The Australian Financial Review recently reported that research house Morningstar has downgraded Fortescue Metals (ASX: FMG) from a ‘hold’ to a ‘sell’ citing concern over debt levels.
This comes just two weeks after the AFR also reported that broker JP Morgan had upgraded Fortescue to ‘overweight’ from ‘neutral’ on the analysis that the current weakness in the iron ore price was unlikely to continue and hence the outlook for Fortescue was favourable.
These are significantly differing opinions and highlight the alternative focus of the analysts. Fortescue has on-balance sheet net debt to equity of approximately 250%, coupled with annualised negative free cash flow of around $8 billion. Few, including Morningstar, would describe Fortescue as having a ‘fortress-like’ balance sheet. Investors shouldn’t fool themselves, there are significant risks in this venture.
On the positive side, Fortescue is aiming to raise over $3 billion from the part sale of its rail and port infrastructure. While this is a large amount of cash to recoup, its not enough to shore up the balance sheet and fund the planned capital expenditure schedule.
A look at Fortescue’s performance compared with the two majors and the index suggests that there is a cloud hanging over the company.
Source: Google Finance
As the chart above shows, Fortescue’s exposure to the iron ore price and concern around its balance sheet strength and funding has led to significant share price underperformance. While BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) have both underperformed the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) over the past 12 months by around 19% and 29% respectively, Fortescue has underperformed by a whopping 47.5%.
The resource sector slowdown and subsequent cost cutting are also having negative repercussions for mining service companies, which I have warned of previously. This effect has been evident in recent announcements made by Woodside Petroleum (ASX: WPL) regarding the postponement of its $45 billion Browse Basin development and by Calibre Group’s (ASX: CGH) significant earnings downgrade.
Many stock market participants are attracted to resource stocks in the hope of ‘striking it lucky’ — so long as they understand they are speculating (also known as gambling) then good luck to them. For investors looking for a lower risk-reward trade-off, a focus of balance sheet strength and the long-term outlook is paramount.
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