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Six firms in cyclical industries battle excess debt.
Economist Staff, The Economist
December 16, 2008
If A rollercoaster keeps cranking upwards for long enough it can be tempting to relax your grip—just for a moment. The bosses of some of the world's biggest basic-materials firms did exactly this and are now suffering. Lulled by expectations that industrialisation in China and other developing countries would ensure sustained demand, leading firms in the steel, cement and mining industries have entered the recession with far more debt than is normally viewed as prudent (see table).
Much of this reflects the ambitious acquisitions of 2006 and 2007. For the six leading firms reviewed by The Economist, cash spent on deals in those two years accounts for four-fifths of their total net debt of $136 billion. The steel industry's largest producer, the combined ArcelorMittal, has high gearing in part due to its cash-and-stock-financed merger, and the sixth-biggest producer, India's Tata Steel, is burdened by the leveraged takeover of its Anglo-Dutch peer, Corus. In cement, the world's biggest producer, France's Lafarge, bought Orascom Cement of Egypt, and the third-largest, Mexico’s Cemex, purchased Rinker, a big Australian rival. Xstrata, the mining industry's serial acquirer, is highly geared, and giant Rio Tinto has record debts thanks to its purchase of Alcan. Last month BHP Billiton, a rival mining firm, withdrew a stock bid for Rio, saying its debts and the difficulty of making disposals raised risks to an "unacceptable level".
Such concerns are mirrored in the prices of credit-default swaps (CDSs), a type of insurance against bankruptcy, which have risen to alarming levels for all six firms (see chart). For those who mistrust the volatile CDS market, other red lights are flashing. As in past recessions profit expectations have fallen savagely along with demand and prices. From their peak, analysts' forecasts of operating profits next year have dropped by 30-50% for all six firms, leaving less cashflow than expected to support debt. Share prices have plunged too, so that net debt is comparable to, or well above, the firms' market capitalisations. Borrowing levels that seemed manageable in the boom now look rather high. Might they even pose a threat to these firms' survival?
There are no quick fixes. Raising equity is tricky since investors have been sucked dry by capital-hungry banks. Dividend cuts would not help much: these firms sensibly stuck to stingy payout policies. Disposals could occur only at miserly prices, if at all, because most potential buyers have no access to funds themselves. Rio has abandoned plans to raise $10 billion from asset sales this year, for example.
That means the only option is to try to ride out the recession. But companies can do this only if they have enough liquidity (cash and undrawn bank lines) to refinance maturing debts. Relying on debt markets would be foolhardy: ArcelorMittal has managed to roll over some of its French commercial paper in recent weeks, but the prospects of being able to borrow large amounts on normal terms are bleak.
The good news is that all but one of these firms took a careful approach to structuring their debts. The exception, Cemex, has $8 billion of its $16 billion of net debt maturing in the next 18 months, according to Standard & Poor's, a rating agency, and only $560m of cash (excluding cash held as collateral). The Mexican firm is now trying to arrange a new debt package with a syndicate of banks.
The other five firms look more secure. None is in immediate danger of breaking its debt covenants. ArcelorMittal, Rio and Lafarge have sufficient liquidity to cover maturing debt for the next year or so. Xstrata and Tata Steel have two years’ worth of cover. The latter also has a "get out of jail free" card: $6 billion of its $10.7 billion of net debt sits in Corus and is not guaranteed by the Indian parent company. In extremis, Tata could walk away from its costly acquisition. (This month Corus asked for aid from the British government.)
These firms also still expect to generate cashflow, just much less of it. With their liquidity buying them some time, next year will be about squeezing the business until the pips squeak. The acquisitions all made industrial sense, so synergies should boost profits: Rio, for example, has so far made only about a third of the savings expected from the Alcan deal, and Tata Steel is about halfway through its programme. Beyond such synergies, both Lafarge and ArcelorMittal have recently launched new cost-cutting plans. The slump means inflated costs for equipment and raw materials are falling, while inventories can be run down. ArcelorMittal hopes to release $5 billion of working capital over the next six months, which would cut its net debt by 15 percent.
But in the fight to survive the biggest weapons are cuts in production and capital spending. ArcelorMittal has led the way on the former, with a reduction of output by one-third that even its chairman, Lakshmi Mittal, calls "very aggressive". The cuts to investment plans are as dramatic: ArcelorMittal, Lafarge and Cemex have sliced their budgets for next year by between one-third and one-half, and on December 10th Rio cut its planned capital expenditure in 2009 from $9 billion to $4 billion. Xstrata has yet to announce its plans but a 50% reduction is possible. For the six firms combined, this would mean a $15 billion boost in annual cashflow—equivalent to about 18 months’ worth of interest costs.
That, along with adequate liquidity for at least five of the six, makes survival likely. It also raises an intriguing question. The deals of recent years mean these industries are more concentrated and indebted than ever before. That in turn has forced huge, rapid cuts in actual and planned capacity, which could stabilise prices faster than in past downturns. It is a glimmer of hope during these bleakest of times.