MARC has affirmed its ratings of MARC-2ID/AID and AID on Kinsteel Bhd’s (Kinsteel) RM100 million Murabahah Commercial Papers/Medium Term Notes Programme (CP/MTN) and RM100 million Murabahah Medium Term Notes (MTN) Programme. The rating outlook is maintained at stable. The affirmed ratings and stable outlook incorporate Kinsteel’s strong competitive position in several steel product segments and an efficient distribution network which serves as a broad customer base, complemented by a track record of satisfactory performance. The cash flow and credit protection measures of the consolidated entity are, however, currently weighed down by operating subsidiary Perwaja Sdn Bhd’s (Perwaja) cash flow deficits and recent operating losses. Also, the group’s relatively high level of outstanding debt continues to be accompanied by high financial expenses, leading to weak debt service coverage.

The Kinsteel group is involved in the manufacturing and trading of finished long steel products such as reinforced bars, wire rods and wire mesh. Kinsteel has expanded its steel-making capacity upstream to include the manufacture of direct-reduced iron (DRI) and semi-finished steel products such as billets, blooms and beam-blanks.

In the nine-month period ending September 30, 2010 (9MFY2010), Kinsteel reported a revenue of RM1,275.2 million (9MFY2009: RM1,537.1 million) and pre-tax profit of RM0.3 million (9MFY2009: pre-tax loss of RM106.3 million). Although the group had benefited from better export demand in the ASEAN region at the beginning of the year, this was offset by higher iron ore prices and sluggish domestic demand during the third quarter of fiscal 2010 (3QFY2010). Kinsteel’s operational performance has been reliant on a pickup in domestic demand for steel, however, this has yet to materialise as a result of the slow pace of construction spending during the first half of 2010. The group’s outlook in the fourth quarter is expected to remain weak in view of elevated iron ore prices.

In addition to a slowdown in demand, Kinsteel has experienced margin pressure due to a 30% increase in iron ore prices in the third quarter of 2010 amid stagnant steel bar prices. The pressure on margins is not expected to ease in the near term given iron ore prices which reached US$186/MT in January 2011, although billet prices have improved to US$675/MT during the same period. MARC believes that the group would be reliant on a sustained recovery in steel demand to reduce the group’s significant build-up in inventory to RM1,303.6 million as at 3QFY2010 (FY2009: RM1,014.6 million) and to generate sufficient liquidity to fund its debt servicing obligations. The sizeable inventory build-up has impacted its cash flow from operations (CFO), resulting in a deficit of RM25.4 million during the period (9MFY2009: RM147.4 million), and an increased reliance on short-term borrowings to finance its working capital requirements and debt repayment in 3QFY2010. MARC notes that the group has met its latest redemption of RM10 million of its MTNs in August 2010 and RM50 million of Perwaja’s MTNs in September 2010. The group’s negative CFO has resulted in Kinsteel’s debt-to-equity ratio rising to 1.04 times in 9MFY2010 (FY2009: 0.95 times). MARC is concerned that the greater shift towards short-term borrowings may increase the group’s refinancing risks and increase its susceptibility to liquidity risk during the steel sector’s cyclical trough.

At the company level, Kinsteel’s revenue decreased to RM962.9 million in FY2009 (FY2008: RM1,076.5 million) due to lower steel prices during the year. Kinsteel’s pre-tax profit rose to RM32.3 million (FY2008: RM29.7 million). The slower demand for finished steel products has increased in Kinsteel’s working capital needs as reflected in its growing trade receivables of RM569.5 million (FY2008: RM285.3 million) due from its subsidiaries. Kinsteel’s cash flow from operations remained negative at RM23.7 million (FY2008: positive RM112.8 million). The operating holding company fared significantly better than the consolidated group in 9MFY2010, its profit margin improved to 7.4% in 1HFY2010 (full year FY2009: 6.5%) on the back of revenue amounting to RM616.3 million and operating profit of RM21.0 million. However, MARC notes a marginal increase in its D/E ratio to 1.77 times as at 9MFY2010 on the back of a 20.5% increase in short-term borrowings.

The stable outlook incorporates MARC’s expectations of stable operating performance at Kinsteel taking into account management’s actions to mitigate the upswing in iron ore prices and track record of resilience to challenging market conditions. At the same time, MARC acknowledges the continuing pressure on the group’s consolidated credit profile give the steel sector’s current weak fundamentals. MARC believes that further support for Perwaja could be necessary from Kinsteel should the timing of domestic steel demand recovery extend beyond 2H2011 and/or demand recovery proves to be anaemic. A combination of increased liquidity needs and a further deterioration of the group’s leverage and debt service coverage metrics could trigger a revision of the ratings and outlook.

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