ARI (Arrium) : At Rock bottom, ore not?

[Snoopy]

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Emphasis of Matter - Going Concern

Without modifying our opinion above, attention is drawn to the directors assessment of going concern in note 1 of the financial statements. The matters outlined in note 1 indicate the existance of material uncertainty that may cast doubt on the ability of the group to continue as a going concern. and therefore the group may be unable to realise its assets and extinguish its liabilities in the normal course of business and in the amounts stated in the financial report.

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This in the audit business is what is known as 'tagging' the accounts. There was no such tag in the signing off of the full year FY2015 accounts six months earlier. So while the doom merchants have been calling doom for a long time, it seems events leading the fall into administration are quite recent.

The following paragraph has been copied and posted from Note 1 in HYR2016: (Note 1 is the long winded summary of accounting policy that no-one ever reads, but in this case should have been highlighted in bold as required reading). The auditors at least did their job in pointing to it:

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The Group has prepared detailed cash flow forecasts for the next 12 months, which incorporate continued actions to address going concern. The Group uses best estimate assumptions in the development of cash flow forecasts which include the use of independently sourced information for key assumptions. The Directors note, however, that some of the key assumptions underpinning the cash flow forecasts are inherently uncertain and subject to variation due to factors which are outside of the control of the Group.

This includes iron ore prices, South East Asian steel prices, the AUD:USD exchange rate and demand for the Group's products.

Key assumptions included in cash flow forecasts are:

1/ an iron ore 62% Fe price of US$44 for H2FY16 and US$45 for FY17,
2/ AUD:USD foreign exchange rate of $0.70 for H2FY16 and $0.69 for FY17 and
3/ a recovery in steel margins over the forecast period.

In the event that assumptions vary significantly from those forecast, the Group considers that it has options available to meet its obligations. These include divestment of significant businesses or assets and sourcing additional or alternate funding or terms from financiers.

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The 'alternative finance scenario' seems to have gone out the door with the binning of the GSO deal and the subsequent angering of the existing banking syndicate!

SNOOPY

[Snoopy]

Slide 8 of the Capital Raising presentation says that:

'Gearing' = (Net Debt) / (Net Debt + Equity)

If I use that definition with the data that I used in the previous post:

Interest bearing liabilities = $1,611.3m
Cash is $181.7m
Total Equity = $2,962.2m
Total Assets = $6,406.0m

then I get the following:

'Gearing' = ($1,611.3-$181.7) / ( ($1,611.3-$181.7) + $2,962.2) = 32.6%

This same percentage is later referred to as 'Statuatory Gearing', although the statute it is apparently linked to is not defined.

The above information relates to FY2014. Using the same method I have calculated the gearing as at EOFY2015, and crucially EOHY2016 (the last available balance date).

	Net Debt	Equity	Gearing Ratio
FY2014	$1,429.6m	$2,962.3m	32.6%
FY2015	$1,750.2m	$2,554.9m	40.7%
HY2016	$2,075.9m	$2,328.4m	47.1%

'HY2016' represents the position at 31st December 2015. Arrium has made a commitment to their banking syndicate to keep that gearing ratio below 50%. They weren't in breach of that covenant at the last balance date. But they look to be getting very close, and the trend that the above table demonstrates would not provide banker confidence!

SNOOPY

[Snoopy]

FY2015 (Actual)	Iron Ore	Mining Consumables	Recyclables	Steel	Total
EBIT	-$97.4m	$153.0m	-$2.4m	$-33.2m
EBIT (corporate)	-$4.0m	-$7.0m	-$4.9m	$-13.0m	-$8.9m
D & A	$187.6m	$49.2m	$10.7m	$95.0m	$350.2m
EBITDA	$86.2m	$195.2m	$3.4m	$48.8m	$333.6m
Net Interest Bill	-$18.8m	-$22.6m	-$11.1m	-$38.3m	-$90.9m
EBITDA/Interest	4.6	8.6	0.31	1.3	3.7
Tax Payable					-$37.0m
Net Interest Bill					-$90.9m
EBDA					$205.7m

The EBITDA/(Net interest Bill) covenant (> 3.0 to 3.5) is now lowering towards the upper end of the critical range (down to 3.7). Everything was still looking OK (from a cashflow generating perspective) at the EOFY2015 balance date though.

