Arrium's insurance against an iron ore price plunge

Arrium directors are self-evidently very bearish about the outlook for the iron ore price, or perhaps just ultra-conservative, because the $754 million-plus equity raising announced today is effectively a massive insurance policy against the price continuing to fall.

Having had one near-death experience during the financial crisis, the directors presumably don’t want to chance their luck with a company now both leveraged to the iron ore price and financially leveraged.

With $1.7 billion of debt and a market capitalisation of less than $900m, the precipitous fall in iron prices over recent weeks towards $US80 a tonne threatened to severely destabilise the group.

With cash costs in the low $US70 a tonne range once transport costs are included and the option of scaling back or shutting down its higher-cost mine to bring costs down significantly, Arrium could have waited to see whether the iron ore price would stabilise.

However, it makes more sense -- and it is more prudent -- to raise capital before everyone knows you need it.

Arrium may be the first of the iron ore-price exposed companies to raise equity but it is unlikely to be the last, given the probability that the current pricing environment is unlikely to be short-lived. It may well deteriorate further given the rising tide of supply and the so-far limited response from China’s high-cost domestic producers.

The raising, which is underwritten, will help deal with the level of financial leverage in the group. While gearing doesn’t look overly aggressive at 31.4 per cent, Arrium is carrying $1.7bn of net debt. The raising will reduce that to about $976m and lower gearing to 17.9 per cent.

While Arrium does have some diversification within its cash flows -- it has a mining consumables business that generates solid and stable cash flows -- it is leveraged to the iron ore price and to the Australian dollar/US dollar relationship.

With iron production of about 13 million tonnes a year, a $US1 a tonne movement in the iron ore price would impact its earnings before interest and tax by about $15m. A US1c movement in the Australia dollar would affect EBIT by closer to $20m. With the Australian dollar finally starting to slide, it will help mute the impact of the dive in iron ore prices.

In fact, the impact of a weaker dollar would be greater given the consumables business has North and South American operations generating US dollar revenue and earnings.

Arrium has two iron ore operations in Australia, the Southern Iron and Middleback Ranges mines in South Australia. Southern Iron is much higher cost than Middleback and therefore its production could be dialled down or mothballed if Arrium wanted to lower its production costs.

At the moment, cash costs (excluding capitalised costs, depreciation, royalties, marketing and administration costs) are running closer to $48 a tonne. Arrium could lower that into the high $30s a tonne if it shut down Southern Iron, so it has a safety valve if it needs one. It is, in any event, focused on lowering costs further.

Arrium directors and their advisers were no doubt acutely conscious of the likelihood that some shareholders aren’t going to be pleased at being asked to contribute to such a large one-for-one issue.

The issue is renounceable, with provision for retail rights trading, and at 48 cents per share has been priced at a 26 per cent discount to Friday’s 65 cent closing price and a 40 per cent discount to the three-month volume-weighted average price.

The fact that it is fully underwritten means that regardless of the shareholder attitude towards the issue, Arrium has secured the capital to tide it through what could be a difficult couple of years before the market for iron ore finds some level of balance between supply and demand.