Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Thursday, 20 November 2014

Time to Buy FMG? Really?

FMG Crashes Yet Again

A curmudgeonly post today, I'm afraid, so apologies in advance!

Several times in the last couple of weeks there have been "is now a good time to buy Fortescue Metals Group?" themed articles doing the rounds, since the FMG share price has crashed by well over 50 percent over the last few quarters.

In this era of instant gratification, I accept that this will be an unfashionable post, but whatever, I am going to put forward the "no" case...and not only because the share price crashed by another 7.74 percent yesterday (yikes, by the way - a good time to invest?). 


Even more unfashionably I'm going to take a cursory glance at the capital structure of FMG, something which is done all too rarely by Mum-and-Dad investors (read "price chart speculators"), I fear.

Interestingly, I had to wade my way through 125 pages of "soft and fluffy" Annual Report marketing material (largely detailing all the "good works" that FMG is doing with local communities) to get to the part that as a Chartered Accountant I am most interested in - the actual financials.

It's not as if investor presentations are much help in this regard either, although granted the production report quarterlys do reveal some snippets of information on debt maturity profiles.

FMG in the Pilbara

For those not familiar, Fortescue is essentially a huge leveraged bet on one commodity, being an iron ore production and exploration company in the Pilbara region of Western Australia, which by the way is well worth a visit if you ever get chance. 

The resource base of the company is nothing short of colossal at more than 15Bt. Unfortunately iron ore (and coal) producers in aggregate have flooded the market with supply in recent times, resulting in a commodity prices crash.

I only tend to update the iron ore price information in our packs monthly, but what I have charted shows that prices have tanked to a level not since in 5.5 years and could soon take out US$70 the way things are progressing.


As we'll explore below, Fortescue is a highly leverage play on demand for iron ore, but is highly leveraged in another way too - debt.

Result Highlights

No arguments here, EBITDA, which Fortescue reports in US dollars, has been ramping up at a tremendous rate by 58 percent to US$5.6 billion in FY14 (FY13: US$3.6bn), with NPAT up by an impressive 57 percent in FY14 to US$2.7 billion (FY13: US$1.7 billion). Big numbers, hey!


With volumes having ramped up at an fearsome pace, C1 costs and total delivered costs have come down nicely, thanks to some squeezing of efficiencies by FMG and some good old-fashioned economies of scale.


The FY14 bottom line therefore looks very healthy, and the company can remain comfortably profitable even at today's considerably lower commodity prices...


P&L

Superficially, all looks well on the income statement. A monster increase in revenues to above US$11.75 billion making finance expenses of US$741 million appear, relatively speaking, fairly immaterial. So, where's the risk, one may ask?


Aha. Below we are now beginning to get to the crux of the matter. A huge increase in EBITDA has been driven by surging volumes and a falling production cost, but was already offset in FY14 by a declining iron ore price. 

But consider what we already know about volumes - can the market really absorb further increases of the magnitude already seen?

Will higher cost producers now be squeezed out to help stop the commodity price freefall? Will some operations be halted or mothballed? Probably yes, to some extent, but on the demand side a good deal depends on how much you believe what you hear from and about China.

[Edit: Cliff's Canadian operations may be the first in line to go...]


FMG Capital Structure

The FY14 statement of financial position revealed a company with US$2.4bn in cash and thus net debt (i.e. borrowings less cash) of US$6.9bn. Heck, that's one leveraged balance sheet! And that's after US$3bn of debt repayments in the financial year, bringing net debt down from US$9.9bn. 


The first senior notes, US$1 billion of them, begin to mature in calendar year CY2017 as per the below debt maturity profile, although this tranche of debt is pre-payable at FMG's option from April 2015. Some massive debt maturity loom large in CY2019...


Cash Flow Profile

The cash flow statements reveal net cash inflow from ops of US$6.25bn, but outflows from financing of US$4.6bn due to more than US$3bn of debt repayments, with the US$853bn below in interest & finance costs paid representing the cash flow impact of the US$741 million in "finance expenses" we saw previously in the income statement.


The Wrap

With a iron ore price which has been crashing, a company with a mountain of debt, a highly elevated debt-to-equity ratio and a serious question mark (as far as my understanding of demand for iron ore goes, at least) over how much more iron ore supply the market can absorb, are these the kind of dynamics which would encourage you to make an investment?

No, me neither!

There exists a jolly good reason for which the market prices stocks like this superficially "cheap" at a PE ratio of well below 5, and that's because buying today simply because the price has crashed is in essence just a leveraged gamble on the future direction of one commodity price, rather than a considered investment based on any improving fundamentals. 

Back the Field, not a Horse?

An even less fashionable viewpoint here, but why not consider backing the field instead of individual horses? 

Looking back at the companies which originally comprised Britain's FT30 index (now superseded by the FTSE100) some of the names and brands are familiar to me, although many have long since been taken over and operate as subsidiaries. A handful of companies do survive.

Yet for a significant number of the company names I might as well be looking at a series of ancient Egyptian hieroglyphs ("What the heck's this? A bird with a human head?"). Seemingly invincible companies fail more regularly than we tend to think, even the large ones.

Diversification into a wide range of companies which includes industrials and financials, when this is so easy to achieve today, may be favourable for most investors to picking individual stocks, except perhaps for a controlled portion of a portfolio. 

After all, if the greatest ever share market investor Buffett can do half his stash investing in apparently rock solid Tesco, the supermarket chain which had been increasing its earnings relentlessly for a couple of decades, how robust can the picks of the average investor be, really?