R&I Rating Methodology by Sector

Transcription

1 R&I Rating Methodology by Sector Blast Furnace Steelmakers December 20, 2018 R&I applies this rating methodology mainly for creditworthiness evaluations of steel companies that use blast furnaces. R&I has established a separate rating methodology for steel manufacturers with electric furnaces that use iron scrap as a feedstock to produce ordinary and special steel products, because they differ from blast furnace steel manufacturers in many respects such as market size, competitive environment, cost structure and raw material procurement. I. Evaluation of Business Risk 1. View of industry risk Steel is a basic material used in a wide range of manufacturing and non-manufacturing sectors. Because of ample reserves of the raw materials and the well-established mass production technologies, steel can be obtained comparatively inexpensively. Depending on the objective or application, steel materials can be given various functions and characteristics, and because the processing technology is broadly diffused as well, steel is an easy-to-use material. The size of the global market is therefore immense. Steel product applications vary according to the stage of economic development. During the economic take-off stage or initial growth period, steel bars and shapes for civil engineering works and construction account for the majority of steel demand, and the growth of steel demand greatly exceeds that of GDP. As a country's industry structure develops and its economy matures, however, the proportion of steel sheet, plate and pipe for manufacturing increases, and the rate of growth in demand eases. Partly because growth in demand in China, the world's largest steel consumption country, has already slowed, the market's growth rate is lower than in the past. With the exception of some products, differentiation of steel materials is difficult, and prices are determined based mainly on supply and demand at the time of each sale. When supply capacity outstrips the quantity demanded, there is a risk of the market entering a prolonged slump. As the variability of raw material markets has increased, the variability of the steel materials market has this website or any other information included in this website belong to Rating and Investment Information, Inc. ("R&I"). None of the information, etc. may be used, in whole or in part, (including without limitation reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), or stored for subsequent use without R&I's prior written permission. 1/8

2 risen as well. Consequently market volatility is high. Steel is a typical process-based industry, and substantial investment is required to introduce manufacturing facilities, including peripheral infrastructure. Although investment recovery takes many years, the risk that the economic value of manufacturing facilities will decline is limited, with the underlying manufacturing process well established. There is little probability of demand diminishing as a result of steel being replaced by other materials or a change in customers' preferences, and the risk of inventory obsolescence also is low. Accordingly the capital and inventory investment cycles are comparatively long. Based on the above industry characteristics, R&I judges the steel industry to have a medium degree of industry risk. (1) Market size, market growth potential and market volatility The size of the steel industry's global market is immense. During the years from the early 2000s to about 2013, global steel demand exhibited a high growth rate that was driven by the economic development of China and other emerging countries. China has become the world's largest steel-consuming nation, but its growth rate for demand has slowed since roughly While high growth is expected to continue mainly in India and the ASEAN (Association of South East Asian Nations) region, the overall market growth potential will likely be lower than in the past. Steel products find uses in an extremely broad range of applications, including durable goods such as automobiles and home electrical appliances, consumer goods such as beverage cans, production goods such as construction equipment and industrial machinery, resource and energy-related goods such as oil well pipes and pipelines, and materials for civil engineering works and building construction. Since users are not clustered in specific industries, steel demand is affected by all economic activity. Meanwhile, steel product prices reflect changes in the balance of supply and demand from period to period and fluctuate considerably. If supply and demand have deteriorated structurally, there is a risk that the market will be sluggish for an extended period. Price volatility has increased for iron ore and coking coal, the main raw materials, as well as for auxiliary raw materials such as ferroalloys and for energy, and this has led to greater fluctuations in the prices of steel products as well. Market volatility is high. (2) Industry structure (competitive environment) There had been many steel firms around the world, whether state-owned entities or 2/8

