The investor’s guide to Fortescue Metals Group Limited shares

Credit: Chatham House

While the ASX has fallen by 2% year-to-date, a number of mining stocks have performed well. For example, Rio Tinto Limited (ASX: RIO) is up by 4% and BHP Billiton Limited (ASX: BHP) has risen by 5% year-to-date as an improved outlook for commodities has helped to boost investor confidence in the stocks.

However, fellow iron ore miner Fortescue Metals Group Limited (ASX: FMG) has doubled in 2016. A key reason for this is the improved financial standing of the business. Fortescue has been upgraded to ‘stable’ by rating agency Moody’s, with its credit rating of Ba3 being reaffirmed.

This will undoubtedly have improved investor sentiment in the company’s outlook and has been caused in part by Fortescue’s decision to repay a further US$500 million of debt which was not due for repayment for another three years.

This will further reduce Fortescue’s debt of US$8.4 billion (as at December 2015), which is already down significantly from a previous high of around US$12.7 billion in June 2013. Lower debt levels following the US$500 million repayment will cut the company’s interest expense each year by upwards of US$20 million and this should allow it to either build its cash reserves for future investment, or pay off even more debt over the medium term.

Clearly, Fortescue’s net debt to equity ratio is becoming healthier and stood at 78% in December. With its interest coverage ratio due to expand from 2015’s rather slim 1.6 following further repayments, it would be of little surprise for investor sentiment to keep on improving.

Allied to Fortescue’s ability to repay its debt and improve its financial standing has been progress on its cost reduction. Cash costs for 2016 are expected to be around a quarter of what they were four years ago at US$13 per tonne. If met, this would indicate that Fortescue is more competitive than it previously was compared to iron ore mining rivals such as BHP and Rio Tinto. And with Fortescue raising production to 167 million tonnes per annum, it is little wonder that according to Morningstar, Fortescue is forecast to increase EPS by 100% between 2015 and 2017.

In terms of cash flow, Fortescue remains financially sound since free cash flow amounted to just under US$1.2 billion last year. This should provide the company with sufficient means to repay debts and to increase dividends to shareholders, both of which could act as positive catalysts on its share price.

Although there are signs that the iron ore price has stabilised, it remains volatile and uncertain. Supply may be reduced by the Simandou project being mothballed by Rio Tinto, but since Fortescue is a pure play iron ore miner it remains closely tied to the fortunes of the steel-making ingredient. Therefore, while further gains are possible and Fortescue is now in a much better space from a financial perspective, its outlook is still uncertain.

Therefore, it may be prudent to take a look at a 'new breed' of blue-chip stocks.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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