ESSAR STEEL ALGOMA INC 0064A
December 23, 2012 - 7:47pm EST by
eal820
2012 2013
Price: 88.00 EPS $0.00 $0.00
Shares Out. (in M): 1 P/E 0.0x 0.0x
Market Cap (in $M): 1,116 P/FCF 0.0x 0.0x
Net Debt (in $M): 1,116 EBIT 0 0
TEV ($): 1,116 TEV/EBIT 0.0x 0.0x

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  • Canada
  • Steel
  • Commodity exposure

Description

Investment Thesis (all figures in $Canadian)

The Essar Steel Algoma Senior Secured First Lien bonds provide a compelling investment opportunity. The company’s ABL is even more attractive but harder to source. The opportunity is available for at least 3 basic reasons:

1)     General over supply and therefore pricing pressures in the global but specifically North American steel market

2)     Indalex: Canadian appellate court ruling which has caused turmoil in the Canadian ABL market and forced the company to come to market with an extremely expensive ABL several months ago. Once the Supreme Court rules on Indalex (expected by end of 2012, early 2013), it should remove a major overhang on the company’s capital structure and enable it to refinance at market levels (saving ~$20mm in interest payments a year off of current run rate levels).

3)     Recent quarter – the company had an awful second fiscal quarter (quarter ending 9/30/12; company is 3/31/12 FYE). The company printed negative EBITDA and had “missing” volume of about 100K which scared the investor community. The miss, combined with a perceived overall tight liquidity profile led analysts to downgrade the firm’s capital structure to Sell making the argument that the company would run out of liquidity (and be forced into a CCAA proceeding at some point in 2013).

 

Buying the Senior Secured Notes at current price of 88 provides a 16% YTM. Creates the company at 5.9x LTM EBITDA through the ABL and Senior Secured Notes (face; 5.5x at current prices).

Buying the ABL at 98-99 with an assumed 102 call in September 2013 provides an extremely safe 11-12% yield (why it is so safe is described below).

 

Company Overview

Essar Steel Algoma is a Canadian producer of steel products. The company is based on the Great Lakes in Sault Ste. Marie, Ontario. The company produces Flat products, specifically, Sheet and Plate and is the only producer of Plate in Canada. Plate is a more value add market than Sheet and there are fewer competitors operating in the plate market across North America. Current product mix is approximately 80-85% Sheet (lower priced and lower margin) and 15-20% Plate (higher priced and higher margin).

The major end-users of ESA’s sheet products are the automotive industry, welded pipe manufacturers, hollow structural product manufacturers and the light manufacturing and transportation industries.

The major end-user of plate products is the fabrication industry, such as in the construction or manufacture of railcars, buildings, bridges, off-highway equipment, storage tanks, ships, armored products for military applications and large diameter pipelines.

The company was acquired by the Essar Group (“Essar”), a multi-billion dollar privately owned Indian Conglomerate but which has various subsidiaries, some of which are publicly floated and some which have public debt such as Essar Steel Algoma. Essar has operations worldwide spanning Energy, Steel, Infrastructure, Shipping, Telecom and other industries.

Essar acquired Essar Steel Algoma (“Algoma”) in June of 2007 with an initial equity investment of C$530mm. Essar highlights that it injected an additional C$262mm into the company through its acquisition of select Cogeneration assets from Algoma but we would note that they paid fair value for those assets which were transferred to another Essar subsidiary so we do not view that as a pure equity investment into the business.

Brief background on Steelmaking:

There are two basic methods for making steel – 1) the older method and more common method worldwide is known as the Integrated method which involves taking in Met coal (converted to Coke), Iron ore, a little metal scrap and utilizing a Blast Furnace to create the steel. Leading North American players in the Integrated space include US Steel, Arcelor Mittal, AK Steel and Essar Steel Algoma. 2) The more recent method to making steel is produced at what are called mini mills. Mini mills employ the EAF (Electric Arc Furnace) process which rather than using the raw Iron Ore generally uses scrap metal to “recycle” the iron content into readily useable steel. The EAF method is viewed as low cost relative to the integrated method. While integrated players are exposed to raw material fluctuations in the prices of key inputs such as iron ore and met coal, the mini mill producers are primarily exposed to the price of scrap.

Relative to other integrated players, Algoma is a low cost producer. Since the acquisition in 2007, Essar has engaged in cost cutting initiatives in its operations eliminating C$55/ton in cost. The Company owns and operates a state-of-the-art Direct Strip Production Complex (“DSPC”) line that converts liquid steel directly into coil. The technological combination of casting, reheating and rolling, results in lower production costs as compared with traditional slab casting and rolling operations. In simplified terms, the DSPC process enables the company to avoid a step employed by competitors which wait for the liquid to cool and harden before rolling. Algoma is able to take the hot liquid and convert it into sheet directly. As a result, the DSPC line is one of the lowest-cost North American mills in terms of hot-rolled coil (“HRC”) conversion cost per ton.

The company claims it is within the second quartile of the North American cost curve compared to peer North American steel plants (not clear if looking just at Integrated players or including mini mills as well). In any event, importantly, the company notes that there is approximately 50mm tons of production capacity which is higher cost than Algoma’s operations. The company has outperformed peers (primarily comps itself against AK Steel and the HRC segment of US Steel. Algoma has achieved higher EBITDA margins and EBITDA per ton over most of the last 8 quarters).

 

The company’s asset base includes two blast furnaces (one of which - #6 – is currently idled) with total production capacity of 4.3mm tons and 4mm tons of rolling capacity. The functioning #7 blast furnace has capacity of 3mm tons and the company targets approximately 650K of production volume a quarter, annualized to approximately 2.6mm tons. On 3mm of capacity, that implies capacity utilization in the high 80% range. This is notable, especially as compared to the overall industry which is currently operating in the low 70% range (and even dipped below that in recent months). Because it has relatively small volume compared to the North American market and only operates one plant, it can benefit from fixed cost operating leverage as it is able to run at higher utilization levels and still generally find a home for its product without impacting the overall supply and demand balance in the market.

 

Raw Materials:

The company sources its coal and iron ore material needs through long standing relationships with suppliers. In particular it has a long term contract in place with Cliffs for the supply of its Iron Ore needs. The company requires approximately 1.4x tons of Iron Ore pellets for every ton of steel it produces. This contract was entered into in 2002 and has proved to be a thorn for the company. Cliffs is a high cost producer of Iron Ore. Neither company will disclose the nuances or formula used to calculate the price of the Iron Ore which Algoma purchases (in contrast to AK Steel which while the company has horrible disclosure on just about everything else, is fairly clear in laying out the pricing mechanism by which it acquires Iron Ore which is based on a lagged calculation off of the IODEX). The company also has a coke battery which it uses to produce the vast majority of its coking needs, looking to the spot market when necessary. In terms of Iron Ore, the company believes that over the last 5 years, it has had a $23/ton disadvantage relative to the rest of the North American market. I have pressed the company on this (as certain data does not support this) but given the opaque nature of pricing in general, it is difficult to assess the extent to which the company is at a disadvantage due to its Cliffs contract.

 

Brief Overview of Industry Dynamics

Focusing here on the flat side (more exposed to industries such as Auto) than the Long side (more construction oriented): Not much to say except that it is pretty much well accepted that the global steel industry is suffering from over capacity which has put pressure on global pricing. I have listened to various global conference calls on the steel industry with roundtables in which analysts covering local steel markets (i.e. Europe, China, Japan, North America) all chime in and the sentiment is consistent – there is too much supply. The extent to which supply hampers pricing is somewhat offset by demand. On a relative basis, North American demand, driven by the strength of the auto and other industries has been stable as of late. The US market, however, suffers from recurring mini cycles in which prices rise, the gap between pricing in the US and Europe gets north of $100 (generally the point at which the difference matters), leading to increased imports which floods the US market and puts pressure on pricing. Pricing gets pressured down to a point where it comes close to the break-even point of the mills, reducing the difference between domestic and foreign pricing and leading the mills to raise prices. This has happened at least twice in 2012. This is one explanation for the pricing moves we have seen (other explanations factor in scrap pricing as key drive and the explanations are not mutually exclusive. On the scrap side, pricing which was strong and north of $700 per ton for benchmark HRC in early 2012 was pressured throughout the first half of 2012 as Turkey, a major importer of US scrap for its own steelmaking, reduced its demand for scrap leading to higher scrap availability in the US. The higher scrap led to lower scrap prices which reduced the cost of production for the mini mills and in an over supplied market, led to lower pricing). There are anti-dumping provisions in place in the US which prevents China from dumping many grades of low cost steel (or steel produced at a loss) into the US market.

 

Currently, pricing on benchmark HRC has rebounded from the sub $600 per ton seen in October and is now in the ~$630 context. This pricing though is still too low for most companies, especially the Integrated (higher cost) players to operate with sufficient profitability. A company like Algoma, however, is well positioned relative to comps given where it sits on the cost curve.

