Iron Ore Bear Market Leaves Arrium With Low Bid: Real M&A

Iron Ore Bear Market Seen Dooming Arrium to Lowest Bid
Even after rising 37 percent this week, Arrium shares have remained below the bid price, reflecting traders’ concerns that there may not be a higher offer as iron ore heads for the worst bear market in two decades, said IG Markets Ltd. Photographer: Carla Gottgens/Bloomberg

Traders have become so bearish on the iron ore market that the industry’s most insulting takeover bid ever is seen as the best that Arrium Ltd. can get.

The Sydney-based company, which makes steel and mines iron ore, this week said it rejected a takeover offer of A$3.2 billion ($3.3 billion), including its net debt, from a group including South Korea’s Posco and Hong Kong-based Noble Group Ltd. The bid values Arrium at 0.71 times its net assets, cheaper than any iron or steel company acquisition of more than $100 million on record, and less than a third of the industry’s median deal valuation, according to data compiled by Bloomberg.

Even after rising 37 percent this week, Arrium shares remained below the bid price through yesterday, reflecting traders’ concerns that there may not be a higher offer as iron ore heads for the worst bear market in two decades, said IG Markets Ltd. Iron ore prices have already fallen by almost half from last year’s peak to $104.20 a metric ton. Arrium borrowed heavily to transform itself into a mining company and processor of iron ore, and now risks violating its debt covenants if the raw material averages less than $100 next year, according to Credit Suisse Group AG.

“This is highlighting how dire the industry is looking,” Stan Shamu, a market strategist at IG Markets in Melbourne, said in a telephone interview. “It’s an opportunistic bid, but such a low-ball offer makes the case for the fact that their prospects aren’t too great. With the current conditions, maybe that’s what it’s worth.”

Grinding Media

After Arrium yesterday raised its outlook for iron-ore exports this year, and Australia today said it may impose anti-dumping tariffs on some imported steel, the shares crossed above the 75-cent offer price for the first time.

Arrium rose 7.4 percent to 80 cents a share in Sydney, while steelmaker BlueScope Steel Ltd. gained 4.4 percent. At 80 cents, Arrium’s enterprise value is 0.74 times net assets, matching the cheapest valuation paid in any takeover in the sector, data compiled by Bloomberg show.

Steve Ashe, a spokesman for Arrium, declined to comment on the takeover attempt. Martin Debelle, a spokesman for the group of bidders, called Steelmakers Australia, also wouldn’t comment.

Previously known as OneSteel Ltd., Arrium was spun off by BHP Billiton Ltd. in 2000. A steelmaker that mined iron ore for its own needs, the company began exporting the raw material in 2005 after spending A$400 million to build a processing plant in South Australia.

With two purchases totaling almost A$3 billion, Arrium built its business making so-called grinding media, used to crush steelmaking materials into powder, including plants in Canada and Chile. Last year Arrium bought two iron ore projects in South Australia from WPG Resources Ltd. for about A$320 million.

Debt Burden

The company changed its name in July to reflect its increasing focus on iron ore.

Still, a slump in the price of the raw material hit mining profits while the steel business continued to struggle with high labor costs and a strong currency last year. Net income in the year through June plunged 75 percent, data compiled by Bloomberg show.

Arrium’s net debt of A$2.1 billion, or more than twice its market value, makes it particularly sensitive to languishing iron ore prices, said Tim Schroeders, who helps manage $1 billion at Pengana Capital Ltd. in Melbourne.

“If we go through a protracted period where prices don’t improve, or deteriorate further, it’s going to be difficult for the Arrium board to withstand a takeover,” he said in a phone interview. “It really puts the pressure on Arrium’s board to deliver improved earnings at a time when they’ve got to seriously consider what they’ll do with their balance sheet.”

Lowest Value

Mining accounted for about half of Arrium’s earnings before interest, taxes, depreciation and amortization in the year ended June 30, data compiled by Bloomberg show. Full-year profit fell to A$58 million from A$230 million a year earlier.

Posco, the world’s third-largest steelmaker, said in December that it had considered an acquisition of Arrium and decided not to pursue the deal.

With the shares down 56 percent in a year, Arrium on Oct. 1 said it received a takeover offer of 75 cents a share, or about 38 percent above its closing price last week. The bidder group also includes the National Pension Service of Korea and Korea Investment Corp.

