Fortescue Metals Group Limited (ASX: FMG) has agreed to buy out BC Iron's 75% interest in the Nullagine iron ore mine. The price is $1 and brings to an end a seven-year partnership. The mine was closed earlier this year because the cost of production exceeded the level at which it was possible to make a profit. However, the deal adds 6 million tonnes to Fortescue's annual iron ore capacity. This could help it to boost production to its target range of 165-170 million tonnes in the 2017 financial year.
Diversification
However, Fortescue's aim to increase iron ore production may prove to be a poor strategy. Although the price of iron ore has risen by as much as 30% in 2016, its outlook is uncertain. The supply of iron ore is forecast to rise by over 17% in the next four years as projects in Australia and Brazil come onstream. For example, Brazil's Vale is due to start a four-year ramp-up in production from its S11D project. This could cause the surplus in iron ore to almost treble to 56 million tonnes per annum.
Alongside this, demand for steel in China may fall. China is attempting to cool its housing market following annualised gains of 9.2% in house prices over the last year. Restrictions on house purchases have become more common across major Chinese cities. This may reduce construction activity and create a large glut in the supply of iron ore.
In my view, Fortescue's lack of diversity is therefore a risk at a time when the iron ore price may fall. Although the purchase of the 75% stake in Nullagine cost $1, I feel that Fortescue needs to invest in non-iron ore areas to reduce its risk profile. For example, mining peers BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) offer greater diversity and a lower risk profile than Fortescue.
Looking ahead
Fortescue's P/E ratio of 11.1 is relatively low. For example, the materials sector has a P/E ratio of 12.6, BHP has a P/E ratio of 12.9 and Rio Tinto's P/E ratio is 16.6. However, Fortescue's financial standing increases its risk profile. For example, it has a net debt to equity ratio of 62% even after reducing debt levels by US$2.8 billion in the 2016 financial year. When combined with a lower iron ore price, this meant that interest payments were covered 4.8 times by net operating cash flow in the 2016 financial year.
Given the uncertain outlook for iron ore, Fortescue is a high-risk stock in my opinion. Even if it is able to reach its increased production target in financial year 2017, iron ore prices are expected to average US$45 per tonne in 2016 and 2017 according to Fitch. This would put Fortescue's financial performance under pressure and its share price could decline. Therefore, I feel that these three blue-chips offer superior investment opportunities.
