Arrium’s share price was pushed up by 17% on the day of their earnigns results though many analysts do not share the market’s enthusiasm. Adjusted profit increased from AUD 143 million to AUD 168 million but quality remains poor. Profit was boosted by an interest rate on sizable, mainly U.S dollar denominated debt, of less than 5%, a reported tax rate on adjusted pretax profit of just 14% and a one-off, after-tax restructuring charge of AUD 66 million. Arrium tends to report “one-off” charges fairly regularly.

The mining consumables business appears more resilient, but Arrium is unlikely to ever generate returns commensurate with the bloated asset base, due to high-cost acquisitions and ineffective capital investment. While analysts expect oppressive competitive pressure to ease somewhat and margins to recover slightly, it is highly unlikely Arrium’s steel businesses will ever deliver returns commensurate with the company’s cost of capital due to intense industry competition stemming from low barriers to entry. The poor stewardship rating reflects Arrium’s optimistic debt-fueled acquisitions and investments in mining and mining consumables. High operating and financial leverage, coupled with heavy capital intensity, drive our very high fair value uncertainty rating. Those attributes also mean Arrium is not well placed for an economic downturn, particularly if iron ore prices contract.

The headline net loss of AUD 695 million in fiscal 2013 compares with a profit of AUD 58 million in fiscal 2012 and was dominated by impairment and restructuring charges. Operating cash flow of AUD 590 million and reported free cash flow of AUD 253 million were highlights. However, cash flow benefited from a net AUD 210 million favourable working capital movement, plus AUD 120 million of asset sales. While the working capital moves and asset sales show Arrium’s management is correctly running the business for cash, particularly the steel division, stripping out these non-recurring benefits highlights the weak underlying performance.

It’s particularly glaring considering profit from iron ore mining dominated the result, accounting for 60% of fiscal 2013 EBITDA and 80% of EBIT. Arrium has no sustainable competitive advantage in iron ore mining. Reserves support less than six years life and margins are well below those of global iron ore majors like BHP Billiton (ASX:BHP) and Rio Tinto (ASX:RIO). Operating leverage from product discounts and the inferior cost position will be exposed if iron ore prices fall from current favourable levels as we think likely.

Cash flows are discounted with a weighted average cost of capital of 11.3% based on a long-term capital structure comprising 35% debt and 65% equity. The 15% cost of equity reflects high revenue cyclicality, operating leverage and financial leverage. The long-term cost of debt assumption is 6%, however this does not capture the risk of currencies moving against Arrium. More than half the weighty debt burden is denominated in U.S. dollars and Canadian dollars.