Many Aussie miners are sitting on scary levels of debt – so when Fortescue Metals went into a trading halt over its burgeoning debt less than two weeks ago, investors in mining-related stocks watched closely.
The day before the trading halt, Fortescue’s share price fell considerably and the ASX queried the drop. Some speculated that bankers were getting nervous.
Companies in capital intensive industries like mining resort to either debt or equity financing to fund expansion. Excessive debt when trouble hits the industry can drive highly leveraged companies into the arms of a takeover entity or even out of business.
It is no secret that iron ore producers are under pressure from declining commodity prices. It is also no secret that Fortescue Metal’s had the highest gearing ratio of any mining operation in Australia – 226% – going into the trading halt.
Could Fortescue be the first miner to hit the debt tidal wave?
Within four days, Fortescue managed to tie up $4.5 billion of loans from Credit Suisse Group and JP Morgan Chase. This funding removes existing debt covenants and the first payment on the five-year funding term is not due until November of 2015.
However, borrowing new money to repay old money can do little more than buy time if macroeconomic conditions do not improve.
The chart below compares Rio Tinto’s share price to Fortescue Metal’s during and immediately after the trading halt:
As you can see, Fortescue’s share price rallied after the announcement. Interestingly, during Fortescue’s share price rout, Rio’s share price actually advanced (clearly, investors did not view Fortescue’s problems as an ominous sign for the rest of the iron ore sector).
Rio Tinto and BHP are more diversified than Fortescue, although about 92% of the Rio’s underlying earnings do come from iron ore operations (based on its Half Year results). BHP is much less exposed, with around 52% of underlying earnings coming from iron ore mining.
The question remains: If you hold iron ore stocks in your portfolio should you be concerned about their gearing levels? Clearly, debt is one of several financing tools companies use to raise cash. The concern is not so much the debt as the ability to stay current with debt obligations.
BHP’s CEO Marius Kloppers argues that the heady days for iron ore producers are over, stating: ‘In iron ore, the strong financial returns that have been enjoyed by the industry have encouraged substantial investment in new capacity. As a result, the producer response is well-advanced. Our analysis suggests by the end of the 2015 calendar year about three-quarters of the demand growth for the 20-year period will have been met by low cost supply. Going forward, therefore, those who invest in iron ore should do so in the full knowledge that supply will meet demand in due course and that the scarcity pricing that we have seen over the last 10 years is unlikely to be repeated.’
The message here is that iron ore prices are unlikely to approach the lofty levels of the past, which means diminished revenue for all iron ore producers.
The table below lists 10 iron ore producers trading on the ASX, including gearing levels.
Operating Cash Flow
Mt Gibson Iron
Gearing, or debt to equity, is one of the most popular measures of a company’s financial health. Cash flow, cash on hand as well as operating margins are additional factors to consider.
Operating margins can signify a low cost producer; companies with low operating costs can produce higher margins allowing them to maximise revenue, albeit diminishing.
Similarly, operating cash flow levels and total cash on hand indicate the ability to withstand a prolonged period of deteriorating macroeconomic conditions.
If you believe the investing maxim to look for companies with no debt, then three companies stand out – Atlas Iron (AGO), Aquila Resources (AQA) and Gindalbie Metals (GBG). It’s important to realise that some companies simply cannot arrange traditional financing at cost effective rates and therefore resort to equity financing and in some cases asset sales. In other words, a nil debt miner does not guarantee a high-performing stock. In fact, sometimes quite the opposite.
In good times miners still in the exploration stage can raise needed capital by issuing equity to private equity funds and to retail investors. In addition, those with exceptional prospects can sell corporate bonds of varying lengths and interest rates.
As sentiment for the mining sector sags, however, pure plays and one project miners will begin to face difficulties issuing new equity or attracting bond investors at any price.
Gindalbie is an example of a company with a single but attractive project on the go, the Karara iron ore mine in Western Australia. They have a partner in China’s Ansteel with whom they have offtake agreements (an offtake is a commitment from a customer to buy a percentage of the producer’s output).
Gindalbie recently acquired funding via a A$209 million equity raising, a US$1.2 billion project loan facility and a US$336 million working capital facility with no interest or repayments until 2014. Gindalbie’s CEO Tim Netscher acknowledged the difficulty miners are having attracting funding in this climate; he credited the company’s offtake agreements as the advantage needed to secure financing.
Aquila Resources (AQA) has both coal and iron ore projects but the company is burning cash and has stayed afloat by selling off assets to the very joint venture partners that once made this company attractive. Aquila could struggle to keep the funding levels up. The company recently reported an A$6 million dollar loss for 2012, with $42m in profit coming from an asset that has now been sold. The situation was perhaps best expressed by an analyst at Credit Suisse who sliced the price target from $6.00 to $2.75, commenting that although asset sales have left the company with added cash, AQA is “no longer a producer of anything!”
Atlas Iron (AGO) has a healthy balance sheet with substantial cash on hand and no debt.
The company has two operating mines and four projects under development. Since the beginning of 2012, private institutional equity placements and asset sales have shored up their balance sheet. However, this company is a pure play iron ore producer totally dependent on Chinese demand. Like the other mid-caps and juniors, funding will be challenging if the price of iron ore remains soft.
Mt Gibson Iron (MGZ) has three operating mines with minimal capex needs since expansion efforts are limited to the already producing facilities. Despite the low debt and low gearing, the company’s operating margins decreased 20% year over year and cash flow per share dropped 74% year over year.
Both Atlas and Mt Gibson have reasonably good numbers, but the same caution could be said of all these companies – operating margins and cash positions include revenue generated at substantially higher iron ore prices than now exist.
Of the remaining three companies, a glance at the numbers would suggest Northern Iron (NFE) would represent the highest risk, followed by BC Iron (BCI), with Grange Resources (GRR) as the lowest risk target.
In July of 2012 Northern Iron was a takeover target from two separate investment firms seeking its Norway iron assets due to the higher quality of the ore. The company says these offers are under review. On 31 August the company issued an announcement of cost saving actions in light of deteriorating margins, rising production costs, and pricing pressures. All expansion and exploration projects have stopped and a corporate restructuring has reduced the number of employees.
Grange Resources (GRR) has one operating mine and one development project. The company’s growth strategy is based on acquisitions which, considering the current funding and economic climate, does not bode well for finding opportunities.
BC Iron (BCI) operates a Western Australian iron ore mine in a 50/50 joint venture with Fortescue metals. BCI has had offtake agreements with Hong Kong based Henghou Industries since 2009 to supply 20 million tonnes over 8.5 years. The company also has 100% ownership of five exploration licenses in the Pilbara region. The following one year share price chart is hard to explain:
How can a pure play iron ore producer with half ownership in one producing mine be up 20% in this market? BA Merrill Lynch and Macquarie have BUY ratings on the stock with Macquarie calling BCI “the best low-risk iron ore recovery play around.”
Of course the key phrase in the comment is iron ore recovery. When and how much will the price recover?
Even though the CEO of BHP is bearish about the prospects for iron ore, analysts at JP Morgan are considerably more bullish – declaring that iron ore prices could rebound as early as September due to declining stockpiles and improving Chinese demand.
It should be noted, however, that while there is risk in betting on recovering iron ore prices, there is also risk in betting against them.
For months short sellers remained convinced that Fortescue’s crushing debt load could not be sustained in the face of declining prices. Meanwhile, Fortescue’s shares rose 17% following the announcement of the company’s successful financial restructuring.
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