The stock in focus this month is Fortescue (FMG). When constructing portfolios and looking specifically at individual stock selection, the stocks that we don’t own can have just as much impact on performance as the ones we do own. Avoiding stocks that are challenged individually or in sectors that are facing significant headwinds is just as important as picking the top performers.

FMG is a good example of this balance between risk and reward. FMG is an iron ore producer based in the Pilbara region in North Western Australia. FMG is a low cost producer, producing 165 mt of iron ore per year since first shipment in 2008. Globally they are one of the lowest cost producers, with an all in sustaining cost of $US49/t. This compares to producers like BHP and RIO with production costs in the mid-$US30’s and small-scale Chinese producers at closer to $US100/t. However, the iron ore produced by FMG is slightly lower quality than the other Australian producers and therefore commands around $US10 less from steel producers.

The biggest challenge for the iron ore producers over the past 14 months has been the crash in the price of iron ore due to a number of factors, but primarily a slow down in growth in China particularly in the steel intensive construction sector. At the same time there has been a significant increase in the supply of iron ore both from FMG and the other low cost producers. The theory has been to drive higher cost supply from the market (particularly Chinese domestic producers) to firm up longer term prices and market share. However, as with the aluminium market where there was a similar dynamic over the last 5 years, the heavily subsidised Chinese production has proved hard to force from the market.

This fall in price, despite being offset to an extent by increased sales, lower costs and the falling AUD has obviously put pressure on revenues of all the iron ore producers. Where it is particularly relevant to the risk associated with owning FMG relates to their balance sheet.  With over $US 9 billion in debt, it is important for FMG to consider how long these low prices will persist and to remain aware of the realised price they need to service and repay their debt. What this means is that FMG becomes highly leveraged to the vagaries of the iron ore price to the extent where the outcome is quite binary. While this means FMG is a great way to play an aggressive view on the iron ore price, there is a chance that the company may not be able to service its debts if the iron ore price continues to slide. While we think this possibility is remote, the steep fall in the share price reflects the added risk of the stock.

Quick Stats:

• Founded in 2003 and produced their first iron ore in 2008
• Have shipped over 500 mt and produced 165 mt last year
• All in sustaining costs of $US49/t

If you would like more information please call 1300 ELSTON or email info@elston.com.au and an adviser will be in touch.