Fortescue Metals: a thousand cuts

Do not blame China's economic slowdown for the fall in the iron ore price. Demand there is still rising, albeit more slowly. Instead, oversupply of the steelmaking ingredient is behind the price fall for ore landed in Qingdao to $50 a tonne (from nearly $120 a year ago). Low-cost producers BHP Billiton and Rio Tinto can handle that. Smaller one-trick ponies such as Fortescue Metals, Australia's third-largest producer, and Atlas Iron are in a bind.

Atlas last week said it would suspend mining. Fortescue cut costs and mined less in its latest quarter to use up stock, cut working capital and release cash. Founder Andrew Forrest even called for iron ore miners to cut output to arrest the price fall. He is a fine one to talk: in Fortescue's update for its third quarter to end-March it increased ore shipments by 28 per cent from a year ago to 40m tonnes.

At first blush, Fortescue's self-help looks to be paying off. Production costs have fallen 26 per cent from a year ago to $25.90 per "wet" tonne; it guided to $18 for its 2016 fiscal year. Still not in the same league as BHP or Rio. Its cost of landing wet ore in China fell 17 per cent in the quarter to $34. But steelmakers do not pay for moisture. When it comes to dry ore, Rio and BHP can land their product more cheaply.

Trouble is, Fortescue may have gone as far as it can on costs. Nor can it do much to alter the fact that it sells lower-grade ore than rivals. That shows in an achieved price of $48 a dry tonne in the quarter (versus a $62 average index price) and break-even guidance for 2016 of $39. Goldman Sachs forecasts an index price of $44 then. Thin margins ahead.

Then there is Fortescue's net debt of $7.4bn, or almost 100 per cent gearing. Two-fifths of profit before interest and tax goes in finance charges. A cash call or selling a stake would be a quick fix. But an investor would have to believe that ore demand will grow and that China needs those Fortescue tonnes as peers bring on extra capacity. Yours for 3.5 times earnings for a reason.

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