Longer pieces: Credit Crunch

COPING WITH THE CREDIT CRUNCH
from Forward July-August 2009

CREDIT CAUTIOUS
Tightness in credit markets and lower demand continue to put pressure on even the healthiest of metals companies. Service center executives Forward magazine spoke with say more consolidation is in the cards.
Interviews by Michael Chevy Castranova


SERVICE CENTER PARTICIPANTS
Roy Berlin, president, Berlin Metals LLC, Hammond, Indiana
Marion Britton, vice president and CFO, Russel Metals, Mississauga, Ontario
Karla Lewis, executive vice president and CFO, Reliance Steel and Aluminum Co., Los Angeles, California
Terence Rogers, executive vice president and CFO, Ryerson Inc., Chicago, Illinois
Mary Valenta, executive vice president and CFO, O’Neal Steel Inc., Birmingham, Alabama
What have you seen in credit availability over the past eight months or so? Is it getting tighter or looser?
Valenta: I would say generally it is still really tight. With many banks and many of our customers it is still fairly tight. I can’t say it’s loosening, but I can’t say it’s getting tighter.
Lewis: There are a couple different ways I would look at it from a Reliance perspective as a $10 billion public-equity and debt company. Over the past six months it would have been extremely difficult to raise new funding at our level—we’re a triple B minus, so we’re investment grade. But even at that level, companies were having difficulty raising additional debt in the various credit markets that freed up a little bit earlier this year [but then] tightened up again. Now it’s opening up again. So currently credit seems to be a little bit more available and the cost is a little better. But we’d still be paying a significantly higher cost today than for the debt that we currently have in place.
Talking to a lot of commercial bankers, their business is probably more profitable now than it’s ever been because they’re able to charge a much higher margin. [But] good companies can get credit.
Berlin: Luckily for my company, our credit facility doesn’t expire until early next year. But LIBOR [London Interbank Offered Rate] has come back down to its more historical relationship to prime, so LIBOR now is roughly about .5%, and prime being at 31⁄4 [as of early June]. The bank has margin, if you will, to borrow money from other banks, then loan it out and make a spread. … [Banks] now want to make it LIBOR plus 41⁄2—that would raise your rate from the current 21⁄2 to 5, in essence doubling your interest rate. The effect of that is raising the borrowing costs for companies in our business at a time when business levels are reduced and makes it more expensive to borrow money.
Britton: Credit availability is better in Canada than it is in the U.S. I think that the banks in Canada are in slightly better shape than the ones in the U.S., which does help. They work under tighter rules than some of the U.S. banks. [Canada’s highly regulated national banks have a lower ratio of loans and investments to capital compared to U.S. banks, which limits the banks’ risk. U.S. banks went as much as twice as high on the loan-and-investment side of the ratio.]
Has your financing historically come from banks or public markets, or have you been self-financed? A combination? Has that changed during this credit crunch?
Lewis: Historically we’ve raised most of [Reliance’s debt] through credit facilities and had done some private placement notes. Starting in 2006, we entered the public debt market and did a bond offering. We haven’t done anything to change our capital structure because we’ve got adequate availability, and [with] the structure and cost of the debt that we have in place right now, there’s no way we could replace it at the cost we have. We are looking to just maintain what we have.
Britton: We have a U.S. high-yield bond outstanding, plus two banking syndicates, and we’ve had that for more than 15 years. It’s been something we’ve typically had, whereby we have our equity, and then a chunk in long-term debt. But then we use the banking facility to fund the ups and downs in the working capital.
Berlin: We’re privately owned and we borrow from the banks. The cost for money for everybody in the whole supply chain has gone up. We do currently have an industrial development bond that we originated three years ago and there’s seven years more to go, and then we’ll be paid off. If we were to [originate] that bond today, our rate would be a couple percent higher. We’re paying 5-point something, and General Electric, who underwrote that bond, said if we were to repeat that again the rate would be in the 7s somewhere. It wasn’t a huge bond, $2.5 million.
How has the credit situation affected your purchasing from producers? How has it affected ongoing or planned projects?
