Fitch Affirms Fortescue at 'BB+' on Iron Bridge Project Approval

(The following statement was released by the rating agency) Fitch Ratings-Sydney-April 04: Fitch Ratings has affirmed Fortescue Metals Group Limited's Long-Term Issuer Default Rating at 'BB+' following the company's approval of the USD2.6 billion development of Stage 2 of the Iron Bridge Magnetite Project. The Outlook is Stable. A full list of rating actions follows at the end of this commentary. The affirmation reflects Fitch's view that the project supports the Australia-based miner's efforts to improve production flexibility and moves it closer to its strategic goal of having a majority of products with greater-than-60% iron content. This, combined with the additional flexibility to be provided by the USD1.3 billion Eliwana mine development announced in May 2018, will further enhance the miner's ability to respond to cyclical and structural global demand shifts for iron ore, supporting its profit margins and allowing it to retain its market share. The company expects the Stage 2 development, an unincorporated joint venture between its subsidiary, FMG Iron Bridge Limited, and Formosa Steel IB Pty Ltd, to deliver 22 million tonnes per annum (mtpa) in high-grade 67% Fe content magnetite concentrate iron ore by mid-2022. FMG Iron Bridge will contribute USD2.1 billion to the total cost of Stage 2, including USD274 million in deferred contributions from Stage 1, from the financial year ending June 2019 (FY19) to FY22, with Formosa funding the remainder. Fitch will likely consolidate Fortescue's proportionate share of debt in our adjusted debt metrics despite the intention to fund its subsidiary's contributions with non-recourse project debt. We expect Fortescue's leverage, measured by FFO to adjusted net leverage, to remain below 3.0x, the level at which Fitch would consider negative rating action. Our forecasts also factor in Fortescue's already significant capex pipeline with the Eliwana development. We believe Fortescue's record in developing, constructing and operating mines on time and on budget - having constructed five iron ore mines in less than 15 years - minimises the execution risk around a project of this size and a shift to processing a different type of iron ore. The company has also invested USD0.5 billion in Stage 1 of the project to reduce processing technical risk, which has allowed it to perform extensive testing and development work at Iron Bridge, including the construction of a pilot plant and full-scale project plant, which replicates the full flowsheet, to prove the viability of the mine. To date, one million tonnes of ore have been processed through the plant. We understand this testing will continue over the construction period to optimise the processing procedures. KEY RATING DRIVERS Price Realisation Impacts Profitability: Fortescue's cost of mining and shipping iron ore to its main market in China compares well with other major low-cost iron-ore producers such as Rio Tinto (LON:RIO) Ltd (A/Stable) and BHP Group Limited (A/Stable). However, its profitability is not as strong due to price adjustments based on its lower Fe content blend. The price adjustment to the benchmark (62% Fe Platts CFR Index) has narrowed from its highest level of around 35% since December 2018 due to increased demand from Chinese steel mills that are currently experiencing lower steel margins. The company's mines were positioned in the second and lower-third quartiles of the iron-ore global cost curves in 2018, according to CRU's business-cost model, which adjusts for grade and price realisation. Fitch expects price realisation to improve as Eliwana and Iron Bridge come into production and raise production flexibility and the average Fe content of its products. Eliwana's approval has enabled Fortescue to introduce a 60% Fe content blend - West Pilbara Fines - which was first delivered in 2019 and volumes are likely to rise to 40mtpa once Eliwana begins production in December 2020. Iron Bridge will enable Fortescue to market the mine's 67% Fe content ore as a distinct product or use the ore in the blending of other products, depending on market conditions. This will enhance Fortescue's profitability as it can respond to changes in demand and price realisation for various grades of iron ore. Further Cost Improvements Challenging: Fitch expects the company's C1 costs (which include the cost of mining, processing, port and rail) to average around USD13 per wet metric tonne (wmt) in FY19, which is at the top end of the company's guidance of USD12-13 per wmt. This recognises that factors beyond Fortescue's control can have an impact, such as crude oil prices and the Australian dollar exchange rate. Investment-Grade Credit Metrics: Fortescue's credit metrics are strong for its rating, and we expect FFO adjusted net leverage to remain below 2.5x over the next four years. This includes the impact of the Eliwana mine project, which will be financed by operating cash flows, the USD2.1 billion contribution to Stage 2 of the Iron Bridge project, which Fortescue has