Twiggy caught in a Fortescue fix

Twiggy Forrest finds himself in that most uncomfortable of positions for an entrepreneur, highly leveraged against a falling asset price.

The alarm bells started ringing loudly just over a week ago when, virtually out of the blue, his Fortescue Metals Group abruptly truncated the ambitious expansion plans for its West Australian iron ore business, announced swinging cost and job reductions programs and the $US300 million sale of a power station.

That was a response to the then free-falling iron ore prices. While the prices, which had plummeted below $US90 a tonne – less than half where they were trading a year ago – have stabilised in the past few days at around $US100 a tonne, that's not enough for Fortescue to have viable projects given the mountain of debt that it is carrying and the spending commitments it has locked in to complete its diminished, but still substantial, expansion program.

The fall in the price, and the dramatic Fortescue response to it, make it unsurprising that the group has, according to the Australian Financial Review, asked its lenders to waive the covenants on its debt. The ratings agencies and securities analysts have been warning in recent days that those covenants and Fortescue's ability to meet its obligations would be under severe pressure in the near term and beyond because of the impact of the steep fall in iron ore prices on its earnings.

What happens next will determine Fortescue, and Forrest's fate. Forrest is a vastly more experienced entrepreneur than Nathan Tinkler, who appears to be experiencing similar and indeed worse debt-induced issues because of the parallel falls in coal price. Forrest and Fortescue also have more substance – Forrest has built Fortescue into the world's fourth largest seaborne iron ore producer and it is generating significant amounts of cash.

It is conceivable that his lenders will show some forbearance and give the group a temporary waiver to allow it to complete its expansion from 55 million tonnes to 115 million tonnes a year (it was originally envisaged that production would rise to 155 million tonnes) and start generating the extra cash the increased output will produce.

With $8.5 billion of debt at balance date and a further $US1.5 billion raised subsequently Fortescue probably falls into the category of owing so much that it represents as much its bankers' problem as its own. It is in no one's interests for the banks to act precipitously or take any action that exacerbates Fortescue's plight.

The fact that Forrest and his chief executive, Nev Power, have acted with alacrity and decisively in response to the plunge in prices and also opened an immediate dialogue with the banks would encourage those bankers to support them. Forrest and Fortescue clearly aren't in denial of their predicament, which can be an issue with entrepreneurs.

Fortescue also has some other potential asset sales, including its port and rail infrastructure, that could help generate cash and reduce its borrowings, although the problem with selling assets to reduce debt is that it effectively raises operating costs in the longer term and unless there is a further material and sustained rebound in the iron ore price Fortescue is going to be marginal at best anyway.

The reason Fortescue has as much debt as it has (it also has $2 billion of cash, although there are probably restrictions from its bankers as to how they can be used) is the conventional one within entrepreneurial companies. Forrest owns about a third of Fortescue and has been loath to see his control of the company he built diluted.

Adding that much financial leverage to the operational leverage against the iron ore price, however, always meant that the expansion plan had to be executed perfectly and some significant reduction in the debt load had to occur before iron ore prices fell back. Instead Fortescue has been caught mid-stream and with debt that was within sight of its planned peak just as the prices imploded.

The obvious way to stabilise Fortescue, and the one that the market has been advocating in the past fortnight, would be to conduct a major equity raising. Forrest would, understandably, be reluctant to do that particularly with a share price that has fallen about 40 per cent in the past two months and today slumped below $3.

He'd be hoping that once the destocking cycle in the Chinese steel sector is over the price will push back up towards the $US120 a tonne level regarded as the floor price provided by the marginal Chinese domestic iron ore producers and enable him to avoid a highly-dilutive equity raising.

If the pressure continues to mount, however, he may not have a choice. At this point any option he has to keep the banks calm and at a safe distance has to be entertained.