The Arrium board needs to steel itself

Arrium's bidders are playing a risky game by asserting they can fix the steel arm while offering to pay nothing for it. The board needs to look for at least double the current bid.

The Arrium board needs to be looking for at least twice the $1 billion, or 75 cents a share, that Posco and Noble Group are offering for their company.

If the bid succeeded at this price, the Korean consortium would be getting a global mining supplies business cheaply and an iron ore mine, port and national steel business for nothing.

It’s not well understood that Arrium is now mainly a company that is the world’s leading supplier of the balls for grinding mills. It’s a strong business that makes about $200 million a year profit from this and would be valued at 10 times that if it were standing alone.

But it is connected to a steel business that has been beaten up by the exchange rate, and an iron ore mine that is out of favour because of the recent fall in the iron ore price.

Posco and Noble Group’s early PR campaign in the battle for Arrium is focused around the steel business: they are arguing that they can save it.

Analysts stopped ascribing any value to the Whyalla steelmill and the steel distribution business in early 2011, when the company’s price slipped below $3 for the last time. It went below 70 cents in August this year, and thereby opened the door for Posco and Noble Group to launch their bid, because of the sudden drop in the iron ore price – nothing to do with steel.

The bidders are now playing an extremely risky game: at 75 cents a share they are not offering to pay anything for Arrium’s steel business, while at the same time asserting that they can fix it and make a profit.

Why are they doing that? Because they want the South Australian government and the Foreign Investment Review Board to think Arrium’s management will close down the Whyalla steelworks whereas they won’t.

It’s a fairly common problem for foreign bidders, the need to talk up what they will do for the politicians and the FIRB, while talking the business down for vendor shareholders, and in this game the dilemma is unusually sharp.

Posco and Noble need due diligence mainly because they don’t know for sure whether Posco’s patented Finex steelmaking technology will work at Whyalla, and more specifically, how much it will cost to install.

The Finex process involves making molten iron directly from iron fines and steaming coal, rather than iron ore and coking coal through a blast furnace, and the main benefit is that the plant is cheaper to build, as well as cheaper to run because you can use lower grade coal.

But Whyalla already has a blast furnace with at least ten years' life left in it, so the capital cost saving is irrelevant. The question for Posco, as new owner of Whyalla, would be whether the investment required to install Finex there – expected to be at least $600 million – would be justified by the lower operating costs from using lower priced coal.

Maybe it would, and maybe this new technique would save Australia’s steel industry, but Posco can’t be sure until it looks at the technical specifications of the blast furnace. The Arrium directors thus have something to sell: due diligence will require an indicative offer of more than 75 cents, and their recommendation, presumably, will cost more again.

The Arrium board will argue that Posco should pay something for the blast furnace, not to mention the rolling mills and distribution network.

Arrium is an important Australian-based and owned global business that has been laid low by the combination of a high currency and low iron ore price. Usually these things wouldn’t go together – the drop in the iron price should have brought the exchange rate down as well, but as discussed this morning (The RBA's interest rate kryptonite, October 3) the dollar is being held up by foreign direct investment, specifically the billions being spent on LNG plants in Queensland.

Because the dollar is still above parity, Arrium’s steel business loses money and is given no value by the sharemarket. But it is slightly better than cash break-even – in other words it’s not a cash drain, at least – and the company is saying it can keep going like this indefinitely, as long as the dollar doesn’t go much higher.

So even though analysts and investors can’t see the value in the steel business, chairman Peter Smedley and the board need to demand that Posco pays for it – they shouldn’t get it for nothing while picking up a global mining supplies business, plus a handy mine and port, on the cheap.

Follow @AlanKohler on Twitter

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