Arrium has agreed to a banking covenant that requires 'interest cover' greater than a level of 3.0 to 3.5 times. 'Interest cover' is based on 'underlying EBITDA' to 'debt service charges'. This equates to my EBITDA/(Net interest Bill) statistic calculated in the above table. There was no problem as at the June 30th 2015, Full Year Balance Date. But what about the interim balance date, of 31st December 2015?

The "EBITDA/(Net Interest Bill)" statistic is done on a rolling twelve month basis. This means I had to get the results for 2HY2015, and add those the latest half year period (HY2016) to get my 'annual picture', below:

HY2016 & 2HY2015	Iron Ore	Mining Consumables	Recyclables	Steel	Total
EBIT	-$6.8m	$216.5m	-$1.0m	$92.6m
EBIT (corporate)	-$4.8m	-$13.7m	-$8.5m	-$24.7m	$249.6m
D & A	$81.4m	$52.9m	$10.8m	$84.4m	$229.5m
EBITDA	$69.8m	$255.7m	$1.3m	$152.3m	$479.1m
Net Interest Bill	-$10.2m	-$17.9m	-$8.3m	-$29.8m	-$66.2m
EBITDA/Interest	6.9	14.3	0.2	5.1	7.2
Tax Payable					-$66.9m
Net Interest Bill					-$66.2m
EBDA					$346.0m

The interest bill is allocated in proportion to the 'end of the study period' balance of liabilities between divisions.

This result is interesting because it shows that underlying Arrium was very much on the road to recovery as a cash generator over the 1st July 2015 to 31st December 2015 period.

SNOOPY

[Snoopy]

This result is interesting because it shows that underlying Arrium was very much on the road to recovery as a cash generator over the 1st July 2015 to 31st December 2015 period.

Time to summarise the 'interest cover' covenant over the latest three periods of consideration.

	Underlying EBITDA (A)	Net Interest (B)	EBITDA/(Net Interest) ( (A)/(B) )
FY2014	$870.5m	$114.8m	7.6
FY2015	$333.6m	$90.9m	3.7
2HY2015 & HY2016	$479.1m	$66.2m	7.2

The main driving factor behind the changes in this table is what happened to the iron ore mining division.

	EBIT	Depreciation & Amortisation
FY2014	$481.3m	$204.6m
FY2015	-$97.4m	$187.6m
2HY2015 & HY2016	-$6.8m	$81.4m

FY2014 was the year in which the drop in the price of iron ore became precipitous. Nevertheless there were enough good months early on in the year to produce a respectable full year result. Andrew Roberts and his team produced an enormous loss in the first half of FY2015. This loss reflected the huge writedown in the value of iron or resources in the development pipeline. The Southern Iron resource became completely uneconomic and was mothballed.

The first full year period without Southern Iron was "2HY2015 & HY2016", which straddled the company's full year reporting periods. This is why the "DA' figure was so much lower for this period. There was a 'mega-devaluation' in the economically recoverable resource at the end of 1HY2015, resulting in a much lower 'DA' figure going forwards on the diminished book value of the remaining resource. While still (just) loss making at the EBIT level, there was a near $100m (actually $90.6m) reduction in the loss as a result of cost cutting measures on the supply side by Arrium management.

It come as a surprise to some. But Arrium looks to be generating more than enough cash to service their existing debts.

SNOOPY

[Snoopy]

'HY2016' represents the position at 31st December 2015. Arrium has made a commitment to their banking syndicate to keep that gearing ratio below 50%. They weren't in breach of that covenant at the last balance date. But they look to be getting very close, and the trend that the above table demonstrates would not provide banker confidence!

Now we have established that it is the overall Arrium debt that is the likely problem, it is only right to ask what that might be. Here is how Matthew Stevens summarised things on p28 of the AFR dated 8th April 2016.

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"The debt forgiveness required by the GSO plan would have seen lenders write off up to $1.5billion of the $2.8billion they are owed. With some justification the banks assessed this as an unnecessarily large and singular allocation of the cost of Arrium's recovery plan. So where might this pain be shared? Now there's the rub."

Arrium owes about $1billion in trade creditors , about $500m to employees and a large but uncertain amount to goverments in the form of future environmental remediation around Whyalla and the Middleback Ranges to the north of South Australia's steel city."

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Adding that lot up is a question of asking "How much change from $A5 billion dollars?" The rumour is that the worldwide tender process for Moly-Cop produced a highest bid of nearer to $1.5b, well below the value of Moly-Cop on Arrium's books. That is nowhere near enough to extinguish the bank debt. I will let Matthew Stevens from the AFR finish his summary:

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"Some banks are saying Arrium drew down $300m or so of bank funding from standing facilities in the weeks before the GSO deal, although Arrium denies this."