 

Historical Financial Performance

Here is a brief summary of the company’s financial performance and key operating metrics:

Summary   Financials 3/31/09 3/31/10 3/31/11 3/31/12 LTM          
Total Sales 2,548 1,409 1,768 2,160 1,973          
% growth - -44.7% 25.5% 22.1% -          
Operating Income 70 (218) (291) 106 (79)          
Plus D&A 222 215 213 187 188          
GAAP Adj. EBITDA 292 (4) (78) 293 109          
% Margin 11.5% -0.3% -4.4% 13.6% 5.5%          
Plus "Exceptional   Items"* 162 54 19 (11) 16          
Adj. EBITDA 453 50 (59) 282 126          
% Margin 17.8% 3.5% -3.3% 13.1% 6.4%          
EBITDA/Ton ($) $176 $22 ($25) $108 $51          
                     
Quarterly                    
  6/30/10 9/30/10 12/31/10 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12 6/30/12 9/30/12
Total Sales 476 470 437 386 566 564 506 524 532 411
% growth - - - - 19.0% 20.0% 15.8% 35.7% -6.0% -27.1%
Operating Income 22 (33) (200) (80) 61 61 (24) 8 2 (65)
Plus D&A 53 52 50 58 48 44 47 48 48 45
GAAP Adj. EBITDA 75 19 (150) (22) 109 106 23 56 50 (20)
% Margin 15.7% 4.1% -34.4% -5.6% 19.2% 18.7% 4.5% 10.7% 9.5% -4.8%
Plus "Exceptional   Items"* (10) (9) 108 38 0 (19) 8 0 4 5
Adj. EBITDA 65 10 (42) 16 109 87 30 56 55 (15)
% Margin 13.7% 2.2% -9.7% 4.1% 19.2% 15.4% 6.0% 10.7% 10.3% -3.7%
*Adds back $108mm in 12/31/10   quarter stemming from Cliffs arbitration                    
EBITDA/Ton ($) $106 $17 ($67) $30 $170 $129 $48 $86 $85 ($28)
                     
Operating Statistics: 3/31/09 3/31/10 3/31/11 3/31/12 LTM          
Revenue Breakdown                    
Sheet & Strip 1,638 1,009 1,224 1,513 1,362          
Plate 725 235 369 465 434          
Freight 134 116 127 141 133          
Non Steel Revenue 52 50 48 41 44          
Total Sales 2,548 1,409 1,768 2,160 1,973          
                     
Shipments (000 Tons)                    
Sheet 2,022 1,917 1,989 2,147 2,050          
Plate 530 299 398 448 427          
Slab 21 8 0 3 0          
Total 2,573 2,224 2,387 2,598 2,477          
                     
Additional Operating Stats                      
Steel Shipments     2,387 2,598 2,477          
Steel Revenue     1,720 2,119 1,929          
Cost of Steel Products Sold   (excluding amortization)     1,732 1,762 1,760          
Average Net Sales of   Realization of on Steel Sales (excluding Freight)     667 761 NA          
Cost per ton of steel   products sold (excluding amort, freight, & exceptional items)     664 628 NA          
                     
Quarterly 6/30/10 9/30/10 12/31/10 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12 6/30/12 9/30/12
Revenue Breakdown                    
Sheet & Strip 338 327 297 263 406 403 341 363 353 304
Plate 94 97 91 87 111 115 116 123 123 71
Freight 34 31 36 27 34 38 34 35 35 30
Non Steel Revenue 10 16 13 10 15 9 15 3 20 6
Total Sales 476 470 437 386 566 564 506 524 532 411
Sheet Sales                    
Tons (000) 514 517 523 435 536 563 522 526 525 477
Sales (C$m) $338 $326 $296 $263 $406 $402 $341 $363 $353 $304
C$/Ton $658 $631 $566 $605 $757 $714 $653 $689 $673 $637
Plate Sales                    
Tons (000) 99 101 106 92 $104 108 114 122 120 71
Sales (C$m) $93 $97 $92 $87 $111 $114 $117 $124 $123 $71
C$/Ton $941 $965 $866 $943 $1,068 $1,053 $1,023 $1,013 $1,027 $1,000
                     
Shipments                    
Sheet 514 517 523 435 536 563 522 526 525 477
Plate 99 101 106 92 104 108 114 122 120 71
Slab 0 0 0 0 1 2 0 0 0 0
Total 613 618 629 527 641 673 636 648 645 548
                     
Additional Operating Stats                 *  
Steel Shipments NA 618 630 527 641 674 635 648 645 548
Steel Revenue NA 454 424 377 551 555 491 522 512 405
Cost of Steel Products Sold   (excluding amortization) NA 415 447 386 426 434 453 448 448 410
Average Net Sales of   Realization of on Steel Sales (excluding Freight) NA 686 616 664 807 768 719 750 739 685
Cost per ton of steel   products sold (excluding amort, freight, & exceptional items) NA 636 654 610 611 616 648 637 640 695

A rough breakdown from the company’s provided cost breakdown for FY 2012 (FYE 3.31.12):

COGs    RM=Raw Material
Fixed 24%  
Energy 8%  
Scrap 9% RM
Purchased Coke 2% RM
Alloys 6% RM
Coal 16% RM
Iron Ore 30% RM
Other 5%  
 Total 100%  
Raw Materials as % of Total 63%  

While people often focus on the Integrated players as being high fixed cost (relative to variable), Algoma’s explicitly breaking out its cost structure indicates otherwise (i.e. variable costs approximate 63% of the total cost per ton). Other companies give very little to no breakout of their cost structure which makes the insight from Algoma extremely telling.

 

Capital Structure

The company currently has an expensive capital structure which stems in part from the ABL it brought to market in September of 2012. Here is the current capital structure of the company:

LTM   EBITDA 126              
Capital Structure as of: 9/30/12   Currency is Canadian   Dollar   Cumulative  
              Mkt Debt/LTM Ann Int
Security Notional Price Market Coupon Maturity Yield to Mat EBITDA Cost
Secured Debt                
ABL -New $344 99 $341 8.750% 9/20/2014 9.4%   30
9.375% Senior Secured Notes* $393 88 $346 9.375% 3/15/2015 16.0%   37
Total Secured Debt $737 5.9x $687       5.5x 67
9.875% Senior Notes $378 70 $265 9.875% 6/15/2015 27.3% 8.0x 37
Total Debt** $1,116 8.9x $952       8.0x 104
less Cash $90              
Net Debt $1,025 8.2x            
Pension Deficit $346 As of 3/31/12 - (9/30/12   BS: $392.7mm)      
OPEB Deficit $490 As of 3/31/12 -  (9/30/12 BS: $536.4mm)      
Pension Adjusted Valuation $1,862 14.8x            
*First lien on all other   assets (outside of AR/Inv); Second lien on AR/Inv                
**Excludes   $25.5mm in Unamortized financing costs, premiums and/or discounts etc.   (Meaning using Gross Number - Par)          

Note: assuming a 102 call in September 2012, the ABL YTC is in the 11-2% range

The ABL is secured by a first lien on Ar/Inventory and second lien on other assets whereas the Senior Secured Notes have a first lien on substantially all of the company's tangible assets and a second lien on the Ar/Inventory. There is minimal additional secured debt capacity (~$25mm per the terms of the Senior Secured Notes). The ABL which was refinanced in September of this year has a LIBOR floor of 1.25%, floating rate of L+750 (leading to coupon of 8.75% in current low LIBOR environment). The ABL was effectively structured as Term Loan as traditional ABL lenders were not interested in the structure so it was fully drawn at the refinancing putting excess cash on the company’s balance sheet (and therefore higher cash interest expense). If availability under the borrowing base is less than the amount outstanding, the ABL must be repaid with payments providing for a permanent reduction in the ABL facility size. The ABL is callable after one year at 102 and given the onerous pricing terms (as well as lower than possible facility size) which characterizes the ABL, the company plans to refinance at the one year mark.

 

Why is the company bound by such an ABL?

The answer to why the company had to come to market with such harsh ABL terms stems from an appellate ruling in the Canadian court system in which a judge ruled regarding the prioritization of pension claims in the context of a CCAA proceeding for a company called Indalex.

 

In Indalex, the appellate court ruled that the two pension plans which the company had, had priority over the DIP loan which had been extended in the bankruptcy. The ruling is a great read and at the risk of oversimplifying a complex legal issue went as follows:

The judge made two novel claims. The first was that a wound up pension plan (related to one of the plans) has the status of a Provincial Deemed Statutory Trust. Prior thinking was that only the amount that was due but not paid had this status but the judge took a novel interpretation of the PBA (Pension Benefits Act) which granted this status to the entirety of the deficiency (i.e. underfunding) of a wound up pension plan. The judge did not give a formal opinion on the status of a non-wound up pension plan and instead looked to what she called a Constructive Trust to grant a similar priming status to the non-wound up pension plan. The core of the Constructive Trust argument was that Indalex as both plan administrator and as debtor/company which had debt had to wear two hats and look out for the interests of the debtors as well as the pensioners. Management failed to protect the interests of the pensioners and therefore the company’s claim (in this case, a related entity had guaranteed the DIP so was actually coming to collect on the subrogated DIP claim) should be subordinated to the full pension claims (including the non-wound up plan). In certain senses, this resembles equitable subordination in the US bankruptcy system.

