MARC DOWNGRADES RATING ON PERWAJA STEEL SDN BHD'S RM400.0 MILLION MMTN PROGRAMME to A-ID; OUTLOOK NEGATIVE

Feb 3, 2012 -
MARC has lowered its rating on Perwaja Steel Sdn Bhd’s (Perwaja) RM400.0 million Murabahah Medium Term Notes (MMTN) programme from AID to A-ID. The outlook on the rating is negative. The rating action, which affects RM160 million of outstanding MMTNs under the programme, is premised on the prolonged decline in the steelmaker’s operating performance and the rating agency’s expectation of deterioration in its leverage and cash flow coverage credit metrics as a result of incremental debt to finance capital expenditure on an iron ore concentration and pelletizing plant.

While Perwaja’s strategic initiative to integrate backwards into iron ore processing would likely contribute to better longer-term performance, MARC believes that the uncertain industry conditions and ongoing pressure on Perwaja’s profitability will make it difficult for the steelmaker to improve its credit measures to a level commensurate with its previously assigned rating within the next 12 to 24 months. This view is reflected in the negative outlook that MARC is maintaining on the rating.

The rating also reflects Perwaja’s vulnerability to decreases in upstream steel consumption and lower steel prices, its domestic market revenue concentration and its sensitivity to raw material price fluctuations, as evidenced by its lacklustre sales and reported losses for two consecutive years and the nine month period ending September 2011 (9MFY2011). MARC also acknowledges the financial support from Perwaja’s ultimate holding company Kinsteel Berhad (Kinsteel) which, together with reduced working capital requirements at the steelmaker, have helped to limit the deterioration in Perwaja’s financial profile and allowed the company to exhibit improved cash flow coverage measures in a challenging operating environment.

Perwaja is engaged in the production of direct reduced iron (DRI), a steelmaking feedstock, and semi-finished long products such as billets, beam-blanks and blooms. In recent times, Perwaja’s profitability has been adversely affected by the negative impact of an incomplete pass-through of raw material cost increases to steel product prices as well as lower demand for billets and DRI. For 9MFY2011, average iron ore and scrap prices have risen by 18.2% (2011: USD182/MT vs 2010: USD154/MT) and 20.5% (2011: USD493/MT vs 2010: USD409/MT) respectively while selling prices for both DRI and billets have only increased by 11.9% and 11.5% (DRI - 2011: USD469/MT vs 2010: USD419/MT) (Billets - 2011: USD652/MT vs 2010: USD585/MT) respectively. The pressure on margins was further exacerbated by increases in electricity and natural gas costs, causing Perwaja to report pre-tax losses of RM54.0 million for 9MFY2011. Prior to that, the steelmaker also posted pre-tax losses of RM67.8 million in FY2010 and RM140.4 million in FY2009.

Perwaja expects to commission the first phase of the RM230.0 million iron ore concentration and pelletising plant in 2012. The plants, which will have a total combined annual production capacity of 2.4 million metric tonnes when both phases are completed, are expected to substantially meet the steelmaker’s internal requirement of iron ore pellets. Total project costs will be mostly funded by new borrowings. MARC understands that Perwaja is also proposing a joint venture between the company and the Terengganu state government to mine iron ore with a view to obtain a regular supply of iron ore. Perwaja is banking on the successful implementation of these strategic initiatives to reduce its dependency on imported iron ore and exposure to volatile iron ore prices, and to realise production cost savings. In MARC’s view, these strategic initiatives are subject to moderate execution risk.

Perwaja has recorded losses for the two consecutive years and the 9MFY2011. Its gearing, as measured by its debt to equity (D/E) ratio, continues to be elevated on the back of these losses notwithstanding a slight improvement in total debt levels and equity base following capital injections. The steelmaker has been generating positive cash flow from operations (CFO) since FY2009 as a result of lower working capital needs in a weaker revenue environment. MARC notes positively the fund raising exercise by immediate holding company Perwaja Holdings Berhad (PHB) to raise RM280.0 million through the issuance of redeemable convertible unsecured loan stocks (RCULS) to Kinsteel for the working capital needs of Perwaja group. As of January 4, 2011, Kinsteel has made a RM70 million RCULS subscription payment to PHB, the balance of RM210.0 million to be paid by early February 2012. The RCULS issuance will address MARC’s earlier concern over Perwaja’s heavy dependence on short-term trade financing to fund its working capital needs.

Against the uncertain outlook in the domestic steel industry and slower-than-expected rollout of infrastructure projects in the country as well as continuing cost pressures, a return to profitability is not expected in the near term. Meanwhile, Perwaja’s debt-funded investment programme will likely make the company increasingly free cash flow negative, and place the steelmaker at increased risk of deterioration in its financial profile. MARC believes that Kinsteel’s ability to provide further financial support to PHB and Perwaja beyond the full subscription of its allotted RCULS in the next 12 to 24 months is limited.

The rating outlook could revert to stable if Perwaja’s operating performance improves over the coming quarters, and the company continues to retain an appropriate liquidity profile in addition to the ability to address its refinancing needs reasonably in advance.

Contacts:
Ahmad Gazzara Czillich, +603-2082 2269/ gazzara@marc.com.my;
Rajan Paramesran, +603-2082 2233/ rajan@marc.com.my.