The biggest slug comes in the second half of 2017, when a $US5 billion credit facility matures.

The schedule is rounded out with $US1.5 billion worth of notes due to be repaid in 2019 and a further $US1 billion in 2022.

"If you have a fair bit of debt like that, it's pretty good for focusing your attention," quips Ian Burston, who served on the Fortescue board between 2008 and 2011.

Initially, many members of the local investment community believed Fortescue would have to sell crucial assets, such as a stake in its port and rail infrastructure, to raise the billions of dollars needed.

"We continue to believe that Fortescue is over-geared and that asset sales will be required to reduce longer-term funding risk. We maintain our sell rating," said former CLSA analyst Hayden Bairstow in a note to clients after Fortescue restructured its debt last September.

But gradually the sentiment turned, helped by a strong rally in the iron ore price over summer and strong production in the Pilbara. A 10 per cent easing of the Australian dollar further helped Fortescue's cause.

By the time Fortescue's full-year results were published last month - showing a $US1.74 billion profit for fiscal 2013, plus the promise of 65 per cent more iron ore production in fiscal 2014 - there was almost unanimous belief that Fortescue could not only meet its debt obligations, but do so without selling down assets.

Citi analyst Clarke Wilkins says confidence really firmed around mid-August, when Fortescue earned $US500 million upfront - along with some other bells and whistles - by selling down a stake in some mostly forgotten magnetite assets to Taiwanese steel maker Formosa.

"I would describe it as the final nail in the coffin in terms of perceptions around the [transport infrastructure] sale proceeding in the near term," he says.

About $US7.7 billion of Fortescue's debt can be repaid early, and Fortescue confirmed this week that the first of it - $140 million worth of preference shares - would be repaid on November 11.

"Just meeting the maturities is not going to be enough for the market, the market wants them to repay it ahead of schedule, which is certainly what they intend to do," says Wilkins.

With spending on expansion projects coming to an end over the next three months, Fortescue can soon devote the bulk of its profits to paying down debt, and analysts expect the company to make between $3 billion and $4 billion worth of profit before the debt schedule gets busy in November 2015.

Credit ratings agency Moody's has already improved its view of Fortescue's Ba3 credit rating from negative to positive, and further improvements there will allow Fortescue to access cheaper debt and make a serious dent in its obligations.

"We forecast Fortescue to maintain solid liquidity, which will assist to mitigate the company's exposure to inherently volatile iron ore prices," says Moody's vice-president Matthew Moore.

"The ratings could be upgraded if Fortescue's expansion plans are completed on time and within budget. Any steps taken to reduce debt, either through asset sales or internally generated cash flow, will have a positive impact on the company's credit profile and apply further positive pressure on the current rating."

Citi's forecast for iron prices to average $US115 a tonne over the next couple of years is well above the $US75 a tonne they estimate Fortescue needs to be able to meet its first debt obligation in 2015.

Analysts at Goldman Sachs estimate Fortescue needs an iron ore price of at least $US90 a tonne over the next three years to meet its debt obligations.

Macquarie has also chimed in, saying Fortescue had "almost weathered the funding storm", while the UBS analyst team says based on current forecasts, they "don't foresee any issues with FMG repaying its debt".

Burston, who now leads Nigerian-focused iron ore miner Kogi Iron, says the common depiction of Forrest and Fortescue as a club of high-stakes gamblers who rolled the dice on the iron ore price is unfair and unwarranted.

"They are not just throwing $100 each way on the last race," he says. "If you look a bit closer than that, they are doing their homework and they are making moves in accordance with that research and their beliefs.

"They are very focused, they are sincere about what they do and they researched it properly, so if there is a bit of courage in there as well that only adds to the flavour of the stew, because it sells the view to the market that they know what they're doing, they're getting on with it and they're going to make it work. So far that seems to be proving to be the case."

But Chanos, for one, remains unconvinced.

Chanos made headlines in Australia during 2012 for his scathing assessment of Fortescue's debt profile and its reliance on the Chinese growth story. A noted China bear, Chanos said in April 2012 that Fortescue was a "value trap" that was too reliant on China's debt-fuelled growth.

"With any kind of reversion to the mean of iron ore prices to $US100 a tonne or less, we're going to see a dramatically lower ability to service the debt and the capital programs they have. And a stock price materially lower than it is today," he said, presciently, in 2012.

