Arrium: A Wonderful Business Totally Underrated

| About: ACN 004 (ARRMF)
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Summary

Arrium is an Australian company active in ore mining and steel producing.

In 2013, Arrium had a loss due to impairment that equals about 40% of today's market capitalization.

6M 2014's profit alone gives a P/E of 8.7, and the company expects similar business in the second half.

Arrium has a debt-equity ratio of slightly below 1, and can afford to pay a dividend yield of 7%.

(Editor's Note: Investors should note the limited trading liquidity of ARRMF, and the inherent risks. Arrium's listing on the Australian Stock Exchange ARI.AX offers enhanced liquidity.)

Companies active in commodity sector are very prone to changes in the price of their products. In times of a bull market, those enterprises are seen doing very well and their share price rises tremendously. If bear market takes over, the effects are exactly the opposite. The whole sector will struggle, and companies with a bad financial structure might get into existential troubles. Recent examples for this can be found in the Australian mining sector. When the country's resource minister declared the end of the mining boom in Australia in 2012, stock prices of mining companies began to diminish. One example would be Arrium Ltd. (OTC:ARRMF), a company that is active in both the production/selling of iron ore and steel. Its market capitalization dropped by about 80%. One reason for this might be that the company had to impair a lot of goodwill (AUD1 billion) in a short time. Nevertheless, after this adjustment, the company is earning good money (profits of 6M 2014 alone give a P/E of 8.7) at a fantastic valuation that is close to total equity minus total goodwill. I think that this stock is extremely undervalued. All numbers mentioned in this article refer to Arrium's reports for 2013 and 6M 2014. (1AUD = 0.93$)

Overview

Arrium is an Australian company active in the mining and steel sector. Its history started when it was spun out from BHP in 2000 as OneSteel. At this time, it was almost entirely a domestically-focused steel manufacturer. Subsequently, Arrium has focused on growing its resource-based operations. Currently, the company has the ability to export about 13 million tones hematite ore per annum. Arrium employs roughly 10,000 employees. The company is listed on the ASX, with a market capitalization of about AUD1.8 billion.

The company has subdivided its operations in three groups:

Mining: This segment mines hematite iron ore and sells it to external customers and the segment Steel. Sites are located in South Australia. Mining also has its own export port facilities at Whyalla, with an annual capacity of 13 million tons.

Mining Consumables: This division sells key mining consumables (grinding media, wire ropes, rail wheels) to resource companies. This part of Arrium is the world's largest supplier of grinding media.

Steel: Here Arrium's steel operations can be found. In May 2013, Arrium combined its Steel Manufacturing and Steel Distribution businesses to form this unit. Some operations associated with recycling are also part of this division.

Annual Results 2013

Arrium's business year starts in July and ends in June. This means, numbers in this chapter cover the period between July 2012 and June 2013. Results for the second half of 2013 are also available, and can be found one chapter below.

Business year 2013 was ambivalent for Arrium. Continuing operations were slightly positive, but discontinuous operations led to a loss of nearly AUD700 million. I have summarized the most important numbers in the following table:

(all numbers in millions of AUD)

Sales decreased from 2012 to 2013 (3.7%), and cost of sales increased slightly (1%). Financial Expenses remained approximately equal, but a loss from discontinued operations led to a total loss of nearly AUD700 million for Arrium in 2013. Discontinuous operations refer to the non-integrated steel businesses, and I've summarized those numbers in the next table:

(all numbers in millions of AUD)

As can be seen, the huge loss can be attributed to impairment of goodwill in discontinuous operations. Arrium's board has decided to close some of its operations in the Division Steel, which led to the necessity of these huge write-offs. It should be noted that even without the write-offs, discontinuing operations are not running well (ignoring any depreciation: EBITDA of AUD160 million). This is also the reason why Arrium holds these assets for sale.

Results in continuing operations were much better. Segment Mining saw an increase in revenue of 19% compared to the year before. This rise can be attributed to a 32% increase in sales volume that was partially offset by lower prices. EBIT for business year 2013 was AUD249 million (previous year: AUD303 million). Reasons for the weaker profit can be found in the depreciation and amortization costs for Whyalla Port infrastructure. Sales revenue in Mining Consumables increased to AUD1,567 million. The division delivered an EBIT of AUD152 million. Total Steel revenue decreased in 2013 to AUD3,486 million. EBIT was negative, with a loss of AUD43 million. It is important to note that Arrium's total cash flow from operating activities was more than AUD590 million.