 

The latter point, namely the use of Constructive Trust is local to Indalex where management acted in bad faith. The more relevant take away was the judge’s ruling that wound up pension plans had Deemed Statutory Trust status.

 

So who cares? What does it mean to be a Provincial (stemming from local Ontario law as opposed to federal law – akin to a state driven legal ruling) Deemed Statutory Trust. Essentially, a deemed trust has priority with respect to Accounts Receivable and Inventory. The potency of this priority stems from the Personal Property and Security Act in Canada (akin to the US UCC). In the PPSA, Section 30(7) states with regard to Deemed Trusts:

“A security interest in an account or inventory and its proceeds is subordinate to the interest of a person who is the beneficiary of a deemed trust arising under the Employment Standards Act or under the Pension Benefits Act.”

http://www.e-laws.gov.on.ca/html/statutes/english/elaws_statutes_90p10_e.htm#BK42

It is crucial to note that the provisions of the Pension Benefit Act only applies to Registered Pensions which excludes OPEB so the underfunded OPEB claims in CCAA cases (and especially in the case of Algoma which has a material underfunded OPEB as outlined above) do not have the benefits of characterization as a Deemed Statuary Trust.

What does it mean for ABLs?

As this ruling directly targets the basic collateral by which ABL’s are structured, namely Accounts Receivable and Inventory, the entire Canadian ABL market has been cloaked with uncertainty pending the Supreme Court’s ruling on the appellate court’s decision in this case, lenders do not have certainty as to the degree to which they are protected by the collateral by which they are secured.

 

It was due to this uncertainty that when its ABL came due in September of this year, Algoma was forced to come to market with a very expensive ABL structured as a Term Loan. The thinking, however is that once all the dust settles, the company should be able to refinance into a more traditional ABL with lower borrowings outstanding and a dramatically lower interest rate.

A few summary points are crucial to note:

1)     If the Indalex ruling is overturned, then all the issues above are moot as generally speaking a wound up pension will not prime the ABL collateral and only the amount due but not paid will have deemed trust status

2)     The court ruling specifically notes that one flaw in the DIP loan in the Indalex case was that it did not make explicit its status as a priming vehicle. Had it done so, then in a CCAA proceeding, the court would in fact be able to allow for a DIP which unconditionally primes even a wound up pension plan (assuming that Indalex ruling is upheld and that the wound up pension plan is rendered a  Deemed Statutory Trust)

3)     According to many lawyers (and what seems evident to us from the basic reading of the Indalex case as well as PPSA 30(7)), all of this relates exclusively to credit instruments which are secured by Ar/Inventory. The “teeth” of the deemed trust is governed by PPSA 30(7) which specifically references Ar and Inventory as that which a Deemed Statutory Trust takes priority over other secured instruments. No matter how Indalex shakes out, the issues at hand do not relate to PP&E which the Secured Notes of Algoma are backed by. The PPSA specifically references trusts created out of the PBA as is the case here which lends support to the argument that the scope of the priming power granted by the PBA to a Deemed Statutory Trust (such as in the case of the wound up pension plan in the Indalex case) is bound by the scope outlined in PPSA 30(7), which restricts it’s priority claim to Accounts Receivable and Inventory.

4)     An extremely important point is that all of this relates to wound up pension plans. If a pension plan is not wound up, it would not be considered a Deemed Statutory Trust. In the Indalex case, it happened to be that one of the pension plans was wound up. Rather than rule on the non-wound up plan, the judge was able to look to the creation of a Constructive Trust as outlined above. In most instances, and especially in the case of Essar Steel Algoma, should a CCAA proceeding take place, it is extremely unlikely the company’s pension plan would be wound up. Doing so requires proactive initiative by management. Management has no incentive, and in fact it has negative incentive to create and empower a class which will have priming rights in the context of a CCAA proceeding. Importantly, by winding up a plan at any point, management would be pulling forward future pension contributions (to wind up the plan today) which from a PV standpoint is obviously NPV negative.

5)     Finally, even in the case that Indalex is upheld AND one is dealing with a situation where a plan is wound up AND we are dealing with an ABL (assuming the perspective above which restricts all of this to Ar/Inventory but not to PP&E and other assets), the power of the Deemed Statutory Trust is restricted to CCAA. It is most likely that the ABL (and or Senior Secured Notes) in a given CCAA proceeding could force a BIA which is what Canadian law calls “Bankruptcy” (akin to US Ch 7; the CCAA is not referred to as Bankruptcy despites it being similar in many regards to US bankruptcy law’s Ch 11).  Under BIA, Provincial Deemed Statutory Trusts would not be upheld. Unlike the CCAA, BIA has an order of priority (i.e. there is a priority by which claimants must be paid out – i.e. secured creditors first, then unsecured creditors, then equity – this is similar to the Absolute Priority rule under US bankruptcy law). The Supreme Court of Canada has said in many cases that a province cannot create a deemed trust or deemed charge that indirectly affects the order of priority. Accordingly, you cannot take an unsecured claim such as the wind up and go ahead of secured creditors in a BIA. So, worse comes to worse, a BIA proceeding could always be forced (likely able to force it) and then the Deemed Statutory Trust would have no standing.

Key Takeaway:

None of Indalex impacts the Senior Secured Notes as we understand. Even the ABL, in the worst case scenario that Indaelx is upheld by the Supreme Court, would only be primed by a wound up plan which is unlikely to be the case should Algoma be forced to seek a CCAA proceeding. And in the unlikely scenario that it is in fact a wound up plan, the ABL would be well positioned to push for the CCAA proceeding to be converted to a BIA proceeding whereby the Deemed Statutory Trust would no longer have any standing.

Thus we are left with a short term overhang which has led to high yielding but well protected secured investment opportunities through either the ABL or the Senior Secured Notes. Once Indalex is resolved, the company expects to be able to refinance  the ABL. Even if Indalex is upheld, for the reasons outlined above, it should be clear to ABL investors that they are still well protected and therefore would be willing to underwrite in accordance with more traditional ABL terms (perhaps with slight increase in rate due to the slight chance that a plan is wound up AND a company is forced into CCAA etc.).

9/30/12 Quarter Overview – what went wrong?

The Indalex overhang had already created pressure on the capital structure of the company prior to the 9/30/12 quarter. This was compounded by weak results in the 9/30/12 quarter. The company reported total shipped volumes of 548K, more than 100K down from the prior year and off of the 650K quarterly volume target. As noted, since the company only operates a single blast furnace, it aims to operate at high utilization (high 80% range which borders on the maximum capacity a furnace can realistically be operated at) and generally has no problem finding a home for its product given the small volume relative to the overall market. Cash cost per ton (COGs) came in at $695/ton which is materially above the $630-$640 range I believe is the current cost per ton at 650K tons the company should be operating at with current raw material assumptions. The company reported negative $15mm in EBITDA and while it had $85mm of liquidity at 9/30/12 (cash on balance sheet less $5mm of cash held for the ABL collateral to reach the $350mm minimum  required BB which includes cash), noted on the earnings call that as of 11/9/12, the cash balance was in the $65-70mm range.

 

The company did a poor job explaining the “missing volume” and the analysts on the call repeatedly tried to get better clarity. At their investor day a few weeks later (12/11/12), the company did a better job but the explanation is still not clear to many. On the earnings call, at the investor day and in company filings, the company referenced an SAP ERP solution implementation as the main driver of the missing volume. Speaking to the company we got a better understanding of the how exactly the SAP implementation impacted the roughly 100K of missing volume: The impact was as follows: 

1)     The company had been planning a shutdown (normal maintenance) of the furnace during the third fiscal quarter (12/31) but decided to push the shut down into Q2 (9/30/12) since it was going to have the SAP implementation anyway which it knew would impact production (thinking was to overlay the shutdown with the impact of SAP). This usually takes about 2-2.5 days and removed 25K from production, meaning 25K tons of steel that was never produced.

2)     The SAP implementation, however, led to IT issues which resulted in it taking longer to get back to stabilized production (i.e. took approximately an additional 2-2.5 days on top of the planned 2-2.5 days which had been pulled forward from the initially expected shut down in Q3). This led to approximately 35K tons that again were never produced.

So far, we have accounted for 60K tons which were simply never produced due to SAP. These are clearly one time in nature as everything is now running smoothly and SAP programs are known for causing transition issues as was the case here but once implemented there should be nothing in the future stemming from the SAP implementation.

