|Summary: While Arrium’s steelmaking division has been a loss maker, its iron ore mining operations are set to deliver a profit boost in the current year based on increased volumes. This is despite an overall drop in the average iron ore price. The $US exchange rate will also deliver an earnings windfall.|
|Key take-out: While an investment in Arrium could be rewarding, it should also be considered high risk.|
|Key beneficiaries: General investors. Category: Shares.|
|Recommendation: Outperform (under review).|
When Arrium was spun out of BHP in 2000 it was named OneSteel and was primarily a steel manufacturer and distributor.
Over time the company has diversified and reduced its focus on steel manufacturing, and in 2012 it changed its name to Arrium.
The steelmaking division has struggled recently and made a small loss last year. The iron ore mining division is performing well, and is positioned to have significantly improved results in the year ahead.
In the last financial year Arrium made an underlying net profit after tax of $168 million, of which $117 million was earned in the second half. This was based on iron ore sales of 4.9 million tonnes, an average iron ore price of $US137 per tonne, and an average $A/$US exchange rate of $US1.015.
By adjusting the second-half result for changes in iron ore price, iron ore volume and the exchange rate I am able to obtain a quick estimate of Arrium’s profit in the current year.
- $117 million – six month earnings for January to June 2013.
- Add $35 million – iron ore volume. Arrium has given iron ore production guidance of 12 million tonnes per annum from June 2013. This is a 22% increase on the last six months’ run rate, and therefore all else being equal will increase the iron ore mining division EBIT by 22%, or $35 million, for six months.
- Subtract $32 million – iron ore price. The iron ore price is down 4.5% to $US131 from the second half average price of $US137. If we assume it stays at about these levels, then there will be a $32 million negative impact due to the iron ore price.
- Add $60 million – exchange rate. The exchange rate has fallen significantly recently and is now $US0.933. Arrium guidance is for EBIT to increase between $13 million and $15 million per year for every one cent fall in the exchange rate. If we assume the midpoint of $14 million, then the EBIT impact due to the recent change in the exchange rate is $120 million for the full year, or $60 million for six months.
- Subtract $19 million – tax at 30% on additional earnings.
- $161 million – new net profit after tax estimate.
My new NPAT estimate for Arrium is $161 million for six months, or $322 million annualised.
The market capitalisation of Arrium is $1.7 billion, giving a price earnings ratio of approximately 5. Arrium looks cheap when compared to average price earnings ratios of 15 or more. This, of course, is based on the two main assumptions that the iron ore price, and exchange rate will not change from their current levels. A number of analysts are predicting that the iron ore price will fall in the short to medium term as additional iron ore supply outpaces demand.
My analysis also assumes that the steelmaking division continues to make a small loss. If this division can be turned around, then more upside is possible.
We know from history that the iron ore price is volatile, and while an investment in Arrium could be rewarding it should also be considered high risk.