Interim Results 2014

As mentioned above, these numbers refer to the second half of 2013, and were published on February 18. After its annus horriblis 2013, things went much better for Arrium, with a rise in total sales of 7% compared to the period one year before, and a total profit of AUD220 million. I have summarized the most important numbers in the next table:

(all numbers in millions of AUD)

Although revenues were up 7%, costs of sales rose only slightly, which led to an increase of EBITDA of more than 100%. While results for 2013 were ruined by depreciation, total write-off in 6M 2013 was only AUD181 million. Half-year profit totaled to AUD220 million.

Segment Mining was running extremely well, with a revenue increase of 135% to AUD877 million. The reasons for this development are both increase in volumes and higher average realized prices for hematite ore. After completion of the expansion, the Whyalla Port has now an annual capacity of 13 million tones. EBIT rose to AUD324 million, up from AUD91 million. Arrium achieved a price of about $126/dmt at costs of $50/wmt (dmt/wmt referring to dry/wet metric ton, without and with moisture).

Revenues of segment Mining Consumables remained flat in 6M 2014 (about AUD787 million). Higher grinding media sales volumes were offset by lower sales to Australian rail wheel and mine ropes businesses. EBIT for the period was AUD76 million.

Once again, the segment that performed the worst was Steel. Reasons for this can be mostly found in the ongoing weakness of the domestic demand, especially constructions markets. Although revenues were down 7% compared to the period one year before to AUD1.43 billion, EBITDA remained flat at AUD30 million. EBIT was still negative.

An interim dividend of 6 cents per share was also announced. This interim dividend alone means a dividend yield of 4.65%. In its outlook, Arrium states that the company expects business to remain stable for the second half of the business year.

Cash flow for Arrium in the last 6 months of 2013 was AUD344 million, up from AUD175 million one year before. As the company was able to sell some of its assets held for sale, cash flow from investing activities was relatively low, with minus AUD92 million. Arrium paid back some of its long-term debt in 6M 2014: interest-bearing liabilities went down from AUD2,550 million to AUD2,180 million. Altogether, the company's cash decreased by AUD204 million.

On December 31 2013, Arrium had a balance sum of AUD7,921 million. With total equity of AUD3,877 million, the equity-to-debt ratio is 0.96. Goodwill/intangibles account for more than 25% of the balance sum (AUD2,046 million). Another AUD460 million refer to mine development expenditure.

If I take the profit from 6M 2013 and adjust it for tax benefits (related to Mineral Resource Rent Tax) of AUD20 million, I get an adjusted profit of AUD200 million. Arrium expects to have similar business in the second half of its business year, which would mean a total profit of AUD400 million. At today's market capitalization (AUD1,762 million), this means a P/E of 4.41, a fantastic value. Even a decrease of profit by 50% in the second half of the year would mean a P/E of 5.9. In the better of the two cases, Arrium would have a ROCE of 10.31%, in the worse one, 7.73%.

Arrium is also valued extremely cheap regarding its P/B: 0.45. Even if I subtract total goodwill of total equity, I get a number that is higher than today's market capitalization of Arrium.

Risks

Like any producer of intermediate goods/commodities, Arrium depends heavily on the situation of its customers. Currently, the most profitable division is Mining, that sells most of its products to PRC. At the moment, growth in demand is expected, but the situation could turn rapidly.

Arrium has still a great amount of goodwill in its balance sheet. If the company had to write it off for any reason, financial reputation and trust in Arrium could be harmed severely.

Another risk can be found in the nature of the company's operations: a natural disaster or a severe accident in one of the company's sites or production facilities could have devastating effects on Arrium.

Conclusion

An iron ore mining division and a steel making segment combined in one enterprise can be a great advantage, as synergetic effects can be used. It is also beneficial from another point of view: diversification. Most money is at the moment earned in Segment Mining. Division Mining Consumables is a sound business, while Steel still suffers from low demand in the domestic market. The board's decision to move away from being a pure steel producer has proven to be wise. The success of the strategy can also be seen in Arrium's stock price. After its lowest value in June 2013, there was a rebound of more than 70% to AUD1.3. Nevertheless, I think the company is valued extremely low at the moment. In 2010, when total earnings for one year were about AUD260 million, the company had a share price of more than AUD4 (although at much higher equity). And today, at earnings of AUD200 for six months, stock price should be only AUD1.37? (Number of shares is approximately equal.) Normally, no one would think twice if he had the opportunity to buy a stock at such a P/B and such a P/E. It is true that the strong dependency on the ore market and Chinese demand holds some risks. But I think they are more than outweighed by Arrium's tremendous opportunities. The board has shown that it is able to lead the company through hard times. I cannot think of any realistic situation where Arrium is worth less than today's market capitalization. I think any investor who will buy the stock today should be rewarded in the short term and in the long term.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ARRMF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.