Each week we screen thousands of corporate bond listings to find what we believe to currently be the best corporate bond for investors needing or seeking higher yields with the least amount of risk as possible relative to its projected return. Our review process goes beyond the simple credit ratings and digs up a different look at the viability of a company to pay its bondholders. The following example, recently selected for addition to our high yielding corporate bond portfolio, illustrates why we believe these Ba3/BB- rated US Dollar (Yankee) bonds from FMG Resources (OTCPK:FSUMF), with an over 5.5% yield to its very short 3 1/2 year maturity, passes the stringent criteria we use on high yield bonds for our clients.
Step 1 - Assessing the Yield Curve
The higher yields fixed income market continues to be driven by money inflows, and remains resilient despite stock market action. Along with declining fixed income yields are heightened concerns for acquiring fixed income instruments that can outpace inflation without adding excessive risks. With the 5 years treasuries currently trading at about a 0.67% yield and the (possibly flawed) CPI at 2.8%, this short term 5.6% bond appears to be able to make a marked improvement in wealth preservation as long the underlying fundamentals of the issuer, which we will review the major elements of here in this article, remain sound.
Step 2 - A look at the issuer
Located in the iron ore rich Pilbara region of Western Australia with close proximity to Asia and India, Fortescue is a relative newcomer to the world market. Formed in 2003, construction of Fortescue's first port, rail and mine project commenced in early 2006, and in the first full year of operations (2010), Fortescue mined, railed and shipped more than 27 million tonnes of iron ore to customers in China. This rose to 40 million tonnes over the 2011 financial year and the expansion plan is targeting a run rate of 155 million tonnes per annum over 2013/14. Construction is now well underway at Fortescue's new mine in the Solomon Hub with a rail spur being constructed to link this operation into the existing rail and port infrastructure system.
Since inception, Fortescue has spent or committed almost $15 billion on resource projects in the Pilbara region of Western Australia. In its early years Fortescue was recognized as the highest investing exploration company in Australia. Having discovered a resource base of over two billion tonnes of iron ore, Fortescue then established the company's original mine, first rail line and open access port, investing over $4 billion on infrastructure, mining fleet and rolling stock. Fortescue has now commenced an $8.4bn expansion program with work programs well advanced for a scheduled completion date of end December 2012.
Currently, Fortescue holds reserves of over 2.2 billion tonnes of hematite ore within the Pilbara region and is the world's fourth largest iron ore producer, behind Vale (VALE), Rio Tinto (RIO), and BHP Billiton (BHP). The resource base for FMG stands at just over 11.4 billion tonnes and growing. All of these resources and reserves have been delineated from only 20% of Fortescue's massive Pilbara tenement portfolio spanning 88,000km2. With such upside exploration potential, Fortescue is firmly positioned as one of the world's major resource houses and over the next two years, Fortescue is expecting to triple in size, increasing iron ore exports by 180%.
Step 3 - We like companies that are profitable.
For the half year ending Dec.31 2011, the underlying EBITDA (calculated as Operating Profit adjusted for depreciation and amortization) was US$1.51 billion, an increase of 15% over the prior year's period generated through revenue growth of 33%. Net profits were recorded at A$800.8 million compared to A$314.1 million for the prior same period. Earnings per share were A$0.257 compared to A$0.101, and dividends for the Interim period were set at A$0.04/share, compared to A$0.03 for the previous corresponding period.
Step 4 - Interest Coverage Ratios
Finance expenses were reported at A$250.6 million, while operating profit was A$1,394.4 million, giving Fortescue better than 5x's coverage. Considering their recent increase in debt, we expect these financing cost will be noticeably higher in their next financial report, but we also expect their increasing profits to outpace any increase in finance costs and enable them to easily service the debt.
Step 5 - We like companies with lower debt to cash ratio.
In October 2010 a major refinancing of the debt was launched into the international corporate bond market. The $2bn issue was six times oversubscribed and enabled Fortescue to extract very favorable pricing terms. Since then a further $3bn of additional funding has been raised through the issue of more unsecured bonds for the expansion of existing operations at the Chichester Hub, the creation of a new mining operation within the Solomon Hub and the continued development of Fortescue's rail and port infrastructure.
In June 2011, Fortescue also established a $600 million unsecured 3 year syndicated bank facility to provide additional liquidity and support. This facility remains undrawn. Having recently completed a debt capital raising of US$2 billion, total debt is last reported at US$6.20B and total cash at US$2.47B, giving a very good cash to debt ratio of less than 1:3. However, this ratio may decline as larger capital expenditures relating to continued expansion progresses.
Step 6 - We like companies that have flexible balance sheets
Fortescue Metal Group Ltd.'s debt of $6.2 billion is less than 43% of its current market capitalization, so we consider it to have reasonably good balance sheet flexibility. While it was reported late in June that Morgan Stanley was seeking to acquire a 1.9% stake in Fortescue at a share price nearly 5% higher than where it is currently priced, we have seen no indications that the company intended to offer any additional equity offerings. It does, however, lend a vote of confidence toward the future of the company and the flexibility of choices they might have should they need or desire to raise additional capital.
Step 7 - We like higher yields.
This US dollar denominated Yankee bond issued by Fortescue Metals Group has a face coupon of 6.375 and, priced at a slight premium, currently has a 5.6% yield to worst call at par in 2015. Otherwise, its yield to maturity in January 2016 is 5.8%. In contrast, three year U.S. Treasuries are only yielding a paltry 0.34%. Although the credit ratings are widely different, we believe this greater than 5% difference in yields is extremely high given the risks that we can identify.
Step 8 - Risks Considerations
Although Fortescue has a rapidly growing business with very high profit margins, they have significant capital expenditures and expansion plans that could change their forecasts should the Chinese and global demand for iron ore be significantly altered. Given the longer dated contracts typically involved, we don't see this possibility as being much of a concern for these shorter maturity bonds.
We believe that these FMG Resources bonds have similar risks, similar maturity, and a similar yield to the Clean Harbors (CLH), Seagate Technologies (STS), or American Railcar (ARII) bonds reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
This is an exceptional yield, especially considering its very short 3 ½ year maturity and strong possibility of being called one year earlier. Although FMG's bonds are rated as Ba3/BB-, we believe they are a savvy risk that offers a significantly higher yield from a company having a good cash position, sound interest coverage, and a flexible balance sheet.
Ratings: Ba3/ BB-
Yield to Maturity: 5.819 %
Yield to Worst: 5.623 % (callable at par, 2/01/2015)
Disclosure: Durig Capital and certain clients may have a position in FMG Resource bonds.