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Fortescue Buys Time, Rather Well

Australia | Sep 19 2012

FMG announces very positive re-fi
– Plenty of breathing space the result
– Brokers upgrade ratings
– Stock now even more highly leveraged

By Greg Peel

As at yesterday the spot iron ore price was trading around US$109/t which would have allowed Andrew “Twiggy” Forrest the chance to sleep a little better. He can also now sleep better in the knowledge that the sudden tanking of the iron ore price will not immediately bring his Pilbara dream unstuck following yesterday's rather remarkable re-finance deal.

Forrest's pure-play iron ore production company Fortescue Metals Group ((FMG)) had been carrying just under US$3.6bn of debt obligations with US$1.5bn due to mature at the end of 2013. This made FMG a fairly highly leveraged production operation compared to the legacy iron ore businesses of the majors. However, with China still expected to power along and the iron ore price very supportive, FMG's expansion plans to a total 155mtpa capacity seemed very do-able. That is until the spot iron ore price suddenly crashed through US$120/t and then very quickly through US$90/t.

The price has now bounced but this doesn't detract from the fact FMG's fortunes are highly leveraged to the iron ore price. The company's first response was to put the final phase of its 155mtpa expansion plans on hold for the time being. Its next response was to address its debt obligations. With iron ore prices teetering, FMG was staring at potential breaches of debt maintenance covenants.

Yesterday FMG was able to make, in the words of Goldman Sachs, “a very positive announcement”. The company has secured an underwritten commitment for a senior secured credit facility of up to US$4.5bn on an interest rate of 5.0-5.5%, with the first debt maturity now due in November 2015 rather than end-2013. There are no maintenance covenants attached. The maturity extension and the lack of covenants are what makes this deal so positive, along with the implicit US$945m added injection of funds into the FMG balance sheet (the balance of the old and new deals).

The deal has provided FMG with “significantly more breathing room,” suggests Citi. Even at today's iron ore price level or without any asset sales, the company can now choose to take the 155mtpa expansion plan back down off the shelf. Indeed UBS is expecting the expansion to recommence by the end of this year and has already incorporated this assumption into its valuation model. A rise in the iron ore price and/or asset sales will allow FMG to pay its debt off more rapidly, Citi notes.

Citi calculates the iron ore price needs to stay above US$105/t for FMG to finance the capex on the expansion. Selling assets would provide a lower cut-off price but Citi would prefer it didn't sell non-core assets such as power stations and villages, as this would increase costs and operating leverage. Citi would prefer FMG to sell a stake in its operations (which would thus underpin valuation).

The deal should allay market fear regarding the potential for an equity raising in the face of sustained depressed iron ore prices, RBS Australia suggests. Key funding concerns have been removed.

Goldman Sachs believes the deal provides both for expansion capex and sufficient liquidity to offer protection against further volatility in iron ore prices. GS calculates FMG could withstand a long-term average price of US$90/t before having to raise more debt or equity. Goldman's own view is of higher iron ore prices ahead – a view echoed in its report by UBS – but the analysts nevertheless provide a warning.

Fortescue was already a debt-leveraged iron ore play making its share price highly leveraged to the iron ore price. The real hope was that with production revenues the company could reduce its debt and thus its leverage sooner rather than later. Yesterday's announcement is positive from a survival point of view, but FMG has now increased, rather than reduced, its iron ore price leverage. Thus while Goldman has a Buy rating on the stock, it recommends buying only if the investor agrees with the analysts' positive iron ore price outlook.

Which is another way of saying Fortescue wasn't for the faint-hearted to begin with, and is even less so now. Deutsche Bank agrees, noting “we continue to view FMG as high risk given the skinny cash margins, increasing opex [operational expenditure] due to asset sales, a greater reliance on debt despite a need to deleverage, capex creep and risks around the ramp-up”.

Hence while both UBS and RBS have now upgraded FMG to Buy from Hold, and Citi remains on Buy, Deutsche is sticking with its Hold rating. Deutsche is now alone in the FNArena database in not having a Buy or equivalent rating but not all database brokers have updated their views as of this morning.

As we await further updates, de-risking of FMG's funding concerns has led to a consensus target price increase to $5.02 from $4.90 so far, or some 33% above the current trading price.

This is one for those with a decent risk/reward tolerance.

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