Fortescue Metals Group Limited (ASX: FMG) has risen by 49% in the last three months. That's ahead of the 9% gains of iron ore peers BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO). Much of this is due to Fortescue's improved finances and strategy, although its continued dependence upon the iron ore price increases its risk profile in my view.
Financial standing
Fortescue's balance sheet leverage has been reduced so that it now has a stronger financial footing. Net debt was cut from US$7.2 billion at 30 June 2015 to US$5.2 billion a year later. The reduction in debt levels of US$2.9 billion was achieved through a series of tender offers and on-market buybacks.
Further, Fortescue's debt profile is now healthier than it was previously. No repayments are due until 2019. This provides Fortescue with financial flexibility so that it can pay down debt further or invest in future growth opportunities.
As evidence of the improved status of Fortescue's balance sheet, its credit rating was upgraded by Moody's and Fitch last month. Its net debt to equity ratio of 62% is down on financial year 2015's figure of 95%. This reduces Fortescue's balance sheet risk and makes its long term outlook more sustainable in my view.
Strategy
Fortescue has reduced spending to become a more efficient business. For example, in the 2016 financial year it reduced average C1 operating costs by 43% to US$15.43 per wet metric tonne (wmt). Further cuts are likely to be made. Fortescue reported that by the 2016 financial year they had fallen to US$13.10/wmt, which will boost margins in future.
Alongside cost reduction, Fortescue has reduced capital expenditure and increased production. For example, capex was more than halved to US$304 million in financial year 2016. Sustaining capex was favoured to exploration spend and this improved free cash flow by 93% to US$2.7 billion. Production increased by 10% versus the prior year. This helped to lessen the impact of lower iron ore prices and could continue to do so in the future in my view.
Dividends
Fortescue's improved cash flow enabled it to increase dividends by 200% so that it now yields 4.3%. This is behind popular income stocks such as Australia and New Zealand Banking Group (ASX: ANZ) and Telstra Corporation Limited (ASX: TLS). They have yields of 6.6% and 6.2% respectively.
However, I feel that Fortescue's improved cash flow would have been more efficiently used in further reducing debt, rather than in improving the short term income return of shareholders. Although its dividend payout ratio of 36% is within the 30%-40% target range, I believe that it is an inefficient use of capital during an uncertain period for the iron ore industry.
Iron ore
Despite the improvements made to Fortescue's business, its fortunes are closely tied to the future price of iron ore. Fortescue is upbeat about demand from China for iron ore imports thanks to its One Belt, One Road infrastructure project. However, Fortescue faces an uncertain future. If the price of iron ore falls then even if cost reductions and production increases continue, its profitability and share price could decline. Therefore, in my opinion Fortescue is a stock to avoid.
