Australia | Nov 03 2011
– Weaker iron ore prices impact on OneSteel's earnings
– Brokers cut estimates and price targets
– Lower earnings increase debt covenant risks
– Ratings downgraded to reflect uncertain outlook
By Chris Shaw
Management at OneSteel ((OST)) yesterday downgraded 1H12 earnings guidance, indicating net profit after tax for the period is now likely to be in a range of $55-$75 million. This is well below previous market expectations, as UBS for example had been anticipating an interim net profit of $112 million.
As RBS Australia points out, the reduction to earnings guidance highlights the negative side of OneSteel's vertically integrated model. Weaker iron ore prices in recent weeks have depressed export sales for the company but there has been no relief to the steel manufacturing operations from lower input costs as steel prices have also dropped.
The fall in iron ore prices has, according to RBS, been exacerbated by Chinese customers requesting contract prices be adjusted to closer to current spot market prices. This could result in some contracts paying 16-32% less in the current month on RBS's numbers.
This flows through to a significant earnings impact, as Deutsche Bank notes the iron ore operations of OneSteel represent around 86% of FY12 earnings. To account for the new guidance from management, brokers in the market have been quick to lower earnings estimates.
Deutsche Bank had already been 15% below consensus for FY12 but the broker has reduced estimates by a further 50% for the full year, while JP Morgan has lowered its base case numbers for the year by 32%. The FNArena database shows consensus earnings per share (EPS) for OneSteel now stand at 18.6c for FY12 and 32.4c for FY13.
One issue for OneSteel is if present iron ore pricing and steel making and distribution conditions continue for some time. As JP Morgan notes, such conditions would mean debt covenants will be tight by next June.
Deutsche Bank agrees, noting its revised estimates indicate an EBITDA/interest ratio of four times, which is close to the covenant estimate of 3-4 times. If iron ore prices remain under pressure there is further downside risk to earnings in the view of Deutsche, which would add to debt covenant pressures.
While it would likely take a bear case scenario to lead to a covenant breach in the view of RBS Australia, the lack of earnings visibility for OneSteel at present suggests even the possibility of a breach is likely to act as an overhang on the stock until iron ore prices recover.
This makes future iron ore prices important, and here the market has mixed views. UBS has revised its December quarter price forecast to US$136 per tonne fob, but expects a bounce back in 2012. The broker's March quarter forecast remains US$170 per tonne.
In contrast JP Morgan suggests there is support for iron ore prices around US$130 per tonne, though the broker does not fully discount the risk prices dip below US$120 per tonne over the rest of FY12 and into FY13. Deutsche Bank has taken a conservative route and factored in prices of US$120 per tonne for the rest of FY12.
On the back of revised guidance from OneSteel there have been downgrades to broker ratings, with RBS Australia cutting is recommendation to Hold from Buy and Deutsche Bank to Sell from Hold. The FNArena database shows OneSteel is now rated as Buy five times, Hold once and Sell once.
The Buy argument is a valuation one, JP Morgan estimating at current levels OneSteel is trading on an earnings multiple in FY13 of just three times, even allowing for an iron ore price of US$120 per tonne. UBS and Macquarie offer similar arguments in support of the stock.
For Deutsche Bank there is little scope for OneSteel to outperform in the current environment, especially as there is now a real risk of a capital raising to deal with debt covenant issues. This risk supports the move to a Sell rating.
RBS Australia takes the middle ground, while agreeing with Deutsche the shorter-term outlook for OneSteel is now much more uncertain than had been the case. While the stock should rally if iron ore prices recover, RBS sees better leverage from iron ore plays such as Fortescue Metals ((FMG)) and Atlas Iron ((AGO)).
The database shows a consensus share price target for OneSteel of $1.91, down from $2.10 prior to the update. Shares in OneSteel today are slightly higher and as at 11.20am the stock was up 0.7c at $0.992. This compares to a trading range over the past year of $0.985 to $3.06, the current share price implying upside of around 78% to the consensus price target in the FNArena database.
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