Where Arrium went very wrong

What looked likely to be the first of a number of iron ore price-influenced capital raisings may well, because of its performance, turn out to be both the first and last. Arrium’s $754 million equity raising hasn’t gone well.

That’s an understatement. When Arrium announced the one-for-one issue on Monday it contained a $656 million accelerated renounceable entitlements offer and a $98 million institutional placement at 48 cents a share. The stock had been trading at 65 cents before the announcement and the theoretical ex-rights price was about 55 cents a share.

Today Arrium announced the institutional component of the issue had raised $367 million -- only about 79 per cent of the institutional entitlements were taken up. The rest were cleared in a bookbuild at 48 cents, so the institutions that renounced their entitlements get nothing. The placement raised the $98 million sought, taking the proceeds so far to $465 million.

Unsurprisingly in the circumstances, the Arrium share price crashed, falling to 40 cents. If it stays there the retail component -- about $290 million -- will be a debacle for the institutional sub-underwriters and be very painful for Arrium shareholders.

Arrium -- the company rather than its shareholders -- will, given that the issue was fully underwritten, get its money, de-leverage an otherwise over-leveraged balance sheet and significantly reduce the risk of its exposure to the iron ore price.

How could an issue from a well-regarded company, pitched at a 26 per cent discount to the pre-announcement share price, which shores up and de-risks its balance sheet so substantially, get trashed to the extent that the Arrium issue and share price have been trashed?

The larger part of the explanation appears to lie in what Arrium didn’t do, rather than what it has done.

It was only a month ago that Arrium produced a very solid set of full-year earnings numbers, with underlying net profit up 83 per cent to $296 million. Directors declared an increased dividend in what could have been taken as a sign of confidence in the outlook. In meetings with institutional shareholders after the result there were, apparently, no indications of any concern by the company about its balance sheet or prospects.

A couple of weeks later the investors have been hit with a 1:1 capital raising. They were blind-sided and, it appears, some of them were so unhappy they decided to boycott the raising. There may well be an emotional element to the institutional response. Arrium also has some quant or algorithm-driven institutions on its register, which wouldn’t have helped subscriptions to the raising.

If there were an emotional strain to the response, it might well have rational under-pinnings. If institutions felt they had been ambushed by the Arrium board and management it would influence their view of Arrium’s credibility and generate a loss of trust.

It might also lead institutions to ask themselves whether, by making such a big issue without any warning, the company was signalling that it knows or suspects or fears something that the market hasn’t been conscious of.

It should be pointed out that the big fall in the iron ore price -- at one point to just over $US80 a tonne -- has occurred just in the past couple of weeks. With $1.7 billion of net debt in their balance sheet, that alone would have caused the Arrium board to have abrupt second thoughts about the stability of their financial position if the price were to continue to plummet.

There may also be a strand of broader nervousness in the institutional reaction to the issue. China’s tweaking of monetary policy, the imminent vote on Scottish independence, the gradual drawing closer of the moment when US monetary policy starts to firm and a recognition that equity markets are priced aggressively mean that investors don’t need much of an excuse to keep their hands in their pockets.

Whatever the explanation, or explanations, the smashing of the Arrium share price is probably being exacerbated by some institutions dumping their holdings and by some shorting of the stock.

The more aggressive institutions know that unless circumstances change there’s likely to be a significant over-hang from the retail component of the raising that will eventually have to be off-loaded, although the retail offer is open for a month so there is time for the share price to recover.

It is conceivable that when the dust settles and long-only funds look at the opportunity to buy into a far more conservatively financed group, with strong and stable cash flows (about $200 million a year of earnings before interest, tax, depreciation and amortisation from its mining consumables business), and the option to significantly lower its iron ore production costs if necessary by shutting down the higher cost of its two mines, the price might stabilise. A lower Australian dollar should also help the earnings of both the consumables and iron ore divisions.

In the near term, however, there are going to be some angry shareholders and bruised directors, managers and sub-underwriters and a clear message to other companies considering capital raisings:  DON’T surprise the market.