Rogers: There are three or four items that we have deferred until market conditions change, including issues with our IT systems upgrade to SAP [software]. And we’ve deferred a couple of other what I would call opportunistic expansions—not anything we needed to do.
It’s not a matter of liquidity or availability of capital, it’s really a matter of prudence. We’ve been—as have most of our competitors—in an aggressive mode of trying to reduce our inventory to meet the levels that we were seeing in terms of sales in the market. We certainly have purchased far less than we have historically, but that had nothing to do with accessibility to credit. It was really more just managing the inventory levels down commensurate with the market activity.
Valenta: I would say the economic recession has had more impact limiting our original planned growth. There are a number of strategic growth plans that we have on hold primarily because the demand levels are down right now.
Lewis: From a credit perspective, that has not impacted our purchasing at all. From the fact that there’s relatively no business—and I shouldn’t say “no business,” we’re still selling a lot of metal—but more based upon just demand levels, we have certainly cut back on our purchasing activity.
Berlin: Because our rate has not yet reset, it hasn’t affected us at all. In the bigger picture, everyone’s cost is going up in the system. Plus, as your inventory becomes worth less as the price declines—it’s declined rapidly since last summer—that’s collateral you use to borrow money. That collateral becomes worth less. Banks also loan money on machinery. The machinery market has tanked, and so that used-equipment valuation has become worth less. … Typical collateral for a company would be their real estate—some companies own their own buildings—and there’s been a decrease in value of real estate. Equipment is worth less, real estate is worth less and the banks are raising the rates, so you have the availability of less funds overall, and a higher cost of those funds overall.
What have you heard from your customers in terms of obtaining financing to buy from you? When did you start to see a slowdown?
Lewis: It happened pretty quickly, the beginning of November of ’08 [for Reliance]. We don’t sell metal to the auto and appliance industries—companies who sell more directly to them were hit earlier than we were. We have a pretty big chunk of business that’s nonresidential construction.
Order patterns of our customers have become smaller and more frequent, [but] that’s actually the type of business that Reliance does every day. We believe that until there is a general comfort level that prices have … stabilized, people will continue to just buy what they need and won’t buy any stock material.
Rogers: [During] 2008 as a whole, volumes were down from 2007, but particularly in the third and fourth quarters, and into the first quarter of 2009. The buying patterns have been at levels we haven’t experienced in decades. It was sliding downward, and then certainly took dramatic drop-offs in the fourth quarter and the first quarter.
Berlin: [We started to see a buying slowdown in] the fourth week of October. We were having a good October, but in that last week our customer releases just slowed down and our last few days of the month were terrible. October was a good month, but that [slowdown] then extended in November and December and it was like, whoa. It was like the spigot was just turned off.
Britton: It was like going to a cliff, and then falling off in the last quarter of 2008. All of a sudden people realized that either they needed to conserve cash or their banks were saying, “No, you can’t borrow more.” Or else they just weren’t selling as much at the other end, so they said, “We better slow down on our buying because we don’t want to have a huge amount of inventory.” And I’m sure there was some of each.
Did the number of customers’ orders decline or did they stop suddenly? Or did their order sizes become smaller over time?
Berlin: Everyone got afraid. The fear was kind of like a domino effect. You had the credit meltdown in September, and it took a month for the sense of what was going to happen from it to percolate through the system, and everyone’s buying just froze shut. And then all the buyers lost their visibility for their companies to project their own sales, and so the buyers were told, “Don’t buy so much, we don’t know what we’re going to sell.”
The numbers in November, December, we probably saw a 50, 55% decrease in our volume levels over September, October. That’s a big number. There was a slight recovery in January, but if you look at [the Metal Service Center Institute’s] numbers for the shipments out of the service centers in the first quarter, [they] were down by 40 to 43% across the board for service centers in the aggregate versus the first quarter of ’08. One month I was 37 and they were reporting 42, so everyone was in the 35 to 45% range in terms of a decline in business versus the same period a year ago.