The A$3.2 billion offer, including net debt, values Arrium at 0.71 times its book value, data compiled by Bloomberg show. That’s cheaper than any of the 70 other takeovers of iron and steel companies worth more than $100 million, data compiled by Bloomberg show. The median valuation for the deals was 2.64 times book value.

Price Cuts

The bid implied an enterprise value of A$1.7 billion for Arrium’s iron ore operations, or about 4.9 times the unit’s Ebitda of A$344 million last year, according to estimates from Morgan Stanley and data compiled by Bloomberg. That compares with a median of 5.8 times for 45 members of the Bloomberg Industries Iron Ore Mine Principal Index, including Atlas Iron Ltd. and Fortescue Metals Group Ltd.

While Arrium rejected the bid as too low, traders have so far proven unwilling to bet on a substantially higher offer, with the stock remaining below the offer price of 75 cents a share. The shares rose to within half a cent of that price yesterday, their highest since August.

Posco and Noble, which acquired Australian iron ore producer Territory Resources Ltd. in August last year, may be most interested in the iron ore assets, Morgan Stanley analysts Philip Bare and Shaun Lim wrote in an Oct. 1 research note.

China’s Growth

Arrium, which yesterday said it expects export sales to reach a rate of 11 million metric tons a year by June 2013, would give Posco enough supply to cover half its needs, the analysts wrote. That makes the outlook for iron ore critical to the company’s ability to extract a higher price from bidders, IG Market’s Shamu said, pointing to another deal where prices have been cut as circumstances deteriorated.

In August, China’s Sichuan Hanlong Group cut the price of its takeover bid for Australian iron ore mine developer Sundance Resources Ltd. by 21 percent. Sichuan Hanlong had agreed to pay A$1.36 billion to take control of Sundance Resources in October 2011 when iron ore prices were still at $171.30 a metric ton.

“There’s a realization that the growth that we’ve had is not going to be the same in the future, so we’re looking at lower prices and lower growth in iron ore volumes, and lower growth in steel-making volumes,” said Mathew Hodge, an analyst at Morningstar Inc.

Proven Wrong

Iron ore has slumped 46 percent from a record $191.90 a metric ton on Feb. 16 last year to $104.20 a metric ton yesterday, amid expectations that China’s demand for the raw material has peaked. While the 8 analysts surveyed by Bloomberg currently forecast that iron ore will average $137.50 a metric ton in 2013, the most recent of those estimates are all below the median and as low as $116 a metric ton.

If iron ore traders are proven wrong about China’s demand for steel, prices may rise sharply. The commodity will be higher by the end of the year and peak at $170 a ton by the end of 2013, said Justin Smirk, a commodity analyst at Sydney-based Westpac Banking Corp. Steel consumption in China is yet to peak, he said.

“We’re not talking about a major recovery in prices, but we are talking about prices coming through and strengthening in the next year,” said Smirk. “We think the Chinese economy is going to stabilize and improve.”

‘Skeptical Mindset’

Still, any deterioration in iron ore prices could leave Arrium in violation of agreements with its creditors. Iron ore must average over $100 a metric ton in Arrium’s current financial year for the company to “avoid covenant stress,” Credit Suisse analysts Michael Slifirski and Sam Webb wrote in a Sept. 5 report. That may prompt the need for a capital raising of around A$600 million, they estimated.

“They risk having the banks in the driving seat, but they don’t disclose what their covenants are, so it’s hard to say whether they will or they won’t breach,” Morningstar’s Hodge said in a phone interview from Sydney. “You can only guess, but it’s uncomfortable and they potentially risk a dilutive equity raising.”

While a recent weakening in the Australian dollar makes the steelmaking business more competitive, it also makes it more difficult for Arrium to repay some of its debt, Hodge said. Nearly three-quarters of the company’s A$1.8 billion of bank loans at the end of June were denominated in U.S. and Canadian dollars, according to the company’s 2012 annual report.

Uncertainty about the outlook for iron ore is keeping investors from betting that Arrium will be able to drive the takeover price much higher, said Shamu of IG Markets.

“In bull markets, when a company rejects a takeover, the price goes higher than the initial bid,” he said. “At the moment, it’s that skeptical mindset that investors have. This takeover seems to be reflecting current conditions and the uncertainty we’re facing.”

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