3)     35-40K tons are what they made for an order for a customer but due to the SAP transition could not document the shipment documents so could not ship them. Thus inventory at 9/30/12 has finished goods of approximately 35-40K tons of product (primarily higher priced plate per the company) which is inventory and ready to be shipped to a specific customer.  This is product that the company produced but again due to SAP issues simply could not get out the door. That this is the case is confirmed by the company’s guidance for Q3 shipments (12/31/12 quarter) of between 670 and 690K tons. The extra above the smoothed targeted run rate of 650K tons is due to this order which was shipped shortly after quarter end.

 

As noted, management did not do a good job explaining where the volume went but when taking it bucket by bucket, it is not only understandable but also does not raise concerns that there is a long term volume issue. The street, however, extrapolated from this quarter to subsequent quarters leading to the assumption that volumes going forward would be at a lower baseline level. JPM, one of the few firms that publishes on the company, assumed in their report published after the 9/30/12 results were released that 621K tons would be shipped in the 12/31/12 quarter, followed by 633K in 3/31/13.

 

Given that the company stated that minimum liquidity on an average basis is approximately $50mm, investors also got jittery given the company’s liquidity as of November, combined with the cash flow expectations for the coming quarters leading some to think that the company will run out of liquidity in the middle of 2013.

 

Liquidity

With its current capital structure, the company’s fixed payments are approximately: $104mm for interest , $60mm for pension contributions – $16mm OPEB expense in excess of cash = ($44mm net for pension/OPEB) and $50mm in capex. This totals to fixed payments of approximately $198mm. Capex can be dialed down to $40mm if necessary.

 

The company has stated it expects to end the 12/31/12 quarter with approximately $30-40mm of liquidity which will increase to north of $100mm at 3/31/13. This is in line with seasonal trends as the company typically has a working capital build up in the Fall/Winter quarters in preparation for the freezing of the lakes which leads to material working capital benefits in the 3/31 quarter as the inventory is worked through and sold as shipped steel. This working capital benefit was also not factored in by many but was made more clear in the company’s recent investor day presentation.

 

Nonetheless, despite the above, under current raw material pricing and using benchmark HRC of $650 for 2013, we project EBITDA is in the $160mm range. Normalized cash COGs assuming volume in the 65K ton range are currently in the $630 per ton range though the company noted at its investor day that there are several dollars of costs cutting which should be realized in the near term reducing that number farther. Obviously there is a funding gap and liquidity will be tight. Using these estimates, we would peg the company’s liquidity at $20-30mm at 12/31/13 with the expectation that it again gains a benefit from the working through of inventory in the 3/31/14 quarter.

While tight and far from certain, we think that the company can make it alone without needing any outside support. The company will benefit in CY2014 from what is known as a reopener year in which the company will not be as negatively impacted by its iron ore contract with Cliffs (pricing will be closer to market). If iron ore stays at depressed levels (and if it does not, it will likely mean steel pricing has rebounded as well), the company will have a lower cost structure due to lower iron ore pricing in 2014.  

Additionally, we would expect the company to refinance its ABL structure at the call date in September 2013. The company has told us that the normal run rate interest levels (with a normal ABL interest rate and borrowing levels) is in the $80mm range (assuming the Senior Secured and Unsecured debt remains outstanding as is). This adds $20mm+ to annual cash flow.

 

While as a standalone entity, the liquidity profile of the company appears tight, there is an added kicker in the form of parent support which makes this a very different story.

 

Essar Parent Support

The Algoma steel plant is not an orphaned equity investment by the Essar group. Essar has engaged in projects in North American in the $1.5bn (equity) and $3.0bn (inclusive of debt) size to create a vertically integrated (used here in the traditional sense of vertical integration, not in the sense it is used in the world of Steel to distinguish it from the mini mills) platform similar to some of the other major Integrated (used here in contrast to the mini mills) steel players such as US Steel that have captive raw materials. Essar has invested in a major iron ore project as well as a coal project. The ultimate aim is for the coal project (Trinity Coal) and the Iron Ore project (Essar Steel Minnesota) to supply meaningful amounts of the raw materials which Essar Steel Algoma requires for its Steel production. Of greatest significant, Essar Steel Minnesota and Essar Steel Algoma have entered into an agreement whereby Essar Steel Minnesota will supply up to 4mm tons of Iron Ore pellets to Algoma beginning in 2016 when the current Algoma contract with Cliffs expires. The Minnesota Iron Ore project is in the early phases but is currently projecting cash costs in the $40 range (compared to Cliffs' cash costs in the $80-100 range). While costs may come in above projections, this would still make it one of the lowers if not the lowest iron ore producer in North America. Speaking with both Essar Steel Algoma and Essar Steel Minnesota leads us to conclude that while the contract will be on an arms-length basis, there is certainly an understanding that Essar parent is backing both entities and accordingly we think the pricing will be favorable to Algoma – not just at a more market based pricing (as compared to the unfavorable Cliffs contract) but more attractive than market due to the role that Essar parent company plays in its oversight and control of both companies.

 

From talking with representatives across the Essar family, it is clear that while the steel, iron ore and coal investments are distinct entities, they are viewed at the parent level as a single integrated investment play in the space and it is unlikely that Essar parent would let one part of the vertical integration play slip from its hands. This was explicitly confirmed during the recent Investor Day presentation when Mr. Ruia (part of the family that controls Essar) affirmed numerous times that should Essar Steel Algoma require additional assistance (the number thrown out was in the $50-100mm range), then the Essar parent would be there. It was also made clear that this amount of support was not meaningful to the overall Essar family (i.e. it can be taken with comfort that the support can easily be given).

 

In short, the explicit backstop of the company by the Essar Group gives us confidence that should the company find itself in a liquidity bind, the parent will be there to support it with additional liquidity, especially to help the company get through to 2016 when the entire Essar North American steel platform will become truly vertical as the iron ore contract between Essar Steel Minnesota and Essar Steel Algoma will come into play.

Conclusion

The secured tranches of the Essar Steel Algoma capital structure provide for attractive investment opportunities. While the company may end up with tight liquidity, the Essar parent is committed to keeping the company afloat as part of its broader vertically integrated investment in the space and is unlikely to walk away from a material portion of its overall investment in North America. Should the company run into liquidity issues and Essar Parent not come to support it, resulting in the company being forced to seek CCAA proceeding, the Senior Secured Notes will almost certainly have a portion (likely the majority) of the equity (if not be reinstated). Liquidity would significantly be enhanced following a CCAA proceeding as interest would be reduced dramatically (assume minimal recovery to the unsecureds and the senior secured get equitized, interest would be likely be no higher than $20-30mm annually). On top of that, the company would be able to deal with its onerous pension obligations which require $60mm or so of annual pension contributions. At current prices, an investor will either receive an extremely attractive YTM (what we believe is the likely case given the Essar parent backing) or if in the worst case scenario a CCAA event is required, the equity at an attractive current valuation (certainly less than 6x off of a stressed EBITDA is attractive and it is easy to see how these bonds are more than covered by the Algoma asset base. Some have expressed the "RG" fear, namely the fear that in a CCAA proceeding, the assets will be shuttered as is happening to the steel assets of RG. RG, however, had bad assets - high cost - which is very different from the more attractive assets which Algoma has. That combined with the benefit of the 2016 contract with Essar Steel Minnesota makes Algoma an extremely attractive asset on a purely unlevered basis).

If one can source the ABL, this is probably the most attractive part of the capital structure albeit at 400-500bps lower yield than the Senior Secured Notes. This is because when the ABL was put together in September, the borrowing base calculation resulted in onerous terms since the inventory date on which the inventory was valued was off of the 5/31/12 balance at which point raw material pricing was dramatically higher than it was in September. The borrowing base calculation is off of the Orderly Liquidation Value which sets a percentage off of book value (uses ~85% as traditional ABLs do off of Net Orderly Liquidation value of the 5/31/12 balance which resulted in a % closer to 56% due to the decline in raw material pricing). Accordingly, the actual BB is much lower than it would be if the ABL had been structured without using the balance from 5/31/12 given pricing had dropped so much since then. This means that the ABL is actually much more collateralized than one would generally think since the company is more or less only given credit for ~56% of the book value of its inventory and not the usual 85%. When the company comes to market as it plans to do in September of 2013, it plans to get a much more favorable ABL and potentially even upsize the facility which again would provide an added liquidity buffer to help the company make it through to 2016.

 As a final point, a pair trade between going long the Senior Secureds and shorting the Unsecureds may be attractive to some (not necessarily 1:1 but in some ratio, perhaps 2:1 given the unsecured will trade down much more than the secureds if there is in fact a major liquidity or CCAA event and 2:1 also enhances the carry of the trade).