Valenta: Some customers have said that their inventories are low and they would like to replenish, but they are constrained by bank financing, and some infrastructure projects are delayed while they’re working on financing. I’m not seeing a timing of when things will free up. In most cases we saw a decrease in the amount customers were buying. In a lot of cases, [they are] still placing the same number of orders, but the quantity per order is lower.
Have you extended credit to any of your customers? Has that changed?
Rogers: At any point in time we’ll have upwards of 20,000 customers to whom we’ve extended credit, outstanding balances with customers. Certainly we’ve been tighter [since the crunch began]. We’ve stayed on top of payment patterns more than you would in a typical environment.
Berlin: I give credit to my customers all the time, but I’m being very careful [now], as careful as I can be. If a customer was a few days late previously, say I gave them 30-day terms and they were a few days late a year ago, I wouldn’t have worried too much about it. Today I’m on the phone with them at 31 days and, depending on the customer, you may be on the phone with them at 27 days, saying, “Just calling to make sure you have checks coming scheduled for the 30th.” If I don’t get that check the 31st, 32nd day, then I’m calling them back saying, “The check’s not here and I hate to have to impact orders and releases, but if I don’t have a check I can’t continue to ship.” We’re spending as a company much more time having those kinds of conversations. If my CFO was involved in credit, say, eight hours a week, he’s [now] involved in credit two days a week.
Lewis: That’s a hard question to answer because we’ve got so many different customers and our credit function is decentralized in approximately 160 locations, and our people in the field are making credit decisions every day. But in the words of our credit manager, “You practice good credit policies every day and you don’t have problems.”
Rogers: We certainly have had situations where customers have had difficulty getting the credit they need to manage their business, and those are situations we need to work through. [We’ve seen] an increase in write-offs, and a stretching out of the DSOs [days sales outstanding]. But overall we’re pretty pleased with how well we’ve been able to stay on top of it and tried to avoid having any major issues.
Some companies have reduced working capital and costs. Have you restructured in any way because of the credit shortage? If there is a rapid pickup in demand, what kind of position will you be in to respond?
Lewis: We’ve definitely reduced our working capital to try to better match our customer demand levels. Through the fourth quarter of ’08 and the first quarter of ’09, we reduced our inventory by over $800 million. We’ve taken a significant amount out of our working capital. We’ve also made job cuts, but that’s kind of a business-by-business decision of how deep we go. We had cut 17% of our work force over that same period … and we’re continuing to evaluate that and take action, depending on how the market reacts. … If demand were strong enough, we would love to bring people back.
Berlin: I wouldn’t call it restructuring, but we have had a reduction in work force, and we’ve reduced our machine capacity, our manning of machines, by 40 to 50% since a year ago summer.
Rogers: We were a little bit ahead of the curve in that we were purchased by Platinum Equity in October 2007, and we’re on a fairly substantial restructuring program in terms of decentralizing a lot of operations and really readdressing the way that we go to market. On top of that, as the market deteriorated further, we took another set of actions to try to address our cost structure in light of the market conditions.
On the working capital side, [we’ve instituted] significant reductions in our inventory levels and our receivables, as the sales have declined, and similarly significant reductions in the debt levels that we have with our banks.
As to how our capital structure and the way our funding arrangement with the banks works, as our needs to fund additional sales—the receivables generated by additional sales, as well as the additional inventory we need to bring in to serve our customers—start providing us more accessibility to bank financing, we have a deal that’s sized to allow the business to come back. That committed bank financing through 2012 will allow us to fund the additional working capital needs under our existing bank deal.
Britton: We’ve reduced our costs by laying off people, reduced work weeks and salary reduction. [In February, Russel Metals announced 500 job cuts and reduction of executive and employee pay by 10%.] Working capital—it’s been basically managing the inventory and making sure accounts receivables are collected.
Have you considered any acquisitions? How has the credit crunch affected the status of any of these plans?
Berlin: We’re a mid- to smaller-sized company. I’ve been looking in this last year for a company our size, maybe half our size, who would be a good candidate to consolidate with. I haven’t found that candidate yet. I’ve seen some companies become available because they’re having difficulty, [but] I’m not looking to buy a company in trouble and rescue somebody. There are some companies out there that can do that better than I can.
