Is Fortescue Metals Group Limited a buy at this share price?

Credit: Chatham House

Yesterday Fortescue Metals Group Limited (ASX: FMG) released a report revealing that the company shipped 43.4 million tonnes of iron ore for the June 2016 quarter in line with prior periods. More significantly, cash production costs (C1) were just US$14.31 per wet metric tonne (wmt) down from US$22.16 in the corresponding quarter last year. The company also advised that it expects C1 costs to fall further to between US$12 and US$13 per wmt in 2017.

Impressively, the latest quarter represents the tenth consecutive quarter of falling costs thanks to ongoing productivity and efficiency measures. An example of this is the use of driverless trucks to transport material.

Over the next five years, Fortescue expects its strip ratio to rise to 1.4 from 1.0 currently, which is likely to place upwards pressure on costs over the medium term. The strip ratio is the ratio of waste material needed to be handled to extract a quantity of ore. Costs are also sensitive to foreign exchange rates and oil prices.

Fortescue’s future will be dictated by iron ore prices as much as its production costs. The iron ore price averaged US$55.66 per dry metric tonne (dmt) during the June quarter up 15% on the March quarter. However, Fortescue’s average realised price was lower at US$48.79 per dmt for the quarter.

Fortescue is likely to make money as long as it continues to receive more than $28.40 per dmt for its iron ore. With 2.4 billion tonnes of reserves and many more billions of tonnes of resources it has the potential to carry on producing for decades at current shipping rates.

The company’s net debt was US$5.2 billion at 30 June 2016 and Fortescue currently has an enterprise value (EV) of around US$16 billion. The company paid off US$1.7 billion of debt in the June 2016 quarter and US$2.9 billion during the 2016 financial year and so could conceivably pay off its remaining debt in the next two years.

If conditions remain constant, then the company could be worth much more than its current EV based on existing reserves. Many are forecasting a lower iron ore price in coming years due to oversupply and this negative sentiment is built into the current Fortescue share price.

My view is that the current negativity surrounding iron ore is probably slightly overblown. However, I have no conviction in this view which is the first reason that I am not a buyer of Fortescue at these prices.

The second and more important reason is that mining is a capital intensive and hopeful business. Miners must constantly spend money in order to maintain and increase reserves and often prospecting uncovers nothing of value at all.

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Motley Fool contributor Matt Brazier 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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