Fortescue Metals Group Ltd (ASX: FMG): The Big Surprise
Fortescue has gone through a remarkable transformation over the past twelve months.
This time last year FMG was reeling under the pressure of a crash in iron ore prices. Although they had a reasonable cash margin, which was allowing them to meet their debt obligations, the situation was finely balanced. Rather than gamble on prices improving from what was widely believed to be unsustainably low prices, FMG choice to address the situation then and there.
That started the transformation from a company widely perceived to be a fair weather stock, that was only appropriate for high risk portfolios in a buoyant commodity market.
The company has since significantly reduced costs and at the same time achieving its heady production targets. The iron ore price has been far more resilient than virtually every market commentator had predicted. The Oz dollar is at a level which makes our product competitive in a balanced market.
They have demonstrated that they are very focused on debt reduction and are prepared to explore innovative ways on addressing that. However with the company’s ability to generate huge cash flow in current market conditions, they have demonstrated a real discipline in their decisions and shown that they are driving the process, not being driven be market rhetoric.
At current cash flow rates by simply paying debts out of available cash flow FMG would have their debt levels down to conservative levels within 3 years.
The big surprise is that FMG’s “big brothers”, Rio and BHP were expected to open their purse strings and start paying/rewarding shareholders a greater share of profits. Both knew that such an initiative would have been welcomed by the market and more than likely resulted in a decent rice in the share price ah-la Woodside finally giving long suffering shareholders reason to cheer. However both stood by the tried and trusted “mean” payout strategies. Fortescue on the other hand, who was the company least expected to reward shareholders so early in its life cycle, came to the party.
This says a number of things to the market: firstly, an appreciation that shareholders deserve to share in the benefits of a company’s profitability; secondly, it’s a strong statement by the company that they have their house in order.
It’s not all over yet. The company is still ramping up production. There is still room to further reduce costs. There’s blue sky in partnering others to develop their “riskier assets” as evidenced by the Formosa deal. And the ability to reduce debts through selling infrastructure is a nice back stop should they decide to use it.
I’m not suggesting that Fortescue is about to replace Rio or BHP as the go to stocks in every major fund requiring commodity exposure. Its lack of diversity, and its reliance purely on the health of steel markets, precludes it from that. But then RIO and BHP have found some very innovative ways of destroying enormous shareholder value through past diversifications.
However its transformation over the past twelve months from a debt burdened company perceived to be a marginal producer to a strong, profitable company prepared to reward shareholders for their patience in my mind suggests that FMG will be re-rated by the market. On forward earnings the company looks very cheap.
I noticed that Credit Suisse increased their target to $8.34 following the result. Reading through their research and going through their assumptions I can’t help but agree.