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Is Fortescue Metals Group Limited a buy today?

The share price of iron ore miner Fortescue Metals Group Limited (ASX: FMG) has hardly budged today, despite the company releasing an upbeat quarterly production report.

Some of the highlights include:

  • The miner’s goal of reaching an annualised rate of 155 million tonnes per year was achieved in March 2014, after a massive ramp up.
  • Fortescue shipped a record 31.5 million tonnes in the March 2014 quarter, up 53% over the previous corresponding period.
  • Average realised price was US$107 per dry metric tonne (dmt) compared to Platts index price of US$120/dmt.
  • C1 production costs at US$34.88 per wet metric tonne (wmt).
  • The 40 million tonnes per annum Kings Valley project opened in March.

However, the results were weaker than analysts’ had expected, and Fortescue is going to have to ship 41.6 million tonnes next quarter, a massive 30% more than last quarter, to meet its full year target of 127 million tonnes. Still, that’s what Fortescue is aiming for, and it’s not one to set unambitious targets.

The debt issue

The company’s net debt position was US$7.7 billion at the end of March, including US$1.9 billion in cash and finance leases of US$300 million. So far the company has repaid US$3.1 billion in debt as it commits to reduce gearing to a target of 40%. With the current iron ore price around US$110 a tonne, Fortescue is generating significant cash flows, which should see it repay much of its debt in the next few years. Not that it really needs to, Fortescue’s first debt repayment is only due in 2017.

Outlook

Based on earnings estimates, Fortescue is trading on a P/E ratio of just 4.9 for this year, and 5.6 for 2015, which looks incredibly cheap. By way of contrast, Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited (ASX: BHP) sport P/E ratios of 11.4 and 13.9 for this financial year. In other words, investors are willing to pay twice as much for Rio’s earnings than they are Fortescue’s.

The reason can be mostly attributed to Fortescue’s higher production costs and its significant debt pile. UBS recently estimated that Fortescue’s breakeven price was around US$72 a tonne, compared to low $US40’s for Rio and BHP. Still, Credit Suisse estimates that Fortescue’s production costs would be $3 lower per tonne than BHP’s by 2015.

The key question is, will iron ore prices stay above US$100 a tonne over the medium term? Analysts are sceptical, with Goldman Sachs predicting prices as low as US$80 a tonne next year. Taking that scenario, Fortescue would still likely make a profit, but much less of one and it would certainly curtail any increases in dividends or further early debt repayments.

Foolish takeaway

If you believe the iron ore price will remain at decent levels for some time, then Fortescue looks like a winning punt. The problem is no one really knows where the iron ore price will be in a years’ time, so a bet on Fortescue is a high risk gamble – somewhat offset by a cheap P/E ratio of 4.9. It’s not a risk I’d take personally. For my money, BC Iron Limited (ASX: BCI), which has no debt, plenty of cash, has low cost production, and pays a decent fully franked dividend is a better option.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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