Valenta: Because of the current economy and the current credit crunch [family-owned O’Neal is] cautiously reviewing any future acquisitions. We’re not closing the door on them, we’re still reviewing and considering, but it’s more difficult to do right now.
Britton: Not currently. And we would have to feel comfortable as to what the market conditions are and to see where we’re at before we want to be doing that.
Lewis: We have publicly stated that, during the credit crunch, we were not doing acquisitions until such time that we have more confidence in the market and the outlook going forward. But we’ve also said we expect there to be opportunities that come out of this, and that we will be positioned to take advantage of the right opportunities.
Rogers: There are some potential opportunities in the market. We’ve been an active looker, and we’ll continue to do that. There are certain deals we could do underneath the bank financing that we already have committed. For larger deals, maybe we would have to go back to the market, but there’s a lot of flexibility just in our existing deals to make some acquisitions and to take advantage of the market to try to add some good companies at this point. We’re actively looking, and we’ll always be actively looking.

CREDIT WHERE CREDIT IS DUE
from Forward July-August 2009
The credit market has improved, say investment bankers and analysts, but the cost of credit will remain higher than it was.
Edited by Michael Chevy Castranova
ANALYST AND INVESTMENT BANKER PARTICIPANTS
SCOTT A. ANDERSON, senior economist and vice president, Wells Fargo & Co., Minneapolis, Minnesota
ELI LUSTGARTEN, president, ESL Consultants, St. Louis, Missouri, and senior vice president and senior analyst with Longbow Research, Cleveland, Ohio
RICHARD McLAUGHLIN, steel and metal industry specialist leader, Deloitte Consulting, Cleveland, Ohio
VINCENT PAPPALARDO, managing director, Dresner Partners, Chicago, Illinois
MARK PARR, managing director and equity research analyst, KeyBanc Capital Markets, Cleveland, Ohio
JOHN SAFRANCE, senior analyst, Fraser Mackenzie, Toronto, Ontario
JAMES SWEENEY, director of global strategy research, Credit Suisse Group, New York City
ROBERT WUJTOWICZ, managing director, InterOcean Financial Group, Chicago

How would you describe the current state of the credit markets, particularly as it relates to the metals industry? Can you offer any numbers to put the current conditions into perspective?
McLaughlin: There are two things happening right now which are damaging—one is the shrinkage in overall credit availability, and another is the deterioration of credit quality in certain industry sectors, such as the automotive industry. The automotive industry is very important [to the metals industry], and it’s in a state of disarray. In addition, housing and construction in general are big end users of metals. The deterioration of those markets due to credit tightness has slowed many metals markets dramatically.
Parr: It was the removal of credit from most creditusing segments of the economy that really threw the world into a recession last summer. We’ve seen a number of significant actions that have resulted in major steps toward the reorganization of the credit markets. This would include direct capital injections into the financial sector and the TALF [Term Asset- Backed Securities Loan Facility] funding program. Interbank lending rates and the LIBOR spread have returned to the levels seen before the credit mess really began.
You have seen capital markets willing to supply increased equity raising or new equity-raising [tactics]. The industry has access to both debt and equity in this environment, which is unusual. Normally you see the equity window shut down. It’s a tremendous acknowledgment of the improvement the industry has achieved in the past decade.
Sweeney: We are seeing significant issuance of new debt securities and corporate bonds, but these are debt securities issued directly to market, which are different from bank loans. If you are a big company and can access capital markets, you can raise debt right now.
However, outlook for bank-loan growth is more troubled. A lot of [banks] have troubled loans on their books and are not willing to take chances on loans.
Pappalardo: There have been a significant number of metals-related companies—particularly those that may have had write-offs in November and again in January or February—that are getting pressure from their lenders to get junior capital, which may take the form of subordinated or mezzanine debt or preferred common equity, has a lower priority in a liquidation or wind-down, and doesn’t stand to get paid anything until the senior secured lenders are repaid in full. The banks are seeing many covenants get threatened and are worried about fixed-charge coverage ratios as well as the impact of the drop in inventory values on their collateral base.
