Recently the management team of Fortescue Metals Group Limited (ASX: FMG) has wisely prioritised debt retirement over dividends and some ambitious growth ideas. This approach has led investors to believe that gearing would be swiftly reduced to the targeted 40% level. However, the fact that the iron ore price has dropped 40% in 2014 has presented something of a problem.
Unexpected Plunge
The unexpected plunge in the iron ore price from above US$110 to below US$80 per tonne during the 2014 financial year has put unexpected stress on Fortescue's cashflow. This, combined with the past catching up with the group, is expected to result in Fortescue's net debt levels increasing during the 2015 financial year, despite US$3.6 billion in repayments already being made.
History Returns to Hurt
In 2012, when the iron ore price fell rapidly to below US$80, Fortescue received around $1.1 billion in prepayments from key customers to keep the company ahead of the game (creditors). These prepayments are now due to be filled and the company noted that this will have a negative impact on cashflow. Fortescue is also due to pay a $700 million tax bill before the year's out.
Concerning Future
At the current iron ore price of around US$85 per tonne, analysts expect that Fortescue is mildly profitable, but the large fixed cost base of the mining industry means that every month the price remains below $90 is seriously constraining profit.
I do own Fortescue, which makes me more than a little biased, but I believe that over time we will see the company trading at moderately higher prices. There is a lot of noise being generated about the sector, which makes it difficult to assess the long-term direction of the iron ore price. I would suggest that now isn't the perfect time to invest in the company as there are many others with better near-term prospects.