3 private-sector enterprises. As global merger and acquisition activity gathered steam since the early 2000s, however, the industry underwent reorganization, particularly in advanced nations. In Japan, the two largest manufacturers have acquired overwhelming market share, and the competitive environment is comparatively stable. China, which accounts for about 50% of global crude steel production volume, has numerous steel producers including small and mid-sized ones. In addition to promoting reorganization and consolidation centered on state-run enterprises, in 2017 the Chinese government halted the production of illegal steel materials known as detiaogang. The shakeout of firms whose environmental actions has been insufficient also is progressing. At the same time, electric furnace steel manufacturers that use iron scrap as a feedstock are increasing their production capacity, and new large-scale steelworks are being established in coastal areas. Given these developments, the competitive environment may remain unstable. In ASEAN, comparatively steady demand growth can be anticipated. Even so, the volume of imports from neighboring countries is rising, and supply capacity is trending upward in ASEAN nations as well due primarily to the construction of new blast furnaces. It would be difficult to describe the competitive environment as moderate. While the supply-demand structure and competitive environment for advanced steel products that demand technical capabilities are relatively stable, even companies with a high percentage of advanced steel products must ensure a certain volume of production and reduce manufacturing cost per unit. Competition for high-volume category sales is impossible to avoid, making the competitive environment comparatively severe. (3) Customer continuity and stability Because components of and standards and measurements for many steel products have been set, such items are versatile as basic materials and end-products. Given this situation, differentiation of products among manufacturers in the general purpose products sector is difficult, especially in steel products for construction, and in general customer continuity is low. For the steel products used in specific sectors such as automobiles, shipbuilding, construction equipment/industrial machinery, and resource/energy, however, the demand for quality is high, and steel manufacturers and users frequently undertake research and development (R&D) of materials jointly in order to improve end-product functionality. Products that require certification from customers in this manner enjoy a higher degree of customer continuity. 3/8

4 (4) Capital and inventory investment cycles Steel manufacturing facilities such as blast furnaces have a long physical life, and provided it is used properly, even old equipment can maintain adequate capability. Although the electric furnace method or direct reduced iron method are well established as steel manufacturing processes in addition to the blast furnace method, the scale of production volume at such plants is small compared with the blast furnace method, and the types of products that can be manufactured also are limited. There is little risk that the economic value of facilities will fall, given the low probability of a groundbreaking manufacturing process being newly created. Steel competes with various other materials including plastic, aluminum, titanium and carbon fiber. In light of steel's superiority in terms of price competitiveness, workability and recyclability, however, it is unlikely that demand will decline greatly because of steel's replacement by other materials. The structure of demand is not influenced by changes in customers' preferences. The risk of short-term obsolescence of steel inventory also is low. Besides inventory maintained by steel companies, there is inventory in the market held by distributors, processors and firms known as traders. There have been many cases where market participants at each stage have adjusted inventory when an economic slump has slowed the movement of goods and the market has begun to falter, and their actions have given added impetus to the market slowdown. Attention should be paid to the occurrence of inventory valuation gains and losses or an increase in the working capital burden induced by fluctuations in the prices of steel and raw materials. (5) Protection, regulations and public aspects Steel is positioned as an upstream industry and has a very broad employment base. Countries therefore tend to implement anti-dumping duties and safeguards when the volume of imports from other countries rises and weakens their domestic steel industry. Such measures are restricted to specific product categories, however, and it is unlikely that imports and exports of all steel products will be limited. R&I judges there is no protection or regulations that must be especially considered when evaluating creditworthiness. R&I will monitor how the CO2 emissions reduction policies of each country's government affect the industry. Because differences are expected to emerge in each country's introduction of and mechanisms for measures such as carbon pricing, however, R&I will reflect this in its evaluation of individual firm risk rather than in industry risk. 4/8

5 (6) Cost structure To manage an integrated blast furnace steelworks, a substantial investment is required for the introduction of production equipment and upgrades of peripheral infrastructure. Commensurate expenditures for equipment maintenance and repairs also are necessary. As a result, firms face a heavy burden for fixed costs such as depreciation and amortization and repair expenses, and overall enjoy little flexibility in their cost structure. The weight of raw material costs as a percentage of the cost of goods manufactured is relatively high. It is difficult to immediately shift higher raw material prices to the price of steel. The increase in raw material price volatility has become a risk factor for stably ensuring earnings. 2. View of individual firm risk In contrast to industry risk, which highlights the standard risks of the industry of which the subject firms are a part, the business risk of each company will differ depending on the individual firm risk as explained below. (1) Steelwork competitiveness High production volume is advantageous for covering the fixed costs of steelworks, making the scale of production one of the critical parameters determining competitiveness. To evaluate competitiveness, R&I looks not only at the numerical figures for the entire company but also at factors such as the scale, incidental equipment conditions and productivity of each steelworks. For steelworks established in countries and regions where CO2 emissions costs are high, R&I will closely examine the impact and reflect this in its evaluation. (2) Product mix and technological prowess In general, prices of steel products are strongly affected by market conditions. Different types of products have different supply and demand trends, however, and if products can be differentiated, particularly through technology, the effect of market fluctuations can be controlled to some extent. Having a broad lineup of such products provides an effective way to improve earnings stability. With CO2 emissions regulations being tightened, the demand for environment-conscious products is trending higher. Responding appropriately to social needs requires a high level of technological prowess. R&I examines the R&D organization and policies to verify whether a company will be able to maintain its technical capabilities in the future. 5/8

