FMG – Fortescue Metals Group Limited

Fortescue Metals Group Limited (ASX:FMG) is located in the iron ore rich Pilbara region of Western Australia with close proximity to Asia.

In the space of a decade, ‘Fortescue’ has gone from a company that just began to one that produces 115 million tonnes per annum (Mtpa) today, making it the world’s fourth largest iron ore producer.

Fortescue has achieved this through the engagement and support of its key stakeholders including the company’s people, local communities including traditional land owners, governments, suppliers, customers, non-government organisations and the financial markets.

Since Fortescue’s inception, an integral part of the company’s policy has been its approach to opportunities for Aboriginal people.  In 2006, Fortescue established its Vocational Training Employment Centre (VTEC) in South Hedland to facilitate training and employment opportunities.  Today, the company employs 460 Aboriginal people directly and a further 500 people indirectly via contractors.

Does this business have a sustainable competitive advantage?
One of Fortescue’s competitive advantages comes from its ability to act very quickly relative to its peers.  When the iron ore price dipped sharply from $150 to $90 a tonne in August 2012, Fortescue acted without hesitation at the time to delay its growth plans and the accompanying capital expenditure that went with those plans.  At the same time, it also very cleverly renegotiated the structure of its debt arrangements to give the company some much needed ‘breathing room’ at the time.  This flexibility to adapt to changing market circumstances protected the company during a period of volatility and arguably has made it stronger as the market for their sole commodity stabilized.

A second competitive advantage is the low cost of operation.  Fortescue’s basic cost (C1) to mine iron ore is US$44 a tonne making it one of the lowest cost iron ore producers in the world.  And, it will achieve a production level of 155 Mtpa by December 2013.  With iron ore prices currently around $140 a tonne (average price anticipated to be $110 a tonne over the medium to long term), it is easy to see how the company generates strong profits.

A third competitive advantage is the company’s flexible debt structure negotiated by senior management.  In 2012, Fortescue negotiated a three year interest free loan for $12 Billion, the cost of their expansion plans.  This interest free loan has allowed the company to operate, generate cash flow and pay back the loans in a comfortable manner.  It’s not like it is an interest free loan on a lounge or dining table from a local retailer, it is $12 Billion!!! It was upon the negotiation of this flexible debt structure that I began being interested and a shareholder in this company.

What are the risks facing this business?
The biggest risk to Fortescue’s business is the market price of their sole product being iron ore. Essentially their degree of profitability is determined by the fluctuating iron ore price.  A sustained decline in the Iron Ore price would put Fortescue into renewed difficulty like it did in August 2012.

However, the company courtesy of its near completed expansion plans has one of the lowest costs of operation and would survive longer than some of its smaller competitors.  And, if worse came to worse, I’m sure Andrew Forrest could chip in a few $ billion of his own to keep the company’s creditors at bay.

The amount of debt carried by the company is normally a big no-no for my investment criteria.  However, Fortescue is one of the few companies that have consistently presented a credible pathway over the past year for reducing their debt to a manageable level over the coming years.  They have cash flow from operations, a recently announced joint venture with Taiwan’s largest company ‘Formosa’ and plans to sell their rail & port assets in order to de-gear their balance sheet.

Is it run by able and trustworthy management?

This company was founded by and is run by a truly great Australian.  The non-executive chairman, Andrew ‘Twiggy’ Forrest is one of the most influential people in Australia.  And, he has created a legacy that I think will carry on for many decades to come.  I read recently that Mr Forrest and his wife have pledged half their wealth to charity. It is people of this calibre running companies that I want to align my relatively small but growing investment fund to.

It is my understanding that Mr Forrest cunningly snared the tenements that are now Fortescue’s in the Pilbara from under the nose of BHP and Rio Tinto before he even had the company up and running.  And, I still cannot fathom how he renegotiated $12 Billion of debt into a multi-year interest free loan at the volatile time that was the low point for the Iron Ore price last year.  I’m grateful that I don’t think I will ever be in a position to have to negotiate something with Mr Forrest, because I would lose!!!

Is it trading at a bargain price?
Based on the information available and the pathway to de-gearing the balance sheet taking place, it is trading at a discount to its value at the moment.

Company Code Rank 2013 Actual Valuation Today’s Share Price Margin of Safety 2014 Forecast Valuation 2015 Forecast Valuation
Fortescue Metals Group Limited FMG Bronze 2 $8.89 $4.54 69% $14.51 $12.58

*Please note that forecast estimates of intrinsic value are subject to change on a daily/weekly basis.

Summary
In summary, Fortescue is a profitable business that has grown its production levels very quickly.  The company has taken on a lot of debt in order to achieve this growth.  The company’s share price will ebb and flow with the fluctuations in the iron ore price. It has great management who has a consistent plan in place to de-leverage the balance sheet over the coming year or two.  The company’s share price is trading at a discount to my estimate of value presently.

This article is published by Dean Mico.

Disclosure: The Edge Fund (Dean Mico) owns shares in Fortescue.  Please do your own research.  Any one buying shares from this point in time forward will be helping our cause.

The information provided in this article is intended for general use only. The article is intended to provide educational information only. Please be aware that investing involves the risk of capital loss. The information presented does not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Under no circumstances should investments be based solely on the information herein.

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