With a persistently high level of the Australian dollar and a weak domestic construction market, life has been tough for Australian steelmakers in recent years and their share prices have suffered.
Arrium, however, if you can excuse the expression, has more than one iron in the fire, as it has transformed from a pure steelmaker into a vertically integrated steel business, combined with a significant iron ore mining and export operation and a global grinding media business. This potentially provides the opportunity.
Having maintained close contact with Arrium, we are fully aware of its strategy and able to assess the underlying valuation of the businesses.
We appreciate the benefits that the business should be able to achieve from its ongoing mining expansion and also the cost cutting measures it is enforcing on its steel operations. With this knowledge, we put together a balanced valuation of the different components of the company and worked out the sensitivities to key variables, with the upshot that we assessed that the current share price underestimated the long-term value.
With a long-term assumption of resilience of the Chinese economy, given the levers the government has available to manage the investment and growth rate, we felt that the share price was being unfairly punished. Market concerns over the need for the company to refinance appeared exaggerated and sell-side analysts were taking a very short-term view. If one looked through the third-quarter iron ore price weakness and the culmination of the investment into the mine expansion, however, a return to healthy positive cashflows remained likely which would allow the shares to recover from their low price earnings multiple valuation.
The trust’s position in Arrium has been increased as the share price has weakened, effectively balancing the size of the position with the strength of view. When the share price fell sharply in line with the iron ore price in third-quarter we again spoke with management and reviewed our assumptions but stuck with our contrarian view, remaining committed to the position.
We were not surprised when a consortium led by the steel giant POSCO approached Arrium with an offer to buy the business in October and we were comfortable with the management’s decision to reject the opportunistic proposal. As Chinese economic numbers have proved resilient, however, iron ore prices have recovered from their lows and the shares now stand well above the suggested offer price.
Throughout our analysis we have also focused on the likelihood of the company continuing to pay dividends. While the payout was cut in 2011 we believe that distributions at the lower level will be maintained due to the management’s commitment to shareholders and the prospect of significantly improved cashflow in coming periods. This suggests that the company’s shares will yield more than 6 per cent, which would make a valuable contribution to the income of the trust.
Paul Hilsley is manager of the Legal & General Asian Income trust
