MARC has affirmed the rating of Perwaja Steel Sdn Bhd’s (Perwaja) RM400 million Murabahah Medium Term Notes (MMTN) Programme at AID. The rating outlook has been revised to negative from stable. The outlook revision incorporates the recent deterioration in Perwaja’s operating performance, and continuing pressure from lower volumes and rising input costs. Of particular concern to MARC is Perwaja’s capacity to manage its liquidity position through its industry cyclical trough, given its high debt leverage and significant annual debt maturities. The rating also takes into consideration the importance of Perwaja’s upstream steel operations to its parent company, Kinsteel Berhad (Kinsteel) and assumes continued commitment of Kinsteel to Perwaja.

A major domestic producer of direct-reduced iron (DRI) and semi-finished steel products such as billets, Perwaja has been affected by declining demand in line with the government’s stimulus spending programme in fiscal 2010 tapering off, exacerbated by rising raw material costs. For nine months to September 30, 2010 (9MFY2010), Perwaja registered lower revenue of RM1,108.8 million (9MFY2009: RM1,160.4 million) and a pre-tax loss of RM3.6 million (9MFY2009: -RM155.2 million). Perwaja has been beset by low capacity utilisation rates, which averaged at 55.4% for its 1.5 million metric tonnes (Mt) DRI plant capacity and 67.7% for its 1.3 million Mt billet production capacity in 9MFY2010. The slowdown in demand has also contributed to the company’s significant build-up in inventory to RM874.3 million during the period (FY2009: RM623.5 million), or 205 days of inventory (FY2009: 153 days).

For the third quarter ending September 30, 2010 (3QFY2010), the company registered a lower revenue of RM270.6 million compared to RM373 million and RM465.1 million in 1QFY2010 and 2QFY2010 respectively, marking its third consecutive quarter of decline. Meanwhile, the price of iron ore has been on an uptrend, rising from US$132.50/MT in January 2010 to US$169.50/MT end-November 2010, exerting downward pressure on its operating margins. MARC does not envisage Perwaja’s performance to improve in 4QFY2010. While MARC believes that improvement in financial performance could be driven by a recovery in domestic steel consumption, this is only likely to occur in the second half of 2011 when the projects under the government’s Economic Transformation Plan are rolled out.

Perwaja’s upstream steel operations continue to derive strong support from its parent, Kinsteel, which procures the bulk of Perwaja’s billet production (9MFY2010: 67%; FY2009: 63.8%) for its downstream manufacturing operations of long and round steel products. MARC believes that Kinsteel, with its longstanding experience in the steel industry as reflected in its wide network of established end-markets, has been instrumental in supporting Perwaja’s sales performance and at the same time has been able to achieve greater operational efficiency by integrating operations and management of both companies.

Additionally, MARC notes that as a result of the company’s persistent operating cash flow deficits and progressive limit reduction of the MMTN facility by RM50 million annually since 2009, Perwaja’s funding and liquidity has become increasingly reliant on short-term financing in recent periods. With the concomitant increase in short-term debt, debt-to-equity rose to 1.27 times (FY2009: 1.19 times). The company’s current high leveraged position limits its ability to fund any capacity expansion from borrowings, including a proposal to build a RM400 million pelletising plant with a production capacity of 2.4 million MT. Notwithstanding the possibility of deferring the repayment of its government and related party loans amounting to RM203.4, MARC is of the view that Perwaja’s balance sheet and credit metrics would not be able to accommodate the investment without a material weakening in the company’s credit profile. Perwaja’s balance sheet liquidity is modest, with cash and cash equivalents of RM7.0 million at September 30, 2010.

A revision of the rating outlook to stable would require an abatement of concerns over a continued weakening of Perwaja’s credit metrics and evidence of improvement in the company’s liquidity position. The rating could be lowered if Perwaja’s financial results over the next several months indicate a prolonged period of weak operating performance and a delay in its return to profitability and credit metrics more supportive of an ‘A’ rating.

Contacts:
Rajan Paramesran, +603-2082 2233/ rajan@marc.com.my;
Ahmad Gazzara Czillich, +603-2082 2269/ gazzara@marc.com.my;
Jason Kok, +603-2082 2258/ jason@marc.com.my.