When I started Narrow Road Capital in 2012 many people would question why an Australian credit manager was so negative about lending to commodity linked companies. Australia has a plethora of miners so why wouldn’t I want to lend to at least some of those? The journey that Fortescue has been on highlights why volatile businesses are generally not good credit investments, even when they might be great equity investments.
Over the last year the iron ore price has traded in a band of US$37 to US$70. The recent spike is thought to be in part due to speculation on iron ore futures and in part due to unsustainable debt funded stimulus measures. Over the last year Fortescue has lowered its breakeven price (including maintenance capex and interest) from US$39 to US$29. Put the two together and there have been times of both feast and famine in the last twelve months. Looking forward, the table below shows a range of potential revenue and cost outcomes and the cashflow generated at those points.
For the most recent quarter reported Fortescue had a realised price of US$46 per ton with costs of US$29. Over a year that would lead to net cashflow of approximately US$2.9 billion. However, the iron ore price has risen to US$61 which implies annual cashflow generation of approximately US$5 billion. That dwarfs the US$577 million debt reduction this week and compares favourably to Fortescue’s net debt (including prepayments) of US$6.6 billion. The table below shows the same revenue and cost options, but this time the outcome is expressed as years to repay net debt.
Based on the current iron ore price, Fortescue could conceivably have more cash than debt within two years. Forward prices currently see the price declining from US$59 per ton to US$39 over the next two years. If realised that would see Fortescue making strong headway into its debt in the first year with the pace of reduction falling away thereafter. That sort of profile seems consistent with the current ratings of BB (Standard and Poor’s) and Ba3 (Moody’s). In March Moody’s downgraded their rating using a long term iron ore price of US$40 per ton.
The operational leverage (earnings margin) embedded in Fortescue through the iron ore price creates substantial volatility in earnings and cashflow. Adding financial leverage (debt) makes the business even more volatile. Fortescue’s debt rating of BB/Ba3 means it has financial leverage similar to many private equity transactions in Australia. Yet private equity firms typically target companies with stable earnings margins when they add this level of gearing.
The question of whether the iron price is sustainable at current levels is vital in assessing any investment in Fortescue. If you take the view that current prices are here for the long-term then Fortescue’s market capitalisation of A$9.5 billion appears cheap. It implies debt is fully repaid and the market capitalisation is recovered from cashflows, all in less than five years. If the recent spike in the iron ore price fades and oversupply forces prices below US$30 per ton that would leave Fortescue struggling to generate positive cashflow and creates a major headache with the US$4.8 billion debt maturity in 2019. The potential for such a wide range of outcomes illustrates why Fortescue and commodity linked companies are generally too volatile to be good credits, even when the equity might be a bargain.
Narrow Road Capital is a credit manager with a track record of higher returns and lowers fees on Australian credit investments. Clients include institutions, not for profits and family offices.