His comments inspired an army of short-sellers who rode the stock down to its nadir around the time of the September 2012 liquidity crisis, when almost 8 per cent of Fortescue shares were sold short.

"That vindicated our view on Fortescue, which we are still short on," Chanos told Fairfax Media this month.

"If you can go into a debt crisis when iron ore prices are well above your cost of production, then what's going to happen if iron ore prices really revert to the mean?"

Chanos' views ultimately stem from his belief that China's credit boom - which has seen debt as a percentage of gross domestic product soar close to 200 per cent - is unsustainable.

Much of the China boom has focused on the construction of apartment towers, bridges and other infrastructure that requires steel, and nearly all Fortescue's iron ore is sold into that build-up. With no other commodities to diversify Fortescue's business, Chanos reckons that if the Chinese build-up is unsustainable, so too must be Fortescue's highly geared exposure to it.

No matter how many Australian investment banks declare confidence in Fortescue's ability to service its debt, Chanos says, his view of Fortescue is not about to change any time soon.

"If you believe as we do strongly that the Chinese credit-driven investment boom has to ultimately come to no good, then there is probably no better place to be short than iron ore," he says.

While the big miners expect Chinese demand for iron ore to continue growing until about 2030, the rate of growth seems to have slowed over the past 18 months.

With the world's four biggest iron ore exporters - Rio Tinto, BHP Billiton, Fortescue and Brazil's Vale - all ramping up their export volumes, Chanos believes the extra supply will eventually force iron ore prices down to levels that will trouble Fortescue.

"Keep in mind the increase [in iron ore supply] we have seen since last year hasn't been that big. The big ones are the next two years coming, that's when the real supply hits. So that's when I think it's going to get interesting," he says.

Estimates published by JPMorgan this week mostly support that suggestion. JPMorgan expects that, after increasing by 92 million tonnes during fiscal 2013, total exports from all Australian iron ore companies will rise by 130 million tonnes in fiscal 2014.

It expects iron ore prices to fall in each of the next three years, though all three years are tipped to have iron ore prices above $US100 a tonne.

ANZ expects the price to still be above $US100 a tonne in 2016, but Goldman Sachs expects it to average $US80 a tonne by 2015.

"You have China towards the end of an insane real estate and infrastructure build that cannot continue, and you've got all kinds of new [iron ore] supply coming on to that market. So, you could very much have a witches' brew here of new supply hitting as demand begins to drop and reflecting in [iron ore] prices that head back down towards historical levels, which would put a number of companies back into real financial stress," says Chanos.

Back in the Pilbara this week, Nev Power wasn't sounding like a man who had fretted all night about the direction of the iron ore market.

"I'm tickety-boo, thank you," he said, as he spoke from a lookout above Fortescue's new low-cost Solomon development, which has helped drag down the company's unit costs.

When told that Chanos is still pessimistic about Fortescue's chances of survival, Power says he never had the opportunity to fully explain the Fortescue story to Chanos.

"I've never caught up with him personally, but I think Jim and a number of people in the US who are in these short funds are trying to make money out of negative stories and they try to talk their own book; they try to spook people and scare the market into believing the worst about a company so they can make money out of shorting the stock," he says.

"It's not a very constructive trade they ply, is it? I doubt we are ever going to convince people like that because what they are trying to do is generate an opportunity for themselves to make money."

With the majority of local observers now predicting Fortescue can survive its debt challenge, Power says that those who doubted Fortescue were gradually being silenced.

"We had the doubters out there, but slowly and surely we're silencing them by doing what we said we were going to do," he says.

"People are starting to see that we do deliver against what we say we are going to do, and that's building the credibility and is being reflected in the sentiment in the market."

Ten years after Fortescue was formed and five years after its first ore was shipped to China, Power says there is no reason Fortescue can't continue to be an iron ore force for many decades to come.

"We have already identified over 15 billion tonnes of iron ore in the Pilbara, we have a massive area of tenements that we are still exploring and we are adding to that resource base at about the rate of 1.5 billion tonnes per year," he says.

"We've built infrastructure that is absolutely world class. It is infrastructure that will serve the company, and the country, for that matter, for many many decades to come. I think the foundation we are building for Fortescue is absolutely multi-generational."