"Arrium's battle to defend the indefensible was not helped by the removal of about $800m of short term trade finance over the last nine months or so."

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SNOOPY

[Snoopy]

I admit now that I did not read the auditors statement at the end of the HY2016 results, which contained the following paragraph

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Emphasis of Matter - Going Concern

Without modifying our opinion above, attention is drawn to the directors assessment of going concern in note 1 of the financial statements. The matters outlined in note 1 indicate the existance of material uncertainty that may cast doubt on the ability of the group to continue as a going concern. and therefore the group may be unable to realise its assets and extinguish its liabilities in the normal course of business and in the amounts stated in the financial report.

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"Hey ho, hey ho, its down to the dole office I go." (song the Middlback Ridge Miners have been practising).

The following table shows the immediate before and after market reaction to three critical Arrium announcements.

Date	Event	Closing Share Price
20-01-2016		0.05
21-01-2016	4th Quarter Mining Report Released	0.04
22-01-2016		0.04
16-02-2016		0.06
17-02-2016	Half Year Results	0.05
18-02-2016		0.03
21-02-2016		0.02
22-02-2016	Announcement: GSO Restructuring Plan	0.02
23-02-2016		0.02

For those who cared to look (I didn't), the 4Q mining report contained information on a surprise sharply weaker quarter for mining. If anything, the half year report that covered the period of this mining report contained some quite favourable turnaround figures for both Steel and Mining Consumables. So I find it surprising that the largest negative share price reaction was saved until after the release of the half year report. Or perhaps it was only then that the number crunchers realised the leverage ratio covenant was within an ace of being broken? Personally, if I had calculated the leverage ratio on results release day (I didn't), I wouldn't have been overly concerned because I could see the cash generating position was turning around. But I guess sentiment drives the market in times of crisis.

Between the HY2016 results being announced and the GSO plan being announced, the Alan Gray Funds (collectively the largest shareholder) sold out completely. Alan Gray pumped their share holding on 9th February, as a prelude to rapidly selling everything by the end of trading on 22nd February That depressed the share price into the 1s. So by the time the vastly dilutive GSO deal was actually announced, the damage was done and the share price stabalised in the 2c range.

SNOOPY

[Snoopy]

'HY2016' represents the position at 31st December 2015. Arrium has made a commitment to their banking syndicate to keep that gearing ratio below 50%. They weren't in breach of that covenant at the last balance date. But they look to be getting very close, and the trend that the above table demonstrates would not provide banker confidence!

Below is an extract from the AFR dated 13th April 2016. It is the best summary I have seen on why the banks lost patience. I have emboldened the key points as I see them.

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Lenders 'incensed'

So what went wrong?

Well, Arrium's lending group appear to have spent the last month expressing ever-increasing levels of disbelief, anger and rejection at the management and chairman of the business now entering its second administration in a week.

The lenders were "incensed" by Arrium's decision to shop for a recapitalisation without the lenders' knowledge or consent. They were then left dumbfounded when Arrium went to market with a proposal that the company insisted had arrived only hours before it was introduced to the world on the ASX platform.

And then the Australian banks, in particular, were left "incandescent" when McGrathNicol's appraisal of the confronting proposal identified that GSO and Arrium management planned to close the Whyalla steelworks.

This potential fits comfortably with Arrium's public and private presentation of its crisis. The Arrium narrative is that it is a company of good and bad.

The good is a mining materials business called Moly-Cop that generates strong free cash flows and an east coast steel business built around two relatively modern electric-arc furnaces and steel-forming mills that make good money selling a variety of steel products to the construction industry.

Bad Arrium is also a character of two parts. There is the Whyalla steelworks and a South Australian iron ore mining operation. Arrium's people insist both are burning cash faster than Good Arrium can generate it.

But Arrium's lenders have become deeply sceptical of a narrative that would sustain the closure of Whyalla and the iron ore mines. That scepticism is apparently informed by a collection of expressions of interests in acquiring Arrium Steel that have been lobbed at the banks over recent weeks.

Apparently, the indicative numbers suggest Whyalla should be throwing off an EBITDA of $150 million instead of churning through cash it doesn't have.

For reasons that are pretty obvious, the banks view Whyalla as a non-negotiable in any Arrium work-out. The steelworks directly supports more than 2000 families in Whyalla. Each of them is a customer of an Australian bank. Most of those families would have mortgages, car loans and credit cards. The banks are keen that their lending continues to be secured by jobs.

