Fortescue's delicate debt dilemma

Fortescue has made good progress in winding back its cost base, but with $10 billion of net debt, a couple of unknowns leave its de-risking program hanging in the balance.

Fortescue Mining continues to take advantage of the relative stability of iron ore prices to edge its way out of territory that remains dangerous.

Today’s corporate update, while containing a minor lowering of its forecasts of the tonnage of ore shipped for this financial year (from between 82 million to 84 million tonnes to between 80 million to 82 million tonnes) due to heavy rain, does show that the group is reducing the vulnerability created by its financial leverage and which was exposed during last year’s dive in the iron ore price.

That collapse in the price to below $US90 a tonne has galvanised Twiggy Forest’s group, triggering an intense focus on reducing costs, selling non-core assets to reduce its heavy debt levels and a refinancing of those borrowings that pushed its next scheduled repayment out to November 2015.

In the update Fortescue said the focus on costs and lower-cost production from the Solomon hub would see C1 cash costs for the June quarter ranging between $US38 and $US40 a tonne, helping to pull full-year costs back to the lower end of the group’s previous guidance of $US45 to $US50 a tonne.

With the iron ore price holding around the $US120 a tonne level (having been materially higher earlier this year), solid production and lower costs and capital expenditures Fortescue says it will end the financial year with cash balances of between $US1.7 billion and $US2 billion.

Chief executive Nev Power said that, with the ramp-up in the group’s production capacity to 155 million tonnes per annum nearing completion, it expects to ship between 127 million and 133 million tonnes of ore in 2013-14 with C1 cash costs of between $US38 and $US40 a tonne. It also expects capital expenditure to fall from $US6.3 billion this financial year to $US1.9 billion.

The increased production, lower costs and much-reduced capital expenditure commitments ought to free up even more cash that the group can devote to its current priority – reducing debt. With net debt of about $US10 billion that is an obvious point of vulnerability for the group.

The free-fall in the iron ore price last year focused Forrest’s attention on a balance sheet that reflected the aggressive debt-funded development of the group. The next step in the de-risking of Fortescue will come if it can complete the sale of a minority interest in its Pilbara port and rail assets that was announced late last year.

The timeline for the sale originally had it occurring before the end of this financial year but Fortescue said today that while there had been strong interest and the sale process was "substantially advanced" if there were to be a sale it was likely to be announced in the September quarter. A sale would be expected to generate more than $3 billion, which would make a significant dent in Fortescue debt levels.

Despite the considerable progress Fortescue has made in reducing its costs, building its free cash flows and getting the liabilities side of its balance sheet under control, that sale is important.

Today’s flash purchasing managers index from HSBC is a reminder that China’s economy has slowed as its new leadership tries to stabilise and re-orient an economy with some significant financial imbalances. If that growth rate continues to falter it is probable that iron ore prices will remain volatile and could trend lower as the year progresses.

There are also some structural threats in the iron ore market, which is swinging into balance more rapidly than expected partly because of the surge in production from the massive investment in the sector over recent years, partly because China’s growth rate is slowing and partly because the supply of scrap within China is increasing.

There are analysts who believe the market will move into over-supply as early as next year and that the imbalance between supply and demand will be even greater in 2015, forcing the price down sharply to as low as around $US80 a tonne before the excess production is forced from the market.

Whether than scenario plays out exactly or not, Fortescue wouldn’t want to go into that kind of environment with $US10 billion of net debt and significantly higher costs than the larger Pilbara producers, Rio Tinto and BHP Billiton, and Brazil’s Vale.

It has made good progress on costs and production and is almost over the hump on the heavy capital expenditure program associated with its massive ramping up of production. To really de-risk its balance sheet, however, it needs to build its cash reserves further and that sale of the interest in its Pilbara infrastructure.

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