Arrium Under Pressure

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-Cash consumption continues
-Activity, expenditure needs curtailing
-Limited support in current environment
 

By Eva Brocklehurst

Iron ore mining and consumables business, Arrium ((ARI)), has a dilemma. How to balance grade with volume and achieve the best cash outcome is the nagging question.

The closure of the Southern Iron operations is progressing and, while mining has ceased, Credit Suisse observes the operations continue to contribute negatively. Average grade, hence realisation of the 62% iron ore benchmark prices, declines as management seeks the best outcome in a rapidly changing iron ore market. Remediation, redundancy and contractor settlements will also continue into FY16.

The iron ore business appears destined to consume cash unless the Australian dollar ore price increases, or further cost reductions can be identified and implemented without materially compromising mine life and resource options, in the broker's evaluation. Moreover, the balance sheet recognises the capital invested in this business and this liability cannot be cut out by adjusting the way the iron ore asset value is treated, as was the case with the December quarter write down.

Management has acknowledged the iron ore price could fall further and has plans for future optimisation of Middleback Ranges production. Credit Suisse observes this could involve a further reduction in tonnage, or strip ratio adjustments which compromise mine life. Long-term iron ore supply contracts have rolled off so the business does have greater volume flexibility and there are no commitments extending beyond 12 months. What more can be done? The broker believes activity and expenditure can, and should be, cut, noting the projection for FY16 expenditure of $12m significantly exceeds the statutory $1m required to maintain leases.

The quarter disappointed Goldman Sachs. As the mining division is revamped, operating cash losses continue to grow, exacerbated by severe falls in the iron ore price. Mining exceeded shipments which were affected by poor weather, resulting in the building of stockpiles and higher cash burn. The broker believes Arrium will need to accelerate its optimisation program at the remaining Middleback assets to prevent these factors from being a drag on group earnings and cash flow.

Goldman retains a Neutral rating, as does UBS. UBS makes significant reductions to earnings forecasts and expects earnings per share losses in FY15-16. Such deterioration continues to pressure the already-stretched balance sheet and leaves little headroom for the company. UBS has reduced iron ore price forecasts by over 25% to US$50/t and US$48/t for 2015 and 2016 respectively. In large part these reductions reflect a peaking in Chinese steel production, resulting in forecasts of a global glut, as well as ongoing cost cutting by global producers. The upshot is a material adverse impact on the valuation of Arrium's mining business.

Market conditions are tough but some of the factors that could be controlled also went the wrong way for the company, in Macquarie's observation. The impact of delayed settlements in a falling price environment and lower ore quality resulted in the price realisation moving to 74% from 86%. Falling lump premiums also impacted price realisation. Stripping costs increased at Middleback but the company has signalled it is undertaking further assessment to improve efficiencies. However, this may mean further rationalisation costs and Macquarie does not dismiss the prospect of impairments.

Meanwhile, the balance sheet remains under pressure but, while the company is likely to move close to its covenants in coming months, the broker does not expect a breach. Still, market dynamics are likely to get worse before they get better. While Arrium has some offsets from its mining consumables business, the stock is likely to find limited support in the current environment, in Macquarie's opinion.

On FNArena's database there are five Hold and three Sell ratings for Arrium.
 

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