After S&P and Fitch, Moody’s has now cut ArcelorMittal‘s (NYSE:MT) debt rating to junk. Its senior unsecured note rating was lowered to Ba1 from Baa3, a notch below investment grade status. The lower credit rating was attributed to ArcelorMittal’s failure to pare down its debt which reached $23.2 billion at the end of Q3. Other factors which may have prompted the downgrade are the company’s failure to give clarity on its debt reduction plans and the challenging operating environment it finds itself in.
After S&P downgraded ArcelorMittal on August 2, 2012, Moody’s had said that it would follow suit unless the company reduced its debt by $5 billion by year end. ArcelorMittal said last week that excluding proceeds from any further asset sales, it expected debt to reduce to $22 billion by end of 2012. The amount of reduction is thus much lower than what Moody’s wished for.
The spread on ArcelorMittal bonds has widened and the cost of insuring its debt against default has risen after the downgrade. Moody’s says that ArcelorMittal might breach credit facility covenants in June 2013 unless it repays a considerable amount of debt or secures amendments with lenders to credit terms. 
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Weak Demand For Steel Makes Debt Reduction Difficult
The growth rates have declined due to the prevailing weak macro-economic environment in Europe. Industrial and construction activities are witnessing a prolonged slump. As a result, the demand for steel has nosedived, resulting in the closure or mothballing of a number of steel plants. ArcelorMittal derives 35% of its revenues from Europe and the slump has hit its business very hard. Steel shipments from the Flat Carbon Europe segment for Q3 2012 were 5.8 million tonnes, a decrease of 13.8% as compared to 6.8 million tonnes for Q2 2012. Long Carbon Americas and Europe segment steel shipments for Q3 2012 were 5.5 million tonnes, a decrease of 5.7% as compared to 5.8 million tonnes for Q2 2012. Lower steel shipments were due to significantly weaker market demand and seasonal slowdown. ((ArcelorMittal 6-K Filing, SEC))
The weak demand for steel implies less generation of cash which the company needs to reduce its debt. ArcelorMittal reduced its net debt by $1.6 billion in Q2 2012, but instead of reducing further in the third quarter, debt increased by $1.2 billion. The company said in a statement that its financial position was robust, its plans to improve its debt-to-earnings ratios were on track and it expected further progress in the coming months.
What Does A Rating Downgrade Imply?
The downgrade has been carried out for senior unsecured note ratings. ArcelorMittal now faces a complete loss of its investment grade status. The downgrade in rating of debt would mean higher interest rates, or coupons, for ArcelorMittal on any new issues. The company, however, said that the extra expense would only be $100 million which we believe would have a minimal impact on its financials. The downgrade also has implications for insuring the company’s debt. Following the downgrade by Moody’s, the cost of insuring ArcelorMittal debt increased by 3.5 basis points to reach 557 basis points, the highest since October 11, according to Bloomberg prices for credit-default swaps. This will cause lenders to demand even higher interest rates from the company on any new debt. 
Despite the recent rating setbacks, we believe in the long-term prospects of the company once growth returns.
An economic recovery in the long term should benefit steel companies, including ArcelorMittal. A lot of the negative sentiment already seems to be factored into the current stock price. Until the economy recovers, we don’t see the demand for steel increasing substantially.
We have a price estimate for ArcelorMittal of $18, which is 15% ahead of the market price. We will be revising our model shortly in light of the recent earnings results.Notes:
- Moody’s cuts ArcelorMittal debt to junk status, Reuters [↩]
- ArcelorMittal Cut to Junk by Moody’s on Debt Plan Concerns, Bloomberg Businessweek [↩]