Early signs of strain

So the steelworks must be kept open while its ability to earn itself a future is clarified. To that end, the banks are working with KordaMentha to deliver the liquidity necessary to sustain Whyalla through the opening stanza of administration and beyond.

Of course, the clarity of retrospection has identified earlier signs of strain between Arrium and its banks. As far back as June last year, the steelmakers' trade financiers began winding back on routine short-term liquidity.

But relationships soured further in August when Arrium, to amend and extend its existing covenant light, unsecured bank facilities. Arrium has lines of liquidity with 23 banks that are delivered through three individual syndicates. It is understood six banks, at least one of them Australian, returned the term sheets offered with a request to secure existing and future lending.

Arrium closed the negotiations.

One of the more obvious puzzles in the Arrium situation is how a routinely troubled business came to assemble such a substantial portfolio of unsecured debt. From the banks' perspective, the answer is simple. The Arrium that borrowed the cash boasted an investment-grade rating and borrowers with that standing can easily secure loans on unsecured terms.

As it turns out, the security boot was on the other foot just seven months later. We understand that within the last three weeks, with the banks making it plain they saw no value in the GSO deal, Arrium arrived with a request for up to $500 million in new funding and certainty against foreclosure for something more than three years. The terms offered included a proposal that would have secured past and future bank lending.

This time it was the banks that said "get lost". They felt they would be throwing good money after demonstrably failed management, and they assessed the offer of security over past lending would be rendered worthless if Arrium ended up in administration. And, by then, administration was exactly where the lenders wanted Arrium to be.

This point about layers of credit security in administration is yet another lesson we have learned through these early stages of Arrium's administration. While customer and banks might agree on terms that deliver security to existing streams of lending, the law simply does not recognise risk reassignment in situations like administration.

So Arrium was free to secure new credit by offering security. But changes to the standing of existing credit lines would just not cut the mustard in administration.

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SNOOPY

[Snoopy]

GSO and Arrium management planned to close the Whyalla steelworks.

Can I join some dots here? From the GSO restructuring proposal (my highlighting in bold).

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If the recapitalisation plan is implemented:

1/ GSO will provide up to US$927 million in funding to Arrium;

2/ Arrium’s debt will be significantly reduced, allowing the company to retain its world-class Mining Consumables business which continues to perform well. (This refers to the 45% debt haircut that GSO was proposing for existing lenders)

3/ Arrium will have funding to use towards turning around or restructuring its steel and mining businesses to make them more sustainable; and

4/ Arrium shareholders will have the opportunity to participate in a renounceable pro-rata rights issue.

The funding to be provided by GSO if the recapitalisation plan is implemented will comprise:

A new 6 year senior secured term loan of approximately US$665 million ($A924m at the exchange rate $A1 =$US0.72c)

A renounceable pro-rata rights issue to Arrium's shareholders to raise approximately US$262m which will be fully underwritten by GSO and/or a professional underwriter. These funds would primarily be used to retire outstanding debt (i.e. pay out existing debt at 55c in the dollar!) of the company at the time the recapitalisation is implemented.

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I am going to assume that the proposed equity injection was the minimum needed to keep the company viable, while ensuring almost all the benefits of any recovery went to GSO via interest payments from the proposed newly minted debt arrangements. I am also assuming that Arrium's own pre Voluntary Administration restructuring proposal combined with Moly-Cop growth would have been sufficient to just break even over FY2017.

The total debt funding package proposed by GSO in $A terms was:

$US927 /0.72 = $A1,287m

A proposed 45% haircut on Arrium's existing unsecured $A2,100m debt means that the debt would have reduced to:

(1-0.45) x $A2,076m = $A1142m

That means the difference:

$A1,287m - $A1,142m = $A145m(*)

is the 'hidden off balance sheet liability' associated with the shut down and remediation of the Whyalla steel works site, and any associated mediation and closure of the Middleback Ridge mines!

SNOOPY

PS (*) A few assumptions in this figure. By way of comparison Contact Energy booked an impairment charge of $NZ223m in relation to the closure of the Otahuhu power generation site in South Auckland. So I think my Whyalla figure looks ball park realistic.

[Snoopy]

The above information relates to FY2014. Using the same method I have calculated the gearing as at EOFY2015, and crucially EOHY2016 (the last available balance date).