indicated will be funded by a combination of specific non-recourse project debt and operating cash flows - although the project financing has not yet been agreed - as well as Fortescue increasing its dividends to shareholders. Fitch's consolidation of Fortescue's proportionate share of funding for the Stage 2 development at this point is due to the strategic importance of the Iron Bridge mine despite the plan for non-recourse project debt to fund the project. Flat Iron-Ore Prices: Fitch increased its expectation for benchmark iron ore prices in March 2019 to USD75 per dry metric tonne (dmt) for 2019, and increased the price to USD70/dmt in 2020 and USD60/dmt in 2021, keeping our long-term price at USD55/dmt thereafter. This is based on our forecast that iron-ore prices will remain elevated following the recent rises in iron ore prices after Vale S.A. (BBB-/Rating Watch Negative), the world's largest iron-ore miner, said it would cut around 10% of its output for up to three years after the collapse of a tailings dam in January 2019 - and drives our expectations that Fortescue's EBITDA margins will increase in FY19 (FY18: 45%). DERIVATION SUMMARY Fortescue is among the leading low-cost iron-ore producers globally, which positions it well against peers. Both Fortescue and Vale are highly exposed to a single commodity - iron ore. Vale has historically been considered stronger than Fortescue due to the high iron content in its ore and low cost, despite Fortescue benefiting from its proximity to China and lower sovereign risk than Brazil. However, the financial impact of the tailings dam and the lower production caused by the incident, which resulted in Vale's downgrade and continue to be reflected in the Rating Watch Negative, have offset these benefits and reduced the rating differential between the companies to one notch. The gap between their relative strengths will continue to narrow with our expectations of the increase in the average grade of Fortescue's product suite as its new mines come online. Anglo American (LON:AAL) plc's (BBB-/Stable) rating reflects its significant commodity exposure and geographic diversification as one of the world's largest mining companies. This is despite its high exposure to South Africa, which is a challenging environment with an active, unionised workforce and comparatively high wage and electricity cost inflation. Fortescue, like Anglo American, has improved its financial profile as it prioritises balance-sheet strength. However, Fortescue's weaker profitability is reflected in the one-notch difference between the ratings on the two companies as a result of lower price realisation due to the iron content of its ore being lower than the benchmark. KEY ASSUMPTIONS Fitch's Key Assumptions Within Our Rating Case for the Issuer - Benchmark iron-ore price to average USD75 per dmt for 2019, USD70 per dmt for 2020, USD60 per dmt for 2021 and USD55 per dmt for 2022 - Fortescue's C1 cost to be around USD13 per wmt in FY19 and FY20 - Capex of around USD1.3 billion for FY19, including the contribution to Iron Bridge, in line with company guidance - Dividend payout ratio to remain at the upper end of Fortescue's guidance of 50%-80% of net profit after tax from FY19 to FY22 RATING SENSITIVITIES Developments That May, Individually or Collectively, Lead to Positive Rating Action - Maintaining FFO adjusted net leverage at less than 2.5x on a sustained basis (FY18: 1.6x). - Cost position of key operations, adjusted for grade and price realisation, moving to the second quartile on a sustained basis. - Maintaining neutral free cash flow on average on a sustained basis. Developments That May, Individually or Collectively, Lead to Negative Rating Action - FFO adjusted net leverage that is higher than 3.0x on a sustained basis. LIQUIDITY Comfortable Liquidity, Debt Structure: Fortescue had USD962 million of cash on hand at 1HFY19 and a USD1,025 million undrawn revolving credit facility. It has no debt maturities until 2022, when the first tranche of the unsecured notes issued in FY17 of USD750 million falls due, together with a USD1.4 billion term loan. Total debt (including finance leases) of USD4.0 billion at FYE18 does not include financial maintenance covenants. This provides the flexibility to reshape its capital structure, which is supported by its strengthened financial credit profile. FULL LIST OF RATING ACTIONS Fortescue Metals Group Limited - Long Term issuer Default Rating affirmed at 'BB+'; Outlook Stable - Long-term rating on senior unsecured debt affirmed at 'BB+' FMG Resources (August 2006) Pty Ltd - Senior unsecured notes due 2022, 2023 and 2024 affirmed at 'BB+' Contact: Primary Analyst Kelly Amato, CFA Director +61 2 8256 0348 Fitch Australia Pty Ltd Level 15, 77 King Street, Sydney, NSW, 2000 Secondary Analyst Leo Park Associate Director +61 2 8256 0323 Committee Chairperson Vicky Melbourne Senior Director +61 2 8256 0325 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com; Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com. 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