Just a couple of months ago, we heard troubling stories about the banks. It wasn’t that their profits were slipping; instead, it was the amount of bad debt held on their balance sheets. A majority of this bad debt came from the resource sector.
Falling commodity prices, and huge losses, sent resource companies running for the banks. If they couldn’t improve profits through operations, they could at least borrow to pay out dividends. Of course, not all resource companies applied for more loans. However, it became apparent for the major producers that, in order to stay at the top, they needed an injection of cash.
Now, there’s nothing bad about borrowing money. There is such a thing as good debt. It is money borrowed to invest in profitable ventures.
But at some later date borrowed money will need to be repaid. And this is exactly what some resource companies are doing. A prime example is Fortescue Metals Group [ASX:FMG]. Yesterday they announced to the market that US$500 million worth of debt had been wiped off their balance sheet.
The repaid sum will result in an interest savings of US$21 million per annum. Not a small amount by any means.
Fortescue’s chief financial officer, Stephen Pearce, said, ‘Cash flow generation from our operational performance and cost reductions have allowed Fortescue to continue to repay debt. This brings total FY16 debt repayments to US$2.9 billion, reducing annual interest expense by US$186 million.’
The positive outcome encouraged shares to rally 7.5% yesterday. The stock closed on a high of $3.53 per share, and the company is now up 88.77% for the year.
Source: Google Finance
Was the debt worth it?
From the share price above, it’s obvious that investors are happy about reduced debt levels. But we still need to understand why they borrowed in the first place. This way, we can determine if the debt accumulated was actually worth the trouble.
Fortescue borrowed to build a vast network of mining pits, rail lines and port infrastructure. Digging, building and planning was carried out in Pilbara, Western Australia. Their aim was to break the dominance of iron ore giants like BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO].
So was it a good decision to borrow money? If the returns of their iron ore operations yielded more than the debt repayments, then it was a good decision.
Over the past three years, Fortescue has vowed to pay down their loans. This, of course, caused trouble with management in 2012 when iron ore prices tumbled. At its peak, the Perth-based miner owed around US$13 billion.
Even though output in 2016 was 6% lower than the prior quarter, Fortescue stuck to their vow. They prioritised and budgeted their way to pay down their debt. The company lowered spending by running its trucks and processing facilities harder. They also renegotiated contracts with suppliers.
Essentially they found a way. And it’s really a credit to management. It takes hard work and brains to run a profitable company. And it seems Fortescue has plenty of both. The company said they intend to review investor payouts once debt-to-equity levels are below 40%.
Last month Fortescue estimated its debt-to-equity at around 44%. So it might not be long before investors are rewarded for their loyalty.
Junior Analyst, Money Morning
PS: Fortescue’s share price rally this year emphasises the great opportunities in mining stocks. The resource sector isn’t dead. It’s just subdued. And there is rarely a better time to invest than when share prices are low. According to Money Morning’s resource specialist, Jason Stevenson, there are many more great mining stocks out their along with Fortescue.
After reading Jason’s report ‘The Top 10 Australian Mining Stocks for 2016’, you’ll know exactly where to look. Jason will tell you why now is the perfect time to buy mining stocks. And he’ll share 10 of the best miners trading on the ASX this year.
To get your free copy of Jason’s report, click here.