What To Do About Arrium

This story features BLUESCOPE STEEL LIMITED. For more info SHARE ANALYSIS: BSL

– Surprise dilutive raising
– Steel disappoints
– Iron ore outlook subdued
– Another raising not discounted
 

By Greg Peel

Arrium ((ARI)), formerly OneSteel, is in simple terms the long steel partner to rolled steel producer Bluescope in terms of both representing the BHP Steel spin-off of many years prior. Arrium produces raw materials for sale to steel manufacturers and steel products used in the construction and other industries, along with rail wheels.

What has always set Arrium apart from Bluescope is its mining division. Aside from its steel business, Arrium also produces iron ore for its own input and for export. Thus while Bluescope, maker of Colorbond roofing and other products, struggled in the post-GFC construction collapse, Arrium always managed to bungle through on the back of its iron ore production and solid global demand (China).

The formula works until, of course, the iron ore price crashes, as it has done this year.

The outlook for steel has considerably improved since domestic construction has begun to recover. But Arrium carries a significant level of debt, representing 31% gearing at end-FY14. Thus management’s goal for FY15 is to reduce costs and improve working capital in order to manage its debt, and in order, it appeared at the company’s August result release, to avoid the need to raise capital.

The problem is the iron ore price has fallen a lot further since management signed off on the FY14 accounts, and since FY15 guidance was established. Thus a better outlook for steel, coupled with cost reductions, is not going to provide for earnings improvement. Management has now guided for FY15 earnings to fall below FY14 and what’s more, brokers were disappointed in a downgrade to steel expectations.

There is an element of second half skew involved with regard steel, but further disappointment followed news that iron ore grades are lower than assumed. This exacerbates the impact of lower benchmark ore prices over the last couple of months given an accompanying increase in grade discounting.

If Arrium’s board were the groundkeepers at the Gabba, they have looked to the darkening sky and decided to rush the covers onto the pitch before the umpires had officially called a halt to the test match (as has famously occurred in the past). The board has assessed the iron ore price and outlook, and the immediate outlook for the steel and other businesses, and the company’s debt obligations, and decided a pre-emptive strike is necessary.

Arrium has announced its intentions to raise $754m in new equity via a 1:1 rights issue of $656m at 48c and a $98m book-build placement to institutions at a floor of 48c. As both are fully underwritten, there is no doubt the raising will proceed but as yet the final price is not determined. The 48c floor represents a 26% discount to Friday’s closing price and the issue basically doubles the stock’s share count.

That Arrium should find itself needing to raise capital in a weak iron ore price environment is not in itself much of a shock. That they should do it on Friday nevertheless took brokers by surprise. The company was in no immediate risk of breaching its debt covenants and the assumption was that cost cutting, coupled with earnings upside for steel, would keep the wolves from the door.

Assuming the raising succeeds in providing the cash the board is hoping for, it will almost exclusively be used to pay down debt. Yet at current iron ore prices, Arrium’s mining division will still only achieve around breakeven in FY15. If iron ore prices fall further, another raising down the track is not beyond the realms. In the meantime, a significant buffer to covenant breaches should avoid any quick follow-up, and brokers agree Arrium’s leverage to the construction recovery bodes well for the steel division in FY16.

The issue now is whether shareholders are prepared to pay for the discounted new stock to avoid suffering significant dilution. The new stock will not be eligible for the FY14 final dividend, and three of six FNArena database brokers reporting to date have cut their FY15-16 dividend forecasts to zero, despite the result reduction in interest payments implicit from the debt pay-down.

Given the resultant debt relief, Deutsche Bank does not believe another capital raising is nigh, but the broker does add the caveat “all things being equal”. Credit Suisse believes another raising may become an issue in twelve months if the iron ore price does not increase. CIMB suggests the difference between the announced raising being sufficient in the medium term or simply a short-term fix “relies entirely on your view of the iron ore price”.

One wonders what the Arrium board is thinking today, in light of last night’s 4% bounce.

No one was more taken aback by the announcement than Macquarie. The broker just last week had taken an axe to its iron ore price forecasts which resulted in forecast earnings slashes and ratings downgrades to several miners under coverage. ARI did not escape, suffering a 60% forecast reduction in FY15-16 earnings, a cut in the FY15 dividend to zero and a downgrade to Underperform. Macquarie dropped its target to 78c from 86c at the time.

The broker has now cut its FY15 earnings forecast by another 69%, shocked that the performance of Arrium’s underlying business is actually worse than last week’s earnings cuts implied. Macquarie’s target now falls to 51c.

Credit Suisse already had an Underperform rating and notes the raising on an already depressed share price reflects “a significant deterioration in earnings on an already stressed balance sheet”. The broker’s target falls to 67c from 80c.

Citi and CIMB have both responded with downgrades to Sell (or Reduce in CIMB’s case).

Citi acknowledges that investors would have been expecting some impact from the lower iron ore price but the surprise weakness in steel is likely to drive greater investor caution, the broker warns. Investment may well flow to larger iron ore names with lower costs (ARI is one of country’ highest cost producers) or to less diversified steel names with greater domestic leverage to a performing residential cycle, ie Bluescope ((BSL)). Citi has dropped its target to 52c from 90c.

CIMB happened to be in the process of dropping its long term iron ore price forecast to US$80/t from US$95/t when the news broke. Adding the raising into the mix sees the broker drop its ARI target all the way to 30c from 66c. It is thus of little surprise, with regards the rights issue, CIMB declares “we would not participate at 48c”.

Deutsche Bank is retaining Hold given the ARI share price is trading in line with the broker’s new target. JP Morgan is sticking with Neutral after dropping its target to 60c from 90c, “given the negative sentiment around iron ore”.

Morgan Stanley retains an Equal-weight rating on its own forecast of a US$90 iron ore price base case for 2015, while Goldman Sachs retains Neutral so far on a quick first look.
 

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