Since the start of the year, Fortescue Metals Group Limited (ASX: FMG) has risen by 149%. This beats iron ore peers such as BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO). Their shares are up by 15% and 12% respectively. Here's why Fortescue has risen so sharply in less than eight months.
Financial improvement
Fortescue's financial standing has improved since the start of the year. A key part of this has been a reduction in debt. For example, Fortescue repaid US$1.7 billion of debt during the June quarter. This took total debt repayments for the 2016 financial year to US$2.9 billion. Fortescue's net debt is now US$5.2 billion, with net gearing below 40% and US$1.6 billion of cash on hand as at 30 June.
This has prompted Moody's to upgrade the outlook for Fortescue to stable from negative. It has also affirmed the company's credit rating at Ba3. Moody's noted that the debt reduction lowered breakeven costs and created a buffer in case of lower iron ore prices.
Strategy
In the June quarter, Fortescue reduced expenses for the tenth consecutive quarter. Cash production costs (C1) for iron ore are now US$14.31 per wet metric tonne (wmt). This is a reduction of 3% compared to the March 2016 quarter and a fall of 35% over the previous year. Fortescue expects a further reduction in C1 costs to between US$12 and US$13 in FY 2017 through a focus on productivity and efficiency.
Fortescue has increased production to maintain market share and boost profitability. For example, mined ore in the June quarter was 10% higher than in the March quarter and 14% higher than in the June quarter from the previous year. Further, sustaining capex in FY 2016 was lower than guidance at US$1.33 per wmt versus guidance of US$2 per wmt. Timing issues, higher exchange rates and lower fuel prices benefitted the figure.
External improvements
The price of iron ore increased from US$41 per dry metric ton (dmt) in January to US$60 per dmt in April. It was boosted by increased Chinese demand from the infrastructure and property sectors, while strong exports supported steel production. It meant that Fortescue's average realised price for the June quarter was US$48.79 per dmt.
Although further price gains cannot be ruled out, Fortescue remains a price taker. This means that its risk profile is high and while its financial standing has improved and its strategy has been sound, its profitability and share price are largely dependent upon the price of iron ore. Its lack of diversification between different commodities further increases its risk profile. Although more capital gains could lie ahead, Fortescue's risk/reward ratio remains unappealing.