	Net Debt	Equity	Gearing Ratio
FY2014	$1,429.6m	$2,962.3m	32.6%
FY2015	$1,750.2m	$2,554.9m	40.7%
HY2016	$2,075.9m	$2,328.4m	47.1%

'HY2016' represents the position at 31st December 2015. Arrium has made a commitment to their banking syndicate to keep that gearing ratio below 50%. They weren't in breach of that covenant at the last balance date. But they look to be getting very close, and the trend that the above table demonstrates would not provide banker confidence!

The total debt funding package proposed by GSO in $A terms was:

$US927 /0.72 = $A1,287m

A proposed 45% haircut on Arrium's existing unsecured $A2,100m debt means that the debt would have reduced to:

(1-0.45) x $A2,076m = $A1142m

That means the difference:

$A1,287m - $A1,142m = $A145m(*)

is the 'hidden off balance sheet liability' associated with the shut down and remediation of the Whyalla steel works site, and any associated mediation and closure of the Middleback Ridge mines!

We have identified overall company debt as the big issue. We have also seen that the potential closure of Whyalla triggers site remediation provisions which amount to hidden off balance sheet debt. Now let's combine this off balance sheet debt with the declared debt position as at EOHY2016 and see what happens to the gearing.

Not doing this calculation before was my mistake. Being a 'glass half full' kind of mutt, I did not consider any remediation costs should Whyalla and Middleback Ridge be completely shut down. I should have checked out this 'worst case' scenario :-(

'Gearing' = (Net Debt) / (Net Debt + Equity)

If I use that definition with the data that I used in the previous post:

Interest bearing liabilities = $20.2m + $2,359.3m +$145.0m = $2524.5m
Cash is $303.6m
Total Equity = $2,328.6m
Total Assets = $6,196.9m

then I get the following:

'Gearing' = ($2,524.5-$303.6) / ( ($2,524.5-$303.6) + $2,328.6) = 48.8%

That is creeping towards that critical 50%, yet still just within banking covenants. But have negative earnings over the second quarter for FY2016 pushed things over the edge? Our next point for investigation!

SNOOPY

[Snoopy]

'Gearing' = (Net Debt) / (Net Debt + Equity)

If I use that definition with the data that I used in the previous post:

Interest bearing liabilities = $20.2m + $2,359.3m +$145.0m(Whyalla remediation) = $2524.5m
Cash is $303.6m
Total Equity = $2,328.6m
Total Assets = $6,196.9m

then I get the following:

'Gearing' = ($2,524.5-$303.6) / ( ($2,524.5-$303.6) + $2,328.6) = 48.8%

That is creeping towards that critical 50%, yet still just within banking covenants. But have negative earnings over the third quarter for FY2016 pushed things over the edge? Our next point for investigation!

Thinking about the above calculation, if the Whyalla steelworks shuts, I may also have to reduce any on book asset value of Whyalla to zero. So is that book Total Asset value of $6,196.9m really accurate? If not, then shareholder equity might need to take another hit!

A few years ago, Arrium combined all their steel manufacturing plant and steel distribution business into one 'Steel' division. The steel distribution business is very much a going concern and should not be written down to zero. The great writedowns of FY2015 are detailed on p84 of AR2015. So has the Whyalla manufacturing plant already been written down, or not?

A clue may be found on p85 of AR2015, section 4D. Further up the page 'goodwill' of the Steel division is quantified. But in section 4D, the sensitivity analysis mentions only 'OneSteel Metal Centres'. We can take from this that no goodwill remains attached to the steel manufacturing plants, if that goodwill ever existed.

As at EOFY2015, the value of the 'Long Products Supply Chain Cash Generating Unit' is on the Arrium books at $831.2m, following a $177.1m write down. The $831.2m book value I believe includes the Whyalla steelworks and the The Rod Bar Wire Business (manufacturing bar and rod for the reinforcing market, merchant bar and rod feed for the wire industry with facilities in Sydney and Newcastle (NSW) and Laverton (Victoria)). The remanufacture of steel outside of Whyalla from recycled product is reportedly not under threat. There were no further steel asset impairments listed in the HY2016 report, despite the increasing effects of the dumping of overseas sourced steel into the Australian market. This confluence of facts would suggest to me that Whyalla is already fully written off in book value. If true that means my calculation in post 'Avenue to Administration 3.1' is roughly correct and needs no further adjustment.

But I am not clear about the on book value of Whyalla in the Arrium accounts.

SNOOPY