Shock and ore – Why investors should look out for signs of financial distress in the mining sector
Rarely – if ever – has there been a better time for countries and businesses to turn to the debt markets for financing. After all, as we noted with something approaching wide-eyed amazement in Bonderland, even Portugal – with its starring role in the euro crisis still so fresh in the memory – has been able to find investors happy to pay to own its two-year debt.
What then are we to make of the recent, brief and ultimately fruitless foray into the debt markets by one of the largest producers of iron ore on the planet? In early March, Australia-based Fortescue Metals Group announced plans to raise $2.5bn (£1.6bn) of debt so that it might refinance in advance some existing loans that are due to mature over the next few years.
As the company’s chief executive Nev Power said at the time, the refinancing would “extend Fortescue’s debt maturity profile while maintaining flexibility and minimising interest costs”. That at least was the plan but a couple of weeks later – presumably after gauging investors’ interest (or lack thereof) – the company had to announce it was calling the whole thing off.
By way of explanation, Power said: “Debt capital markets were not favourable at this time and as a result we think it is a disciplined and prudent decision to defer the voluntary refinancing at this stage.” He may well be right but if, as we suggested at the start, debt markets are arguably the most favourable they have ever been in the history of finance, what does it say that Fortescue found them otherwise?
At the very least, it offers an insight into current investor attitudes. These attitudes may not necessarily be correct but clearly, if the markets are feeling pretty relaxed about the risks of lending to the Portuguese government but are unwilling to lend to one of the biggest iron ore producers in the world, they must have their reservations about the company or the sector – or both.
One might reasonably conclude that Fortescue now finds itself in something of a quandary. As Power has also pointed out, the company does not have any debt maturing until April 2017 so it is not as if it needs fresh money tomorrow and yet, as of the end of March, the company did have $7.4bn of net debt on its balance sheet.
At the same time, consensus forecasts for Fortescue’s earnings before interest, taxes, depreciation and amortisation (EBITDA) are $2.3bn for the 12 months to June 2015 and $2bn for the 12 months to June 2016. That means the company’s net debt to EBITDA ratio is now well above 3x and heading towards 4x – and regular visitors to The Value Perspective may recall 2x is normally at the very top of our comfort zone.
To be fair, it is unlikely Fortescue needs to be worrying about any covenants on its existing debt but that bright spot is overshadowed by the recent falls in the price of iron ore – essentially the only thing it sells. Even if prices now hold steady, those consensus earnings forecasts are likely to be too high while that net debt to EBITDA ratio could edge up to still more uncomfortable levels.
The combination of falling prices and elevated levels of debt is rarely a cause for optimism and if, as it appears, that is the situation in which one of the world’s largest iron ore producers now finds itself, investors would do well to watch out for similar signs of financial distress in other parts of the metals and mining sector.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
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