Arrium's prudence gives it some breathing space

When Arrium blindsided the market with a $754 million equity raising last year, its share price was smashed and its board castigated. Without that additional capital, however, the group would now be in absolutely dire straits.

When Arrium ambushed the market with the raising, the iron ore price was above $US80 a tonne. With total cash costs within its iron ore business of around $AS71 per tonne, Arrium had some margin for error, but the margin was slim.

With iron ore prices today around the $US66 a tonne level and new supply still pouring into the market to weight on the price, there is no margin for error. Arrium's iron ore business is consuming cash rather than generating it.

The impact of the additional low-cost supply being added by Rio Tinto, BHP Billiton and Vale will maintain pressure on the price for the foreseeable future. Neither Arrium nor any of the other higher-cost iron ore producers can operate in the hope of a recovery in the price.

The equity issue was criticised on the basis that the Arrium board had given the market no warning and because of a perception that the board had been overly-conservative. Subsequent events support the view that, while the group might have managed the issue somewhat clumsily, the directors were prescient.

Arrium went into that raising with $1.7 billion of net debt. It was badly over-leveraged and, with net debt of $1.4bn today (the decline in the Australian dollar has added more than $200 million to the Australian dollar-denominated number), it remains over-leveraged.

The capital raising, an insurance policy against the continuing slump in iron ore prices that has actually occurred, has, however given Arrium the breathing space to implement plan B.

Arrium has two iron ore operations in South Australia, the Southern Iron and Middleback Ranges mines. Southern Iron is the smaller and significantly higher-cost of the two. It was always an option, which Arrium is now exercising, to shut down Southern Iron and focus on the lower-cost Middleback Ranges operation.

While Arrium's production will fall from around 13 Mtpa to about 9 Mtpa as a result of the decision to mothball Southern iron, and it will take a $1.33bn impairment charge driven mainly by that decision, it will end up with an iron ore business with cash costs about 20 per cent lower than today's, or about $57 a tonne.

The weakening Australian dollar helps. At $US66 a tonne the iron ore price translates to about $A82 a tonne.

Every one cent movement in the exchange rate directly impacts Arrium's earnings before interest and tax (EBIT) by between $9m and $12m a year, with a further indirect impact of about $8m to $10m. Arrium is highly leveraged, not just to iron ore prices, but to currency movements.

Middleback Ranges' ore attracts a 12 per cent discount to 62 per cent Fe ore, so at current prices it would generate revenue of about $A72 a tonne. With total cash costs of $A57 a tonne it would be solidly cash flow positive, with some upside from any further depreciation of the Australian dollar.

Arrium's steel business, and its leading mining consumables business, would also benefit from a lower dollar, with the group saying the consumables, or grinding media, business was generating higher volumes and earnings. Steel earnings in the December half were slightly lower than in the previous six months.

Group underlying earnings before interest, tax, depreciation and amortisation for the first half of the 2015 financial year were expected to be between $180 million and $190 million.

The restructuring of the iron ore business is expected to be completed by June, with the restructuring costs spread over the next several years because of the nature of the agreements Arrium has with Southern Iron's contractors. About $70m will be incurred this financial year.

Arrium had a brutal near-death experience in the first phase of the financial crisis, which would inevitably have left some scars on the corporate memory.

Last year's capital raising reflected the kind of conservatism and risk-aversion you'd expect that earlier experience to engender, while today's restructuring is the kind of decisive, albeit unpleasant, action required if Arrium is to avoid reprising that experience.