Lessons from Arrium's mountain of debt

Once lenders starting offloading big parcels of debt, the writing should have been on the wall that struggling steel and mining group Arrium (ASX: ARI), formerly the BHP spin-off OneSteel, was seriously in survival mode. What added a certain air of inevitability to its recent decision to enter 'voluntary' administration was the sheer magnitude of its debt, and this should remind investors to watch balance sheets carefully.

Arrium does have strong cash flow relative to its reported profits and earnings per share (EPS) is expected to improve. Contributing to strong cash flow is its mining materials business, Moly-Cop which generates strong free cash flows and its east coast steel business which receives good underlying earnings from selling steel products to the construction industry.

Meantime, however, the company was haemorrhaging due to its basket-case Whyalla steelworks and a South Australian iron ore mining operation, and in the end bank lenders simply lost patience with its excessive debt.

Arrium has lines of liquidity with 23 banks, delivered through three individual syndicates, and early as June 2015, the stock's trade financiers were winding back on routine short-term liquidity, and this should have raised shareholder alarm bells.

Big red flags should be waved when a stock's debt exceeds its market cap. In Arrium's case back in October last year, when lenders started getting jittery, the stock's then debt of 1.9 billion was over seven times its then market cap of $254 million.

Fast forward to mid-April 2016, and the stock now has an intrinsic value of nil, and a share price $0.02. Even the stock's staunchest supporters should have finally cut their losses by late-August 2014 when the company began its rapid descent from $0.69 a share on the back of falling iron ore prices.

Post-mortems can be useful, but in reality the company had been in denial for some time, and what eventuated should have come as no surprise to anyone remotely interested in the stock's fortunes.

However, in Arrium's case forensic assessment seems hell bent on finding potential for irregularities within Arrium's accounts, which incidentally bank lenders have lost all confidence in, and the implications for Arrium's management and board are dire.

To avoid breaching its debt covenants in 2016 and beyond, Arrium also threw lenders' another bombshell when they learned it had shopped around for a recapitalisation without their knowledge or consent, only hours before letting the world know.

Lenders were gobsmacked at the substance and timing of a $US927 million ($1.2 billion) recapitalisation deal – funded by Blackstone's vulture fund, GSO Capital – which effectively required them to take a significant haircut.

What everyone wants to know now is whether Arrium was already knowingly on the verge of its cash flow crisis ahead of drawing down the $500 million of liquidity headroom available in existing lending lines.

Equally vexing for bank lenders was the decision reached by GSO and Arrium management that it simply made sense to close the steelworks, which directly employs more than 2000 families in Whyalla.

Thankfully, the banks are working with Arrium administrator KordaMentha to find the necessary liquidity necessary to keep Whyalla open for as long as possible.

It's cold comfort for Arrium shareholders, but the other great mystery is how a stock with such a troubled balance sheet should have been able to take on mammoth levels of debt and on such unsecured terms.

While there's no magic pudding that can save Whyalla, several global investors have expressed interest in acquiring and upgrading the steelworks.

Meantime, with Arrium now in the hands of its administrators, the stock hasn't traded for over a week.

Thankfully, by agreeing to go into voluntary administration, Arrium will at least let creditors recover as much of the debts owed to them as possible. The company has $303.6 million of cash and cash equivalents, and $2.4 billion of interest bearing loans against its name, with almost $2.1 billion of that being bank loans.

The stock is currently trading at $0.02, lightyears away from the $6.00-plus it was trading at mid-2008.

Shareholders need to wait for what's in store, but given that they're at the wrong end of the capital structure, and are unlikely to receive anything, selling and offsetting the tax loss this side of 30 June might be the only realistic option.