 

Disclosure: this is not an investment reccomendation and all investors should perform their own due diligence before making an investment. We may trade in and out of the securities without updating this post.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Indalex ruling removes overhang/uncertainty
Improving profitability if steel market pricing firms up (closer to where prices where in early 2011) then earnings power of company should more than offset cash payments boosting liquidity - entire capital structure will trade up
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    Description

    Investment Thesis (all figures in $Canadian)

    The Essar Steel Algoma Senior Secured First Lien bonds provide a compelling investment opportunity. The company’s ABL is even more attractive but harder to source. The opportunity is available for at least 3 basic reasons:

    1)     General over supply and therefore pricing pressures in the global but specifically North American steel market

    2)     Indalex: Canadian appellate court ruling which has caused turmoil in the Canadian ABL market and forced the company to come to market with an extremely expensive ABL several months ago. Once the Supreme Court rules on Indalex (expected by end of 2012, early 2013), it should remove a major overhang on the company’s capital structure and enable it to refinance at market levels (saving ~$20mm in interest payments a year off of current run rate levels).

    3)     Recent quarter – the company had an awful second fiscal quarter (quarter ending 9/30/12; company is 3/31/12 FYE). The company printed negative EBITDA and had “missing” volume of about 100K which scared the investor community. The miss, combined with a perceived overall tight liquidity profile led analysts to downgrade the firm’s capital structure to Sell making the argument that the company would run out of liquidity (and be forced into a CCAA proceeding at some point in 2013).

     

    Buying the Senior Secured Notes at current price of 88 provides a 16% YTM. Creates the company at 5.9x LTM EBITDA through the ABL and Senior Secured Notes (face; 5.5x at current prices).

    Buying the ABL at 98-99 with an assumed 102 call in September 2013 provides an extremely safe 11-12% yield (why it is so safe is described below).

     

    Company Overview

    Essar Steel Algoma is a Canadian producer of steel products. The company is based on the Great Lakes in Sault Ste. Marie, Ontario. The company produces Flat products, specifically, Sheet and Plate and is the only producer of Plate in Canada. Plate is a more value add market than Sheet and there are fewer competitors operating in the plate market across North America. Current product mix is approximately 80-85% Sheet (lower priced and lower margin) and 15-20% Plate (higher priced and higher margin).

    The major end-users of ESA’s sheet products are the automotive industry, welded pipe manufacturers, hollow structural product manufacturers and the light manufacturing and transportation industries.

    The major end-user of plate products is the fabrication industry, such as in the construction or manufacture of railcars, buildings, bridges, off-highway equipment, storage tanks, ships, armored products for military applications and large diameter pipelines.

    The company was acquired by the Essar Group (“Essar”), a multi-billion dollar privately owned Indian Conglomerate but which has various subsidiaries, some of which are publicly floated and some which have public debt such as Essar Steel Algoma. Essar has operations worldwide spanning Energy, Steel, Infrastructure, Shipping, Telecom and other industries.

    Essar acquired Essar Steel Algoma (“Algoma”) in June of 2007 with an initial equity investment of C$530mm. Essar highlights that it injected an additional C$262mm into the company through its acquisition of select Cogeneration assets from Algoma but we would note that they paid fair value for those assets which were transferred to another Essar subsidiary so we do not view that as a pure equity investment into the business.

    Brief background on Steelmaking:

    There are two basic methods for making steel – 1) the older method and more common method worldwide is known as the Integrated method which involves taking in Met coal (converted to Coke), Iron ore, a little metal scrap and utilizing a Blast Furnace to create the steel. Leading North American players in the Integrated space include US Steel, Arcelor Mittal, AK Steel and Essar Steel Algoma. 2) The more recent method to making steel is produced at what are called mini mills. Mini mills employ the EAF (Electric Arc Furnace) process which rather than using the raw Iron Ore generally uses scrap metal to “recycle” the iron content into readily useable steel. The EAF method is viewed as low cost relative to the integrated method. While integrated players are exposed to raw material fluctuations in the prices of key inputs such as iron ore and met coal, the mini mill producers are primarily exposed to the price of scrap.

    Relative to other integrated players, Algoma is a low cost producer. Since the acquisition in 2007, Essar has engaged in cost cutting initiatives in its operations eliminating C$55/ton in cost. The Company owns and operates a state-of-the-art Direct Strip Production Complex (“DSPC”) line that converts liquid steel directly into coil. The technological combination of casting, reheating and rolling, results in lower production costs as compared with traditional slab casting and rolling operations. In simplified terms, the DSPC process enables the company to avoid a step employed by competitors which wait for the liquid to cool and harden before rolling. Algoma is able to take the hot liquid and convert it into sheet directly. As a result, the DSPC line is one of the lowest-cost North American mills in terms of hot-rolled coil (“HRC”) conversion cost per ton.

    The company claims it is within the second quartile of the North American cost curve compared to peer North American steel plants (not clear if looking just at Integrated players or including mini mills as well). In any event, importantly, the company notes that there is approximately 50mm tons of production capacity which is higher cost than Algoma’s operations. The company has outperformed peers (primarily comps itself against AK Steel and the HRC segment of US Steel. Algoma has achieved higher EBITDA margins and EBITDA per ton over most of the last 8 quarters).

     

    The company’s asset base includes two blast furnaces (one of which - #6 – is currently idled) with total production capacity of 4.3mm tons and 4mm tons of rolling capacity. The functioning #7 blast furnace has capacity of 3mm tons and the company targets approximately 650K of production volume a quarter, annualized to approximately 2.6mm tons. On 3mm of capacity, that implies capacity utilization in the high 80% range. This is notable, especially as compared to the overall industry which is currently operating in the low 70% range (and even dipped below that in recent months). Because it has relatively small volume compared to the North American market and only operates one plant, it can benefit from fixed cost operating leverage as it is able to run at higher utilization levels and still generally find a home for its product without impacting the overall supply and demand balance in the market.

     

    Raw Materials:

    The company sources its coal and iron ore material needs through long standing relationships with suppliers. In particular it has a long term contract in place with Cliffs for the supply of its Iron Ore needs. The company requires approximately 1.4x tons of Iron Ore pellets for every ton of steel it produces. This contract was entered into in 2002 and has proved to be a thorn for the company. Cliffs is a high cost producer of Iron Ore. Neither company will disclose the nuances or formula used to calculate the price of the Iron Ore which Algoma purchases (in contrast to AK Steel which while the company has horrible disclosure on just about everything else, is fairly clear in laying out the pricing mechanism by which it acquires Iron Ore which is based on a lagged calculation off of the IODEX). The company also has a coke battery which it uses to produce the vast majority of its coking needs, looking to the spot market when necessary. In terms of Iron Ore, the company believes that over the last 5 years, it has had a $23/ton disadvantage relative to the rest of the North American market. I have pressed the company on this (as certain data does not support this) but given the opaque nature of pricing in general, it is difficult to assess the extent to which the company is at a disadvantage due to its Cliffs contract.

     

    Brief Overview of Industry Dynamics

    Focusing here on the flat side (more exposed to industries such as Auto) than the Long side (more construction oriented): Not much to say except that it is pretty much well accepted that the global steel industry is suffering from over capacity which has put pressure on global pricing. I have listened to various global conference calls on the steel industry with roundtables in which analysts covering local steel markets (i.e. Europe, China, Japan, North America) all chime in and the sentiment is consistent – there is too much supply. The extent to which supply hampers pricing is somewhat offset by demand. On a relative basis, North American demand, driven by the strength of the auto and other industries has been stable as of late. The US market, however, suffers from recurring mini cycles in which prices rise, the gap between pricing in the US and Europe gets north of $100 (generally the point at which the difference matters), leading to increased imports which floods the US market and puts pressure on pricing. Pricing gets pressured down to a point where it comes close to the break-even point of the mills, reducing the difference between domestic and foreign pricing and leading the mills to raise prices. This has happened at least twice in 2012. This is one explanation for the pricing moves we have seen (other explanations factor in scrap pricing as key drive and the explanations are not mutually exclusive. On the scrap side, pricing which was strong and north of $700 per ton for benchmark HRC in early 2012 was pressured throughout the first half of 2012 as Turkey, a major importer of US scrap for its own steelmaking, reduced its demand for scrap leading to higher scrap availability in the US. The higher scrap led to lower scrap prices which reduced the cost of production for the mini mills and in an over supplied market, led to lower pricing). There are anti-dumping provisions in place in the US which prevents China from dumping many grades of low cost steel (or steel produced at a loss) into the US market.

     

    Currently, pricing on benchmark HRC has rebounded from the sub $600 per ton seen in October and is now in the ~$630 context. This pricing though is still too low for most companies, especially the Integrated (higher cost) players to operate with sufficient profitability. A company like Algoma, however, is well positioned relative to comps given where it sits on the cost curve.