Wujtowicz: The regulators, of course, are looking over the banks’ shoulders with added scrutiny. Naturally then, the banks are having to put the squeeze on service centers and, in effect, telling them, “You have to put down more equity or be forced to liquidate your company.”
Lustgarten: One of the series that we monitor is a Federal Reserve series on commercial and industrial loans, [which] measures the tightening and easing of lending across markets. During this cycle, [the United States] got to be one-third tighter on lending than ever in history. Now there has been an improvement in willingness for banks to lend. … It’s not to say that things are over, but the fear is dissipating.
Anderson: The credit facilities that the Feds have set up—I count 11 of them now—are working their monetary magic, so to speak. The federal funds rate is down to zero and has been there for about six months now and is starting to get some traction. We’re starting to see liquidity spreads moving down, and they are back to where they were prior to the Lehman Brothers collapse last fall.
What has been the impact of the credit crunch in terms of mergers and acquisitions? Has there been a lower transaction volume? How have companies reacted?
McLaughlin: [A recent Deloitte study] refers to deal volumes within the metals industry from March 2005 through March of 2009. In 2007 there were $73 billion worth of transactions worldwide. In 2008, that number fell to $31 billion. In the first three months of 2009, transactions had not even totaled $1 billion. So mergers and acquisitions have virtually stopped, with the exception of China.
Canada is intertwined with the U.S. and is suffering from the same dynamics that we are. No mergers and acquisitions of note have taken place there. The automotive industry plays a significant role in the economy of Ontario. The difficulties that U.S. automakers are having are affecting Canada more than the U.S.
Pappalardo: Transaction volume has definitely slowed. That is no surprise. Most buyers that are in decent financial shape are just trying to preserve cash and are not actively looking at growth via acquisition. The year-end financial statements have made their way through the banking system, and they’re going through their annual review cycle. [These] guys are realizing the cash their borrowers made over the past few years is dwindling. For the most part, forced liquidations are just beginning.
Anderson: The credit crisis could accelerate M&A activity as we come out of this downturn as companies feel the need to combine, cut costs and improve efficiencies.
Safrance: My guess is 2010 will heat up [M&A activity] as some of the companies that were particularly beat up in this go-around can’t get off of the mat.
Sweeney: In terms of leverage, the buyout market was really booming [a few years ago], and that was symptomatic of the credit climate. Some of the debt used in that leverage loan market has really suffered in the crisis. You are not going to get as many leveraged buyouts as before because debt is now more difficult to raise.
Has there been a shift in emphasis on financing sources—say, from public sources of financing to private sources, such as banks or private investors? What has been the effect in terms of the duration of borrowings— that is, short-term versus long-term?
Anderson: When the bond markets froze up or got more expensive, we saw movement toward the banks to fund at least some short things such as payrolls and that sort of thing.
McLaughlin: The public markets seem to be the best option available for metals companies. U.S. Steel recently completed successful offerings—both equity and debt—and ArcelorMittal issued a substantial amount of debt. Corporate offerings are fairly attractive in this market—there’s no question that traditional loans are shortening in maturity and our clients are all facing liquidity concerns.
Sweeney: Borrowing from the government is not something [a company] wants to do, it’s something that it is forced to do. It’s a response to market panic and credit crisis—financial institutions that have borrowed from public sources will want to pay that back. A healthy economy should come from private savers. We are seeing more private lenders make loans.
Pappalardo: Many metals companies will have a bank for a traditional revolving credit facility, but that credit is getting uncomfortably large based on what the projections for the year are. The bank, for example, may have lent to them based on three times total debt to EBITDA [earnings before interest, taxes, depreciation and amortization] a year ago, but now the bank is looking at a significantly reduced EBITDA level and a total debt to EBITDA ratio in excess of five. This makes lenders uncomfortable, and they’re saying, “Wow, we’re getting to the point where our senior loan is at or very close to the value of the entire enterprise, and what we need to happen is to have some junior capital come in below us so that we’ve got an appropriate capital cushion,” even though it’s shortsighted to assess value and leverage based on depressed EBITDA levels, and people expect a recovery at some point.
