Vallourec - Iron ore or tubes business?
All,
Please find our updated model on Vallourec here.
The 2021 boom in iron ore prices has afforded Vallourec an unexpected but welcome chance to ride out the impact of delays in oil and gas CAPEX, which have hampered its core tubes business. Although we remain dubious on Vallourec’s overall EV, the post-restructuring capital structure presents an old fashioned yield play. We remained cautious on Vallourec through the restructuring, discounting the EBITDA improvement and corresponding bond price appreciation from the increase in iron ore prices. However, delving further into our model, stripping out an estimated impact of the iron ore mine on the overall Group, only further reinforces our negative view on the overall EV of Vallourec.
Notwithstanding the concerns, there should be sufficient value to cover the outstanding debt and fully expect the debt to be refinanced at the earliest call date, June 2023.
Business:
- Vallourec is essentially two businesses: 1) The traditional tubes business that relies on the oil & gas exploration cycle and 2) post recent investment, an iron ore producer, that produces 5mt above internal demand.
- The iron ore business has benefitted from the 2020/21 rally in commodity prices which led to Vallourec increasing its EBITDA guidance over the first half of 2021. Although iron ore prices have retraced and are currently below $100/t, Vallourec expanded its iron ore mine over the last couple of years and are in a position to produce 8.5mt of iron ore in FY22. We estimate that 3mt is used internally with the balance sold externally. Vallourec does not report iron ore revenue or EBITDA, but we estimate EBITDA for FY22 from iron ore will be in the €150-170m range at $100/k iron ore price.
- The iron ore sales and EBITDA has provided a useful buffer in the last couple of quarters to the main “tubes” business. There are several “green” shoots in the oil exploration industry and the recovery in oil prices has given oil explorers more confidence in placing orders. No one is expecting a return to the 2012-14 era of boom time in exploration but we are modelling an improvement in underlying conditions in the oil exploration market.
Free Cashflow:
- Simply there is none. A shocking statement for a business with limited leverage, but Vallourec does not produce any Free Cashflow. Our model might be cautious, but even the projections shared by the Company during the restructuring envisaged no free cash flow in FY22 or FY23. This was primarily driven by Working Capital, and this is likely to be exasperated by the evolution of raw materials and energy costs. We envisage FY22 EBITDA to exceed FY20 (FY21 is artificially high due to the spike in iron ore prices), leverage is going to creep up above 3.5x.
Wrong Capital Structure:
- Vallourec exited the restructuring in the knowledge that the leverage was going to increase due to build-up of working capital (Inventories mainly) but the reinstated bonds, with a 8.5% coupon is expensive debt for the Company given its leverage.
- The bonds should and are likely to be refinanced at the earliest opportunity, and are callable in June 2023 at par. At current prices, (102 mid) there is a yield to call of 7.1%
Risks:
- How much has the market priced in? We fully expect EBITDA to taper off as Vallourec proceeds through FY22 (due to the roll off of the excess Iron ore profits) plateauing in the €260-300m EBITDA range. Leverage will increase further the more confident Vallourec are about future business and the build-up of inventories. This appears counterintuitive, but if leverage increases due to Working Capital movements, the market is likely to remain optimistic about Vallourec’s prospects.
- The bigger risk is that the oil exploration boom never materialises. Under this scenario, EBITDA would only be marginally lower than projections (depending on iron ore prices), but without the increase in Working, Capital leverage would be muted.
- However, in this scenario, Vallourec may not be able to refinance the bonds. However, with the 8.5% coupon and the relatively limited total leverage, we would expect the bonds are unlikely to trade-off substantially.
Investment Considerations:
- In the current environment, a 7% yield is attractive. However, all forward projections envisage leverage increasing over FY22 and the refinancing, which is our base case, will be based on investors believing in the expected top-line growth in FY23 and FY24.
- A refinancing is our base case assumption, but we are concerned about the lack of upside and potential for a more negative market reaction to increasing leverage. We are not taking a position at the moment.
Happy to discuss.
Tomás
T: +44 20 3744 7009
M:+44 7786 705 806