     

    Historical Financial Performance

    Here is a brief summary of the company’s financial performance and key operating metrics:

    Summary   Financials 3/31/09 3/31/10 3/31/11 3/31/12 LTM          
    Total Sales 2,548 1,409 1,768 2,160 1,973          
    % growth - -44.7% 25.5% 22.1% -          
    Operating Income 70 (218) (291) 106 (79)          
    Plus D&A 222 215 213 187 188          
    GAAP Adj. EBITDA 292 (4) (78) 293 109          
    % Margin 11.5% -0.3% -4.4% 13.6% 5.5%          
    Plus "Exceptional   Items"* 162 54 19 (11) 16          
    Adj. EBITDA 453 50 (59) 282 126          
    % Margin 17.8% 3.5% -3.3% 13.1% 6.4%          
    EBITDA/Ton ($) $176 $22 ($25) $108 $51          
                         
    Quarterly                    
      6/30/10 9/30/10 12/31/10 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12 6/30/12 9/30/12
    Total Sales 476 470 437 386 566 564 506 524 532 411
    % growth - - - - 19.0% 20.0% 15.8% 35.7% -6.0% -27.1%
    Operating Income 22 (33) (200) (80) 61 61 (24) 8 2 (65)
    Plus D&A 53 52 50 58 48 44 47 48 48 45
    GAAP Adj. EBITDA 75 19 (150) (22) 109 106 23 56 50 (20)
    % Margin 15.7% 4.1% -34.4% -5.6% 19.2% 18.7% 4.5% 10.7% 9.5% -4.8%
    Plus "Exceptional   Items"* (10) (9) 108 38 0 (19) 8 0 4 5
    Adj. EBITDA 65 10 (42) 16 109 87 30 56 55 (15)
    % Margin 13.7% 2.2% -9.7% 4.1% 19.2% 15.4% 6.0% 10.7% 10.3% -3.7%
    *Adds back $108mm in 12/31/10   quarter stemming from Cliffs arbitration                    
    EBITDA/Ton ($) $106 $17 ($67) $30 $170 $129 $48 $86 $85 ($28)
                         
    Operating Statistics: 3/31/09 3/31/10 3/31/11 3/31/12 LTM          
    Revenue Breakdown                    
    Sheet & Strip 1,638 1,009 1,224 1,513 1,362          
    Plate 725 235 369 465 434          
    Freight 134 116 127 141 133          
    Non Steel Revenue 52 50 48 41 44          
    Total Sales 2,548 1,409 1,768 2,160 1,973          
                         
    Shipments (000 Tons)                    
    Sheet 2,022 1,917 1,989 2,147 2,050          
    Plate 530 299 398 448 427          
    Slab 21 8 0 3 0          
    Total 2,573 2,224 2,387 2,598 2,477          
                         
    Additional Operating Stats                      
    Steel Shipments     2,387 2,598 2,477          
    Steel Revenue     1,720 2,119 1,929          
    Cost of Steel Products Sold   (excluding amortization)     1,732 1,762 1,760          
    Average Net Sales of   Realization of on Steel Sales (excluding Freight)     667 761 NA          
    Cost per ton of steel   products sold (excluding amort, freight, & exceptional items)     664 628 NA          
                         
    Quarterly 6/30/10 9/30/10 12/31/10 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12 6/30/12 9/30/12
    Revenue Breakdown                    
    Sheet & Strip 338 327 297 263 406 403 341 363 353 304
    Plate 94 97 91 87 111 115 116 123 123 71
    Freight 34 31 36 27 34 38 34 35 35 30
    Non Steel Revenue 10 16 13 10 15 9 15 3 20 6
    Total Sales 476 470 437 386 566 564 506 524 532 411
    Sheet Sales                    
    Tons (000) 514 517 523 435 536 563 522 526 525 477
    Sales (C$m) $338 $326 $296 $263 $406 $402 $341 $363 $353 $304
    C$/Ton $658 $631 $566 $605 $757 $714 $653 $689 $673 $637
    Plate Sales                    
    Tons (000) 99 101 106 92 $104 108 114 122 120 71
    Sales (C$m) $93 $97 $92 $87 $111 $114 $117 $124 $123 $71
    C$/Ton $941 $965 $866 $943 $1,068 $1,053 $1,023 $1,013 $1,027 $1,000
                         
    Shipments                    
    Sheet 514 517 523 435 536 563 522 526 525 477
    Plate 99 101 106 92 104 108 114 122 120 71
    Slab 0 0 0 0 1 2 0 0 0 0
    Total 613 618 629 527 641 673 636 648 645 548
                         
    Additional Operating Stats                 *  
    Steel Shipments NA 618 630 527 641 674 635 648 645 548
    Steel Revenue NA 454 424 377 551 555 491 522 512 405
    Cost of Steel Products Sold   (excluding amortization) NA 415 447 386 426 434 453 448 448 410
    Average Net Sales of   Realization of on Steel Sales (excluding Freight) NA 686 616 664 807 768 719 750 739 685
    Cost per ton of steel   products sold (excluding amort, freight, & exceptional items) NA 636 654 610 611 616 648 637 640 695

    A rough breakdown from the company’s provided cost breakdown for FY 2012 (FYE 3.31.12):

    COGs    RM=Raw Material
    Fixed 24%  
    Energy 8%  
    Scrap 9% RM
    Purchased Coke 2% RM
    Alloys 6% RM
    Coal 16% RM
    Iron Ore 30% RM
    Other 5%  
     Total 100%  
    Raw Materials as % of Total 63%  

    While people often focus on the Integrated players as being high fixed cost (relative to variable), Algoma’s explicitly breaking out its cost structure indicates otherwise (i.e. variable costs approximate 63% of the total cost per ton). Other companies give very little to no breakout of their cost structure which makes the insight from Algoma extremely telling.

     

    Capital Structure

    The company currently has an expensive capital structure which stems in part from the ABL it brought to market in September of 2012. Here is the current capital structure of the company:

    LTM   EBITDA 126              
    Capital Structure as of: 9/30/12   Currency is Canadian   Dollar   Cumulative  
                  Mkt Debt/LTM Ann Int
    Security Notional Price Market Coupon Maturity Yield to Mat EBITDA Cost
    Secured Debt                
    ABL -New $344 99 $341 8.750% 9/20/2014 9.4%   30
    9.375% Senior Secured Notes* $393 88 $346 9.375% 3/15/2015 16.0%   37
    Total Secured Debt $737 5.9x $687       5.5x 67
    9.875% Senior Notes $378 70 $265 9.875% 6/15/2015 27.3% 8.0x 37
    Total Debt** $1,116 8.9x $952       8.0x 104
    less Cash $90              
    Net Debt $1,025 8.2x            
    Pension Deficit $346 As of 3/31/12 - (9/30/12   BS: $392.7mm)      
    OPEB Deficit $490 As of 3/31/12 -  (9/30/12 BS: $536.4mm)      
    Pension Adjusted Valuation $1,862 14.8x            
    *First lien on all other   assets (outside of AR/Inv); Second lien on AR/Inv                
    **Excludes   $25.5mm in Unamortized financing costs, premiums and/or discounts etc.   (Meaning using Gross Number - Par)          

    Note: assuming a 102 call in September 2012, the ABL YTC is in the 11-2% range

    The ABL is secured by a first lien on Ar/Inventory and second lien on other assets whereas the Senior Secured Notes have a first lien on substantially all of the company's tangible assets and a second lien on the Ar/Inventory. There is minimal additional secured debt capacity (~$25mm per the terms of the Senior Secured Notes). The ABL which was refinanced in September of this year has a LIBOR floor of 1.25%, floating rate of L+750 (leading to coupon of 8.75% in current low LIBOR environment). The ABL was effectively structured as Term Loan as traditional ABL lenders were not interested in the structure so it was fully drawn at the refinancing putting excess cash on the company’s balance sheet (and therefore higher cash interest expense). If availability under the borrowing base is less than the amount outstanding, the ABL must be repaid with payments providing for a permanent reduction in the ABL facility size. The ABL is callable after one year at 102 and given the onerous pricing terms (as well as lower than possible facility size) which characterizes the ABL, the company plans to refinance at the one year mark.

     

    Why is the company bound by such an ABL?

    The answer to why the company had to come to market with such harsh ABL terms stems from an appellate ruling in the Canadian court system in which a judge ruled regarding the prioritization of pension claims in the context of a CCAA proceeding for a company called Indalex.

     

    In Indalex, the appellate court ruled that the two pension plans which the company had, had priority over the DIP loan which had been extended in the bankruptcy. The ruling is a great read and at the risk of oversimplifying a complex legal issue went as follows:

    The judge made two novel claims. The first was that a wound up pension plan (related to one of the plans) has the status of a Provincial Deemed Statutory Trust. Prior thinking was that only the amount that was due but not paid had this status but the judge took a novel interpretation of the PBA (Pension Benefits Act) which granted this status to the entirety of the deficiency (i.e. underfunding) of a wound up pension plan. The judge did not give a formal opinion on the status of a non-wound up pension plan and instead looked to what she called a Constructive Trust to grant a similar priming status to the non-wound up pension plan. The core of the Constructive Trust argument was that Indalex as both plan administrator and as debtor/company which had debt had to wear two hats and look out for the interests of the debtors as well as the pensioners. Management failed to protect the interests of the pensioners and therefore the company’s claim (in this case, a related entity had guaranteed the DIP so was actually coming to collect on the subrogated DIP claim) should be subordinated to the full pension claims (including the non-wound up plan). In certain senses, this resembles equitable subordination in the US bankruptcy system.

