Fortescue Metals Group — who, you’re reminded, recently tried to refinance a couple of billion in debt yielding somewhere in the neighborhood of 7% but pulled the deal when investors wanted 9%, and who then hilariously claimed that the refinancing “didn’t fail” and that to the extent demand was tepid, it had more to do with Janet Yellen and oil than it did with the fact that iron ore prices have collapsed and that BHP and Rio may be intentionally pricing smaller competitors out of the market — had a good idea Tuesday on how to arrest the commodity’s slide: price collusion.
Apparently, chairman “Twiggy” Forrest was attending his own celebration dinner (so we guess he naturally felt like he could say what he really thought) in China when he suggested that anyone who wasn’t intent on acting like a child would do the rational thing and conspire to drive prices up. Here’s Twiggy:
“I’m absolutely happy to cap my production right now.”
“All of us should cap our production now and we'll find the iron ore price will go straight back up to $70, $80, $90 and the tax revenues that will generate will build more schools, more hospitals, more roads, more of everything which Australia needs.”
“And when you’re just driving for market share at any cost and you’re smashing the revenues of your host nation and you’re smashing the revenues of your shareholders, in the end, you smash your own personal credibility. Why don’t those companies who derive their fortunes from our nation act like grown ups and agree to cap their production?”
So essentially, “grow up and help me start a cartel.” While that may or may not be an effective way of solving the price “problem,” it turns out to be illegal, and the Australian Competition and Consumer Commission now wants an explanation. Here’s Chairman Rod Sims:
“In general terms, any attempt by Australian businesses to encourage competitors to restrict outputs is a matter of grave concern to the ACCC.”
So maybe iron ore prices have collapsed, and maybe refinancing 7% debt at 9% is in fact a failure, and it looks like Australia isn’t keen on the whole price collusion idea, but that’s all ok because as CFO Stephen Pearce will be happy to tell you, the company’s position on the iron ore cost curve is “bulletproof.” Morgan Stanley however, isn’t so sure:
FMG should still achieve a very modest FCF margin at spot prices, so more than ever price will determine sentiment. Our single biggest concern is that prices don’t hold at the current level.
Iron ore oversupply and weak prices create margin pressure. So far FMG has stayed ahead of the price decline but the fiscal position is much tighter and goes negative at spot prices…
The table below sets out an approximate cashflow breakdown, based on the current index price, realization factors, production costs and shipping costs. Any of these factors can vary and swing the implied net cashflow margin – but the short of it is that unless the headline price recovers, Fortescue remains viable only so until debt repayments exhaust the current cash balance.
That doesn’t look very “bulletproof” to us. In fact, according to Morgan Stanley, even if prices recover to $75, the company still won’t be able to repay its outstanding debt:
Our base case commodity price assumptions call for the iron ore index price to recover to US$75/t in 2017. Yet even with this assumption we project Fortescue would not accumulate sufficient cash to meet sits debt repayment schedule of US$1.0bn in 2017, US$0.4bn in 2018 and US$6.4bn in 2019.
...and worse still...
At first glance there appears to be several years until the cash balance becomes an issue given the existing cash and timing of the repayments; particularly since there are (so far as we can determine) limited covenants that apply. However, it is worth considering that the ability to issue secured debt may be governed by the 2x Lien debt/EBITDA ratio on a backward-looking 12mth period. At 31-Dec-15 EBITDA was US$3.7bn; two times this is US$7.4bn. Fortescue recently looked to issue US$2.5bn of new secured debt and refinance US$4,9bn of existing debt, i.e. US$7.4bn in total.
EBITDA will be ~US$2bn at the end of FY15 by our estimates. The nominal US$4bn secured debt limit is used by the existing Senior Secured Credit Facility. So the secured debt market option could be closed in three months time – notwithstanding the recent attempt to access it was unsuccessful. This is why the timeframe to address the debt issue can be considered as much shorter than the time frame until a cash shortfall occurs.
...and yes, refinancing something only works when you can get a lower rate than what you were paying before…
If issuing bonds would have increased the coupon rate being paid and brought the FCF under further pressure, this would not have been beneficial in our view.
So asset sales it will likely be in the end. The issue is who will be willing to buy them in the current environment. Of course at the end of the day, all of the above can be summarized with one chart: