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Is Fortescue Metals Group Limited a bargain?

The iron ore price has plunged to lows not seen for years and pure-play iron ore miners are feeling the heat. Western Desert Resources has been forced to call in the administrators, unable to pay its bills with the price of a tonne sitting below US$85 and little relief in sight. To make matters worse, every day a new expert announces that the price could well fall further but should settle between $80 and $100 per tonne over the medium term.

Debt Concerns

Arrium Ltd (ASX: ARI), one of the smaller producers, is expected to mine iron ore at a loss and has announced a highly dilutive and earnings-per-share crushing capital raising that will more than double its shares on issue in order to pay down debt. Arrium’s share price has plunged, but even miners with little or no debt have suffered.

Mount Gibson Iron Ore (ASX: MGX) has no debt but investors are so pessimistic that the company’s cash balance accounts for 70% of its market capitalisation.

High-Cost Producers to Struggle

Analysts at Citi Group believe that all bar one of Australia’s listed pure-play iron ore miners are currently operating at a loss. That company is Fortescue Metals Group Limited (ASX: FMG).

At the current price, Fortescue is expected to make between a 5% and 10% margin, however the equation is complicated by lower quality (grades) of ore mined by Fortescue, compared with giant rivals BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO).

For a comparison, Rio and BHP are operating at 40% to 50% margins in their iron ore divisions!

100% fall in profit

The lower iron ore price is expected to result in many of Australia’s smaller miners reporting a loss in the 2015 financial year, and will likely slow down debt repayment regimes being undertaken by Fortescue and BHP. Pleasingly however, Fortescue is in a much better position than previous years; it currently has cash of nearly $2 billion and the next major debt repayment is not due until 2016-17.

5.8% Yield and a PE less than 10

For Fortescue, analysts have revised down their profit and dividend expectations since the beginning of the year. However it could still deliver earnings per share of over 50 cents in FY15 and a dividend of 10 cents per share. Fortescue looks cheap based on these metrics, however a further fall in the ore price will be bad news for shareholders.

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Motley Fool contributor Andrew Mudie owns shares in FMG. You can find Andrew on Twitter @andrewmudie

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