Why Fortescue is Selling Off Assets to Foreign Buyers

Iron ore mining

Fortescue [ASX:FMG] is looking to sell stakes in its assets in a bid to improve its wobbly financial position. It will need to if it’s going to fix its balance sheet. The embattled iron ore producer is currently loaded with US$7.4 billion in debt.

If you’ve been following the toils of the iron ore industry in recent years, you’ll know why Fortescue is under so much pressure. The reason is easy enough to understand.

As iron ore prices plummeted to US$51 per tonne in April, Fortescue’s cash flow and financial position has gotten shakier. As recently as October 2014 a tonne of iron ore sold for US$80. That’s to say nothing of the US$190 prices in 2011 which are now a distant memory.

Fortescue faces stiff domestic competition from lower cost suppliers. Their cost of production places them in third place behind BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO]. That’s squeezed Fortescue’s profit margins to dangerous levels. They’ve cut dividends to three cents a share after recording an 81% drop in first half profits this year.

It’s these kinds of results that put Fortescue’s CEO on the back foot recently. As BHP and Rio have maintained high outputs even amid lower prices, Andrew Forrest has attacked their market-share driven strategy. He thinks what they’re doing is damaging to the industry.

Mr Forrest’s words may have played some part in slowing this expansion strategy down. Both BHP and Rio announced a moratorium on high profile expansion projects over the next few years.

That’s partly the reason why iron ore has rebounded back above US$60 a tonne.

But that price point is still not at a high enough level for Fortescue to completely fix its balance sheet. Despite cost cutting measures the company remains burdened with debt. And US$60 iron ore isn’t going to change that. 

It’s these debts that are pushing Fortescue towards selling off some of its assets. They managed to secure a loan for US$2.3 billion in March. But that still leaves the company with a huge US$4.9 billion repayment due in 2019.

The price of iron ore is unlikely to trend higher than US$60 in the next few years. That ensures Fortescue’s position will remain precarious without outside help.

What would a sell off at Fortescue look like?  

Fortescue has no interest in a complete takeover. That works well for Chinese companies who have no interest in buying the Aussie mining giant. So any sell off is likely to include new stakes from foreign buyers. But it’s just as likely existing shareholders will increase their stake in Fortescue. 

And it appears that Chinese buyers are circling around Fortescue’s rail and port assets. UBS values these assets US$18 billion. Fortescue has already had discussions with Baosteel [SHA:600019], China’s largest steel producer.

Baosteel already have a joint venture with Fortescue, dating back to 2012. The so called FMG Iron Ore Bridge has merged iron ore assets in the Pilbara between the two companies. Baosteel owns a 12% stake, with Fortescue owning the other 88%.

In 2013, Taiwanese group Formosa took a 31% stake in FMG Iron Ore Bridge.

What does an asset selloff at Fortescue mean for shareholders?

If you own shares in Fortescue, any sell off may address short term concerns you have over the balance sheet. It would also see the company lose some of its cash flow in the process. That could hurt dividends, which have already been slashed by 7 cents a share this year. It’s unlikely that Fortescue would use debt refinancing to increase dividend payouts.

But at least the balance sheet would look a lot healthier. And it would allow Fortescue to keep control of its treasured port and rail assets.

Beyond that, the future looks less certain. Fortescue needs to wipe out its large debt, and it will only do so through asset selloffs at this point. The price of iron ore may never rebound to the level it needs to if Fortescue is to improve its competitiveness.

So the outlook for the next few years is grim. High supply and low prices will carve up profit margins even at the most profitable companies.

But it’s not all bad news for commodity investors. As iron ore profit margins drop, a handful of other commodities are looking to move higher in 2015.

Investment guru Rick Rule has been in commodities for most of his life. Rick is the founder of Sprott Global Resource Investments. His company enjoys a worldwide reputation for resource investment management.

In his 40 year career, Rick has seen several commodity cycles come and go. He can spot companies that are destined for failure. But he’s also an expert at picking out companies that will flourish when the new commodity cycle booms.

Rick says three commodities in particular will boom in the coming months. To find out what they are, and get his tips on how to identify the right companies to boost your portfolio as the new cycle gains pace, click here.

Mat Spasic

Contributor, Markets and Money

Markets and Money

Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets.

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