Fortescue Yearly Profits Plunge By 88% — Can It Survive?

Iron ore mining

Fortescue [ASX:FMG] has announced annual net profits of AU$435 million in the year to June. What’s most concerning is that profits slumped by 88% compared to last year. It’s earnings totalled AU$3.43 billion for the year. That too was down on AU$7.76 billion from the year before.

This massive hit raises questions about its long-term future. Can Fortescue survive in a landscape where commodity prices are falling across the board? Your guess is as good as mine.

In the iron ore industry at least, there’s one truism that rings louder than ever: three’s a crowd.

The future of Australia’s iron ore industry is difficult to gauge. Not because we don’t know where it’s going. It’s difficult because we still don’t know how far, or fast, it’s going to fall.

Sharply declining commodity prices are a fact of life, and have been for several years. Before this current, low-price cycle ends, prices could fall much further still.

As Australia’s largest miners cope with the realities of this, attention turns to solutions. But what solution is there to plummeting prices? Commodities, from iron ore to oil and coal, are all struggling. And it’s all coming on the back of slowing global demand for materials and energy.

How sustainable are Aussie miners then? Can the market support the status quo with rock bottom prices? Maybe, or maybe not.

In iron ore, there’s enough evidence suggesting the domestic industry is overcrowded. In depressed markets, we typically see uncompetitive companies fall by the wayside. The concern for Fortescue is that it doesn’t have enough heft to ride out this storm.

Make no mistake, the mining bust has left us with two giants and a third wheel. Fortescue, unfortunately, finds itself in the position as the industry’s straggler. It’s profit for the year, down by 88%, is a clear sign of this. Profits fell despite its best efforts to offset falling commodity prices. How?

Fortescue’s production levels rose by 33% this year to 165 million tonnes. It also successfully lowered its break-even price from US$60 to US$39 a tonne. Evidently, that wasn’t enough to cushion profits. Nev Power, Fortescue’s CEO, put on a brave face. Here’s what he told investors:

In a challenging environment of lower iron ore prices, this focus on efficiency and productivity from our world-class assets will continue to see operation improvements and cost reductions while we maintain production at 165 million tonnes a year to create long-term value for Fortescue shareholders’.

Long-term value for shareholders? What value?

Fortescue offers investors a fully franked dividend of AU$0.02. It holds US$7.2 billion of debt that doesn’t mature until 2019. It’s market cap, at one time AU$20 billion, now stands at AU$6 billion, with scope to fall further.

The only thing the company offers investors is the promise of more selloffs and spending cuts. Its best bet might be to sell off assets to interested Chinese buyers. Equally, lowering overheads further remains the other option on the table.

Yet that’s the kind of ‘value’ that investors face: cost cuts and subpar dividend yields. Fortescue needs real, organic growth, but it can’t achieve it in this market.

It’s also clear investors don’t see eye to eye on the question of value either. Fortescue’s stock is down 14.10% as of 3:30pm AEST. It’s also declined by AU$0.80 to AU$1.64 a share since June.

Fortescue’s troubles reflect market reality

Of course, Fortescue’s struggles apply equally to competitors BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO]. But the difference is one of size and stability.

Neither BHP’s nor Rio’s position is under immediate threat. Both maintain lower profit margins than Fortescue. Both offer investors with higher yields in real terms. And both are much larger capped stocks in comparison.

Their problems with falling commodity prices are no less important to investors than Fortescue’s. But it goes back to maintaining an air of stability in the face of a depressed market. It’d take a lot more for the big two to end up in the perilous situation Fortescue finds itself in.

The two giants are well equipped to ride out China’s slowing demand for materials. But is Fortescue? Can Fortescue survive if this market stays the course for the next few years? It’s hard to say.

The problem, then, for Fortescue is the question of ongoing viability. If prices remain as low as they’ve been, how can the company grow? It can’t, especially as it can’t compete with BHP or Rio on market share. Right now, exporters prize market share in the hope of driving out competition. But it’s also suppressing iron ore prices as a result.

Iron ore prices plunged as low as US$44 a tonne in June. While it now trades at US$55 a tonne, its still below peak levels of US$180 a tonne.

What’s more, this recent rally won’t last much longer. Producers are still flooding the market with supply. Meanwhile, China’s slowdown is lowering global demand for the commodity. Prices are likely to fall below US$50 again, and soon.

That kind of pressure should hit smaller cap mining stocks the hardest. Atlas Iron [ASX:AGO] is only one high profile casualty of the price decline. Atlas recorded an AU$1.4 billion loss since resuming production recently. These smaller caps simply don’t have the financial muscle to compete with BHP and Rio on profit margins or market share in the long term. This is exactly how the big two want things.

Their strategy, to increase global supply, is a key reason why prices are as low as they are. Destroying smaller caps like Fortescue goes hand in hand with that strategy.

The only question is how long the less profitable producers can hold out against this assault.

BHP struggles to worst result since 2010

Fortescue isn’t the only company struggling with profits. It’s expected BHP will announce its weakest profits in five years when it reports on Tuesday.

The difference between BHP and Fortescue is that the former has the muscle to spend its way into investors’ good books. Analysts expect BHP to cut capital spending and cut costs to shelter its progressive dividend policy. Of course, that’s no different to what Fortescue’s doing. But BHP’s yield of 6.37% at $23 per share is appreciably higher than what Fortescue offers. And it’s worth remembering that Fortescue cut dividends from AU$0.10 to present $0.02 levels.

In contrast, BHP pays out $8.7 billion in dividends at last count. And it maintains plans to sustain those levels.

That said, not everyone remains convinced about BHP dividend policy going forward. Deutsche Bank analysts, for instance, suggest BHP’s need to reassure investors of its long-term growth strategy. It also questions the BHP’s ability to maintain its progressive dividend policy.

It feels BHP’s dividend policy hampers its growth opportunities. What’s more, it asks whether investors will stick with the company amid stuttering profits and lower investments.

Despite this, Deutsche Bank doesn’t see BHP cutting dividends anytime soon. And there’s your answer right there.

As long as BHP dividends don’t fall, investors aren’t likely to care about growth. Anyone with stocks in mining knows that it’s a tough market right now. With a bleak outlook, dividends are one of the few things investors stick around for.

As for Fortescue, its dividend policy isn’t changing either. But how long can it keep up appearances in the current landscape? If commodity prices decline further still, the pressure might prove too much to bear. Cost-cutting, asset selloffs, and plunging profits?

You’d be hard pressed to find much value in that.

Mat Spasic,

Contributor, The Daily Reckoning

PS: Amid falling energy prices, mining stocks have fared poorly this year. But every investment, no matter how it looks, has an element of risk attached to it. As The Daily Reckoning Managing Editor Bernd Struben would say, more risk equals…more risk. That doesn’t just apply to mining stocks; every company you invest in comes with its own potential pitfalls.

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