     

    The latter point, namely the use of Constructive Trust is local to Indalex where management acted in bad faith. The more relevant take away was the judge’s ruling that wound up pension plans had Deemed Statutory Trust status.

     

    So who cares? What does it mean to be a Provincial (stemming from local Ontario law as opposed to federal law – akin to a state driven legal ruling) Deemed Statutory Trust. Essentially, a deemed trust has priority with respect to Accounts Receivable and Inventory. The potency of this priority stems from the Personal Property and Security Act in Canada (akin to the US UCC). In the PPSA, Section 30(7) states with regard to Deemed Trusts:

    “A security interest in an account or inventory and its proceeds is subordinate to the interest of a person who is the beneficiary of a deemed trust arising under the Employment Standards Act or under the Pension Benefits Act.”

    http://www.e-laws.gov.on.ca/html/statutes/english/elaws_statutes_90p10_e.htm#BK42

    It is crucial to note that the provisions of the Pension Benefit Act only applies to Registered Pensions which excludes OPEB so the underfunded OPEB claims in CCAA cases (and especially in the case of Algoma which has a material underfunded OPEB as outlined above) do not have the benefits of characterization as a Deemed Statuary Trust.

    What does it mean for ABLs?

    As this ruling directly targets the basic collateral by which ABL’s are structured, namely Accounts Receivable and Inventory, the entire Canadian ABL market has been cloaked with uncertainty pending the Supreme Court’s ruling on the appellate court’s decision in this case, lenders do not have certainty as to the degree to which they are protected by the collateral by which they are secured.

     

    It was due to this uncertainty that when its ABL came due in September of this year, Algoma was forced to come to market with a very expensive ABL structured as a Term Loan. The thinking, however is that once all the dust settles, the company should be able to refinance into a more traditional ABL with lower borrowings outstanding and a dramatically lower interest rate.

    A few summary points are crucial to note:

    1)     If the Indalex ruling is overturned, then all the issues above are moot as generally speaking a wound up pension will not prime the ABL collateral and only the amount due but not paid will have deemed trust status

    2)     The court ruling specifically notes that one flaw in the DIP loan in the Indalex case was that it did not make explicit its status as a priming vehicle. Had it done so, then in a CCAA proceeding, the court would in fact be able to allow for a DIP which unconditionally primes even a wound up pension plan (assuming that Indalex ruling is upheld and that the wound up pension plan is rendered a  Deemed Statutory Trust)

    3)     According to many lawyers (and what seems evident to us from the basic reading of the Indalex case as well as PPSA 30(7)), all of this relates exclusively to credit instruments which are secured by Ar/Inventory. The “teeth” of the deemed trust is governed by PPSA 30(7) which specifically references Ar and Inventory as that which a Deemed Statutory Trust takes priority over other secured instruments. No matter how Indalex shakes out, the issues at hand do not relate to PP&E which the Secured Notes of Algoma are backed by. The PPSA specifically references trusts created out of the PBA as is the case here which lends support to the argument that the scope of the priming power granted by the PBA to a Deemed Statutory Trust (such as in the case of the wound up pension plan in the Indalex case) is bound by the scope outlined in PPSA 30(7), which restricts it’s priority claim to Accounts Receivable and Inventory.

    4)     An extremely important point is that all of this relates to wound up pension plans. If a pension plan is not wound up, it would not be considered a Deemed Statutory Trust. In the Indalex case, it happened to be that one of the pension plans was wound up. Rather than rule on the non-wound up plan, the judge was able to look to the creation of a Constructive Trust as outlined above. In most instances, and especially in the case of Essar Steel Algoma, should a CCAA proceeding take place, it is extremely unlikely the company’s pension plan would be wound up. Doing so requires proactive initiative by management. Management has no incentive, and in fact it has negative incentive to create and empower a class which will have priming rights in the context of a CCAA proceeding. Importantly, by winding up a plan at any point, management would be pulling forward future pension contributions (to wind up the plan today) which from a PV standpoint is obviously NPV negative.

    5)     Finally, even in the case that Indalex is upheld AND one is dealing with a situation where a plan is wound up AND we are dealing with an ABL (assuming the perspective above which restricts all of this to Ar/Inventory but not to PP&E and other assets), the power of the Deemed Statutory Trust is restricted to CCAA. It is most likely that the ABL (and or Senior Secured Notes) in a given CCAA proceeding could force a BIA which is what Canadian law calls “Bankruptcy” (akin to US Ch 7; the CCAA is not referred to as Bankruptcy despites it being similar in many regards to US bankruptcy law’s Ch 11).  Under BIA, Provincial Deemed Statutory Trusts would not be upheld. Unlike the CCAA, BIA has an order of priority (i.e. there is a priority by which claimants must be paid out – i.e. secured creditors first, then unsecured creditors, then equity – this is similar to the Absolute Priority rule under US bankruptcy law). The Supreme Court of Canada has said in many cases that a province cannot create a deemed trust or deemed charge that indirectly affects the order of priority. Accordingly, you cannot take an unsecured claim such as the wind up and go ahead of secured creditors in a BIA. So, worse comes to worse, a BIA proceeding could always be forced (likely able to force it) and then the Deemed Statutory Trust would have no standing.

    Key Takeaway:

    None of Indalex impacts the Senior Secured Notes as we understand. Even the ABL, in the worst case scenario that Indaelx is upheld by the Supreme Court, would only be primed by a wound up plan which is unlikely to be the case should Algoma be forced to seek a CCAA proceeding. And in the unlikely scenario that it is in fact a wound up plan, the ABL would be well positioned to push for the CCAA proceeding to be converted to a BIA proceeding whereby the Deemed Statutory Trust would no longer have any standing.

    Thus we are left with a short term overhang which has led to high yielding but well protected secured investment opportunities through either the ABL or the Senior Secured Notes. Once Indalex is resolved, the company expects to be able to refinance  the ABL. Even if Indalex is upheld, for the reasons outlined above, it should be clear to ABL investors that they are still well protected and therefore would be willing to underwrite in accordance with more traditional ABL terms (perhaps with slight increase in rate due to the slight chance that a plan is wound up AND a company is forced into CCAA etc.).

    9/30/12 Quarter Overview – what went wrong?

    The Indalex overhang had already created pressure on the capital structure of the company prior to the 9/30/12 quarter. This was compounded by weak results in the 9/30/12 quarter. The company reported total shipped volumes of 548K, more than 100K down from the prior year and off of the 650K quarterly volume target. As noted, since the company only operates a single blast furnace, it aims to operate at high utilization (high 80% range which borders on the maximum capacity a furnace can realistically be operated at) and generally has no problem finding a home for its product given the small volume relative to the overall market. Cash cost per ton (COGs) came in at $695/ton which is materially above the $630-$640 range I believe is the current cost per ton at 650K tons the company should be operating at with current raw material assumptions. The company reported negative $15mm in EBITDA and while it had $85mm of liquidity at 9/30/12 (cash on balance sheet less $5mm of cash held for the ABL collateral to reach the $350mm minimum  required BB which includes cash), noted on the earnings call that as of 11/9/12, the cash balance was in the $65-70mm range.

     

    The company did a poor job explaining the “missing volume” and the analysts on the call repeatedly tried to get better clarity. At their investor day a few weeks later (12/11/12), the company did a better job but the explanation is still not clear to many. On the earnings call, at the investor day and in company filings, the company referenced an SAP ERP solution implementation as the main driver of the missing volume. Speaking to the company we got a better understanding of the how exactly the SAP implementation impacted the roughly 100K of missing volume: The impact was as follows: 

    1)     The company had been planning a shutdown (normal maintenance) of the furnace during the third fiscal quarter (12/31) but decided to push the shut down into Q2 (9/30/12) since it was going to have the SAP implementation anyway which it knew would impact production (thinking was to overlay the shutdown with the impact of SAP). This usually takes about 2-2.5 days and removed 25K from production, meaning 25K tons of steel that was never produced.

    2)     The SAP implementation, however, led to IT issues which resulted in it taking longer to get back to stabilized production (i.e. took approximately an additional 2-2.5 days on top of the planned 2-2.5 days which had been pulled forward from the initially expected shut down in Q3). This led to approximately 35K tons that again were never produced.

    So far, we have accounted for 60K tons which were simply never produced due to SAP. These are clearly one time in nature as everything is now running smoothly and SAP programs are known for causing transition issues as was the case here but once implemented there should be nothing in the future stemming from the SAP implementation.

