For a stock that you could have bought for around six cents a share 10 years ago, Fortescue Metals Group Limited (ASX: FMG) is a success story, but the road hasn't been easy. At around $4.90 a share currently, its growth in iron ore production was the culmination of heavy capital investments with large amounts of debt.
Lower costs are improving earnings margin
Higher earnings from its recent ramping up of production were aided by two things – higher iron ore prices and lower costs. Earnings margins widened when it reduced its C1 production costs to US$32.99/ wet metric tonne (wmt) in the second quarter of FY2014. The cost fell 34% compared to Q2 2013, giving it more breathing space if iron ore prices drop.
Paying down its debt can create huge savings
With higher revenues, the one thing the company is focused on right now is reducing its huge debt. Some of the extra cash flow from higher sales and lower capital expenditure went to paying down borrowings by around US$3.1 billion to a net debt position of US$8.6 billion.
That is still large, but the interest expense savings from the reduction are expected to be about US$300 million. That can be used for operations and further debt repayment. Any unused portion can flow to earnings.
Development costs are going down
Developing its mines, rail lines and port facilities took a lot of money. The recent expansion programs increased that even more. Now that these programs are nearing completion, related costs will decrease, leaving more for debt reduction and earnings. This year and the next may be the period when the company can make good headway in raising its earnings per share and share price.
Foolish takeaway
Reducing debt down to a lower multiple of its net profit would give it a stronger balance sheet, lower interest expenses and potentially higher earnings. In addition, when its gearing goals are met, its dividend payout ratio will become 30%-40% of earnings, so shareholders may see better dividend income.