6 (3) Customer base For steel products for construction, customer continuity is low because the supplier tends to change with each property. Steel products for the manufacturing and resource/energy sectors, on the other hand, require advanced specifications and high quality, and enjoy substantial continuity. R&I evaluates the stability of sales through strength of the customer base in these areas. The strength of the customer base does not contribute merely to improving the stability of production and sales. While technology accumulation is critical if a steel producer seeks to enhance the competitiveness of its advanced steel products, attempting to achieve this solely by amassing research at the company itself may be inadequate. Undertaking commercialization and mass production of products in cooperation with customers is a requisite for the improvement of technical capabilities. (4) Ability for geographical expansion While constructing a stable earnings base in the region where a company has its headquarters is critical, eventually that market will mature. Therefore creating a global production and sales organization, including expansion into regions where demand will grow, is essential for sustained growth. (5) Raw material procurement capabilities Steady procurement of raw materials is indispensable for stable operations. This means a steel manufacturer must ensure required quantities by, for example, concluding long-term agreements with several mines. In addition to stability of procurement, as raw material prices have become more volatile, it is important to establish an organization that can mitigate fluctuations in profits from steel operations by having resource rights. When evaluating a firm's ability to cope with changes in the raw material markets, R&I takes note of the resource rights the firm holds relative to the required quantities. 6/8

7 II. Evaluation of Financial Risk (1) Earning capacity Return on assets (ROA), operating margin, EBITDA (earnings before interest, taxes, depreciation and amortization)/average total assets Because steel is a typical process industry, it is extremely important to assess whether a firm is generating earnings efficiently from its invested capital. R&I focuses on ROA and EBITDA/average total assets, which indicate asset efficiency on a profit and cash flow basis, respectively. R&I also looks closely at operating margins to evaluate profitability. For companies with high profit contributions from resource rights or arrangements such as joint ventures, R&I will appropriately reflect in its evaluation the effects of dividend income or equity in the earnings of affiliates. This approach is used for EBITDA as well. (2) Scale and investment capacity EBITDA, equity capital When examining scale and investment capacity, R&I emphasizes EBITDA and equity capital. Steel manufacturing facilities constantly demand a certain level of upgrade investment. Furthermore, to develop as a firm over the long term, expansion of production capacity, a shift toward higher grade products, the acquisition of resource rights and strategic investments, including the purchase of domestic and overseas firms, are indispensable as well. R&I places more focus on the amount of EBITDA because an ability to continually generate sufficient cash flow is required in order to flexibly make such strategic investments. (3) Debt redemption period Net debt to EBITDA ratio, net debt to operating cash flow ratio The number of years in which a company can repay debt using cash flow as the source of funds for redemption is a key indicator for evaluating the debt burden. When considering cash flow as the source of funds to repay debt, R&I emphasizes the ratio of net debt to operating cash flow, which shows funds actually generated from operating activities, in addition to the ratio of net debt to EBITDA. 7/8

8 (4) Financial profile Equity ratio, net D/E ratio (ratio of net debt to equity capital) Because appropriately managing the debt-equity structure and increasing flexibility in financial management will heighten the stability of creditworthiness, R&I focuses on the net D/E ratio. Strengthening the financial base and enhancing financial resilience are vital to support restructuring of the business in response to changes in the structure of demand or to prepare against an unanticipated deterioration in earnings. In addition to ample equity capital, R&I emphasizes the equity ratio as an indicator of financial resilience. III. Rating for Blast Furnace Steelmakers Issuer Rating Individual Firm Risk Financial Risk Importance Indicator Importance Steelwork competitiveness ROA Product mix and technological prowess Earning capacity Operating margin Customer base EBITDA/average total assets Ability for geographical expansion Scale and EBITDA Raw material procurement capabilities investment capacity Equity capital Debt redemption Net debt to EBITDA ratio period Net debt to operating cash flow ratio Financial profile Equity ratio Net D/E ratio Industry Risk: Medium Note) Importance is indicated by : extremely important, : important, or relatively important. * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 8/8