    3)     35-40K tons are what they made for an order for a customer but due to the SAP transition could not document the shipment documents so could not ship them. Thus inventory at 9/30/12 has finished goods of approximately 35-40K tons of product (primarily higher priced plate per the company) which is inventory and ready to be shipped to a specific customer.  This is product that the company produced but again due to SAP issues simply could not get out the door. That this is the case is confirmed by the company’s guidance for Q3 shipments (12/31/12 quarter) of between 670 and 690K tons. The extra above the smoothed targeted run rate of 650K tons is due to this order which was shipped shortly after quarter end.

     

    As noted, management did not do a good job explaining where the volume went but when taking it bucket by bucket, it is not only understandable but also does not raise concerns that there is a long term volume issue. The street, however, extrapolated from this quarter to subsequent quarters leading to the assumption that volumes going forward would be at a lower baseline level. JPM, one of the few firms that publishes on the company, assumed in their report published after the 9/30/12 results were released that 621K tons would be shipped in the 12/31/12 quarter, followed by 633K in 3/31/13.

     

    Given that the company stated that minimum liquidity on an average basis is approximately $50mm, investors also got jittery given the company’s liquidity as of November, combined with the cash flow expectations for the coming quarters leading some to think that the company will run out of liquidity in the middle of 2013.

     

    Liquidity

    With its current capital structure, the company’s fixed payments are approximately: $104mm for interest , $60mm for pension contributions – $16mm OPEB expense in excess of cash = ($44mm net for pension/OPEB) and $50mm in capex. This totals to fixed payments of approximately $198mm. Capex can be dialed down to $40mm if necessary.

     

    The company has stated it expects to end the 12/31/12 quarter with approximately $30-40mm of liquidity which will increase to north of $100mm at 3/31/13. This is in line with seasonal trends as the company typically has a working capital build up in the Fall/Winter quarters in preparation for the freezing of the lakes which leads to material working capital benefits in the 3/31 quarter as the inventory is worked through and sold as shipped steel. This working capital benefit was also not factored in by many but was made more clear in the company’s recent investor day presentation.

     

    Nonetheless, despite the above, under current raw material pricing and using benchmark HRC of $650 for 2013, we project EBITDA is in the $160mm range. Normalized cash COGs assuming volume in the 65K ton range are currently in the $630 per ton range though the company noted at its investor day that there are several dollars of costs cutting which should be realized in the near term reducing that number farther. Obviously there is a funding gap and liquidity will be tight. Using these estimates, we would peg the company’s liquidity at $20-30mm at 12/31/13 with the expectation that it again gains a benefit from the working through of inventory in the 3/31/14 quarter.

    While tight and far from certain, we think that the company can make it alone without needing any outside support. The company will benefit in CY2014 from what is known as a reopener year in which the company will not be as negatively impacted by its iron ore contract with Cliffs (pricing will be closer to market). If iron ore stays at depressed levels (and if it does not, it will likely mean steel pricing has rebounded as well), the company will have a lower cost structure due to lower iron ore pricing in 2014.  

    Additionally, we would expect the company to refinance its ABL structure at the call date in September 2013. The company has told us that the normal run rate interest levels (with a normal ABL interest rate and borrowing levels) is in the $80mm range (assuming the Senior Secured and Unsecured debt remains outstanding as is). This adds $20mm+ to annual cash flow.

     

    While as a standalone entity, the liquidity profile of the company appears tight, there is an added kicker in the form of parent support which makes this a very different story.

     

    Essar Parent Support

    The Algoma steel plant is not an orphaned equity investment by the Essar group. Essar has engaged in projects in North American in the $1.5bn (equity) and $3.0bn (inclusive of debt) size to create a vertically integrated (used here in the traditional sense of vertical integration, not in the sense it is used in the world of Steel to distinguish it from the mini mills) platform similar to some of the other major Integrated (used here in contrast to the mini mills) steel players such as US Steel that have captive raw materials. Essar has invested in a major iron ore project as well as a coal project. The ultimate aim is for the coal project (Trinity Coal) and the Iron Ore project (Essar Steel Minnesota) to supply meaningful amounts of the raw materials which Essar Steel Algoma requires for its Steel production. Of greatest significant, Essar Steel Minnesota and Essar Steel Algoma have entered into an agreement whereby Essar Steel Minnesota will supply up to 4mm tons of Iron Ore pellets to Algoma beginning in 2016 when the current Algoma contract with Cliffs expires. The Minnesota Iron Ore project is in the early phases but is currently projecting cash costs in the $40 range (compared to Cliffs' cash costs in the $80-100 range). While costs may come in above projections, this would still make it one of the lowers if not the lowest iron ore producer in North America. Speaking with both Essar Steel Algoma and Essar Steel Minnesota leads us to conclude that while the contract will be on an arms-length basis, there is certainly an understanding that Essar parent is backing both entities and accordingly we think the pricing will be favorable to Algoma – not just at a more market based pricing (as compared to the unfavorable Cliffs contract) but more attractive than market due to the role that Essar parent company plays in its oversight and control of both companies.

     

    From talking with representatives across the Essar family, it is clear that while the steel, iron ore and coal investments are distinct entities, they are viewed at the parent level as a single integrated investment play in the space and it is unlikely that Essar parent would let one part of the vertical integration play slip from its hands. This was explicitly confirmed during the recent Investor Day presentation when Mr. Ruia (part of the family that controls Essar) affirmed numerous times that should Essar Steel Algoma require additional assistance (the number thrown out was in the $50-100mm range), then the Essar parent would be there. It was also made clear that this amount of support was not meaningful to the overall Essar family (i.e. it can be taken with comfort that the support can easily be given).

     

    In short, the explicit backstop of the company by the Essar Group gives us confidence that should the company find itself in a liquidity bind, the parent will be there to support it with additional liquidity, especially to help the company get through to 2016 when the entire Essar North American steel platform will become truly vertical as the iron ore contract between Essar Steel Minnesota and Essar Steel Algoma will come into play.

    Conclusion

    The secured tranches of the Essar Steel Algoma capital structure provide for attractive investment opportunities. While the company may end up with tight liquidity, the Essar parent is committed to keeping the company afloat as part of its broader vertically integrated investment in the space and is unlikely to walk away from a material portion of its overall investment in North America. Should the company run into liquidity issues and Essar Parent not come to support it, resulting in the company being forced to seek CCAA proceeding, the Senior Secured Notes will almost certainly have a portion (likely the majority) of the equity (if not be reinstated). Liquidity would significantly be enhanced following a CCAA proceeding as interest would be reduced dramatically (assume minimal recovery to the unsecureds and the senior secured get equitized, interest would be likely be no higher than $20-30mm annually). On top of that, the company would be able to deal with its onerous pension obligations which require $60mm or so of annual pension contributions. At current prices, an investor will either receive an extremely attractive YTM (what we believe is the likely case given the Essar parent backing) or if in the worst case scenario a CCAA event is required, the equity at an attractive current valuation (certainly less than 6x off of a stressed EBITDA is attractive and it is easy to see how these bonds are more than covered by the Algoma asset base. Some have expressed the "RG" fear, namely the fear that in a CCAA proceeding, the assets will be shuttered as is happening to the steel assets of RG. RG, however, had bad assets - high cost - which is very different from the more attractive assets which Algoma has. That combined with the benefit of the 2016 contract with Essar Steel Minnesota makes Algoma an extremely attractive asset on a purely unlevered basis).

    If one can source the ABL, this is probably the most attractive part of the capital structure albeit at 400-500bps lower yield than the Senior Secured Notes. This is because when the ABL was put together in September, the borrowing base calculation resulted in onerous terms since the inventory date on which the inventory was valued was off of the 5/31/12 balance at which point raw material pricing was dramatically higher than it was in September. The borrowing base calculation is off of the Orderly Liquidation Value which sets a percentage off of book value (uses ~85% as traditional ABLs do off of Net Orderly Liquidation value of the 5/31/12 balance which resulted in a % closer to 56% due to the decline in raw material pricing). Accordingly, the actual BB is much lower than it would be if the ABL had been structured without using the balance from 5/31/12 given pricing had dropped so much since then. This means that the ABL is actually much more collateralized than one would generally think since the company is more or less only given credit for ~56% of the book value of its inventory and not the usual 85%. When the company comes to market as it plans to do in September of 2013, it plans to get a much more favorable ABL and potentially even upsize the facility which again would provide an added liquidity buffer to help the company make it through to 2016.

     As a final point, a pair trade between going long the Senior Secureds and shorting the Unsecureds may be attractive to some (not necessarily 1:1 but in some ratio, perhaps 2:1 given the unsecured will trade down much more than the secureds if there is in fact a major liquidity or CCAA event and 2:1 also enhances the carry of the trade).

     

    Disclosure: this is not an investment reccomendation and all investors should perform their own due diligence before making an investment. We may trade in and out of the securities without updating this post.
    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Indalex ruling removes overhang/uncertainty
    Improving profitability if steel market pricing firms up (closer to where prices where in early 2011) then earnings power of company should more than offset cash payments boosting liquidity - entire capital structure will trade up
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