Are some of these companies in danger of being forced to liquidate if they can’t raise junior capital?
Pappalardo: What I’m more concerned about is that there’s going to be a bit of a supply-demand imbalance with the large number of metals companies looking for junior capital to strengthen their balance sheets. For the sub-debt and mezzanine players active in this sector, there’s going to be a huge number of potential investment opportunities available, and they will have to choose which deals they can devote time to. Unfortunately there’s going to be a few people for whom those deals won’t get done because those mezzanine players are just too busy.
In light of the current market, is it dangerous for companies to continue extending credit to their customers? If not, when does it become dangerous?
Sweeney: The most acute crisis phase has passed, and in that phase, extending credit to customers did have increased risks. A lot of company models—including metals companies—are built on extending vendor financing to customers. I’m confident that these markets will be getting gradually better. LIBOR spiked last year and now it’s well below 1%, which is a good sign. It’s indicative that credit is moving more, banks are lending at greater terms. The confidence in government programs has been helpful in alleviating concerns. It’s not a completely healed credit market at this point, but it’s improving.
Are there any general signals outside the industry for metals companies that will indicate freer credit availability is near?
Parr: Credit communities tend to be more backward- looking than forward-looking. The front end of a recovery is financed internally. The signals that you would look for include improving capacity utilization, commodity pricing trends, ISM [Institute for Supply Management] numbers, and durable- and capital-goods orders.
McLaughlin: What the government is trying to do is to offer the banking system an opportunity to dispose of illiquid securities, especially collateralized, mortgage-backed securities. They are still out there as potential write-offs. [As long as they are out there], those keep the credit markets skittish and banks maintain ownership with an ongoing concern about their value.
Will the current credit tightening have any long-lasting effects on the metals industry as a whole?
Anderson: We’re not going back to the leverage that companies were able to enjoy during the boom years. We are in an era of “new normal,” and we’re going to see a much more balanced approach to lending. Underwriting standards probably got too liberal, and we’re moving back to a more sensible underwriting environment with much stricter regulatory oversight. Cost of credit will probably remain somewhat higher than what we’ve seen in the past, and that will be factored into a lot of decisions that metals companies have to make.
Safrance: What I have seen, at least in North America, is an unprecedented willingness to cut production. This is primarily due to consolidation over the past decade. North American mills are operating at approximately 40% of capacity, which is unheard of.
Pappalardo: It’s going to lead to more consolidation. The companies that make it through this— which is all you really want to do—are going to understand just how bad it can be, and they will understand getting scale—which will better help insulate their business from market risks and help their availability of credit— is what’s going to be important in the long run.
McLaughlin: In the future, the U.S. automotive industry might be structurally smaller. With gas up to $4 a gallon, smaller cars are more attractive [for consumers]. That cost would reduce the amount of automotive output, which reduces demand for metals.
What are the characteristics of metals companies that have suffered the most from the current credit crunch? Which are better poised to actually benefit from tightening credit?
Safrance: No rocket science here, as it can be applied to just about any industry. Those that have suffered most have carried enormous levels of highcost inventory or have highly levered balance sheets or high fixed costs.
McLaughlin: I can’t think of anyone benefiting from the tightening of the markets. Steel divides production into flat and long products. The steel in a car body tends to use flat products while companies that produce long products produce supply materials that are used to build roads and bridges. With the [American Recovery and Reinvestment Act] stimulus package tending to be focused on infrastructure, those companies will do better. For example, AK Steel and U.S. Steel principally produce flat products while a company like Gerdau Ameristeel produces long products.
Anderson: Smaller companies are always the first to get discriminated against in terms of credit. We at Wells Fargo do a survey of our smaller and mid-sized business customers, and they’re all reporting lower sales and revenue and other financial problems, but access to credit remains very scarce for them as well.
Pappalardo: Service centers operate at the lowest margins of the value chain, and half of what they do is availability of inventory and stock for people. So they got hit with the biggest downturn in steel prices because they keep the biggest inventory level relative to their margins.