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Fortescue Metals Group – Aussie diggers

The cash flow boom is well underway at Fortescue with the annual dividend doubling, debt repayments accelerating and production pushing through capacity.

FMG’s full year result felt like the end of the beginning. The full run-rate of 155mtpa was achieved after the completion of the Kings Valley mine at the Solomon hub opened back in March this year, a few months ahead of schedule.

In conjunction, FMG has built out its infrastructure including 620km of rail connecting the Solomon and Chichester hubs to the Herb Elliot Port at Port Hedland that already has four shipping berths and a fifth to come in FY15.

As the scale of the group has grown, the economies have begun to kick in so that FMG now finds its production costs nestling perilously close to world best levels at US$31-32/t by FY15 from US$48/t in FY12.

Operating earnings therefore rocketed to US$5.6 billion in FY14, with the additional volume adding US$2 billion and cost efficiency adding US$1.2 billion.

Lower iron ore prices this year had caused consternation among investors but even this factor only detracted US$829 million from the EBITDA growth to US$5.6 billion.

FMG’s ore is lower quality than the benchmark 62% Platts index price that everyone watches. The company has offered higher discounts of 14% to its Chinese customers from 1 July, up from the 12% previously offered.

But the consequence of all this is that free cash flow is rapidly increasing as operating cash flow rises and the capital expenditure requirements diminish. FMG expects to spend US$1.3 billion capex in FY15 compared to the US$1.9 billion spent in FY14 and more than US$6 billion spent in each of the prior two years.

An additional kicker for the company is the lower cost of debt being paid (down from 10.10.1% in FY12 to 5.3% in FY14) combined with the several tranches of early debt repayments made by the company. Gross debt stood at US$9.2 billion as at 30 June 2014 with cash of US$2.4 billion offsetting that.

FMG intends to continue repaying debt early with only CY2019 looming as a big year. Even then the company can repay the US$4.9 billion due in that year early at its option.

An intriguing development has been the takeover offer made by BC Iron (FMG’s joint venture partner at the Nullagine project) for Iron Ore Holdings (owned 52.7% by Kerry Stokes). The combined BCI/IOH business would dilute FMG’s 25% stake in BCI to about 16.2% of BCI/IOH with Mr Stokes coming down to about 23%.

That new company would clearly benefit from its association with FMG if it could negotiate access to FMG’s rail and port infrastructure, although both BCI and IOH already have some practical access.

The deal is more of a sideshow for FMG shareholders at this point but we can’t see it being negative in any way, depending on the final outcome.

FMG’s share price has been ridden down on the back of the lower iron ore price but the fundamentals of the business suggest it should be going the other way.

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