Rusal IPO relying on flawed assumptions of market risk
In its prospectus, Rusal, the heavily indebted Russian aluminium company planning to list in Hong Kong, makes a couple of crucial assumptions about market risk. Both are flawed.
The company rightly highlights both the market price of aluminium and the US dollar-rouble exchange rate as key risks to its performance.
A fall in the global price of aluminium, which is traded in US dollars, would naturally eat into Rusal's cash flow, undermining its ability to service the US$14.9 billion of newly restructured debt the company is carrying.
Meanwhile, any rise in the value of the rouble against the US dollar on the foreign exchange markets would bump up the local currency costs of the company's Russian operations relative to its US dollar revenues, eroding its margins and making it more difficult, even impossible, for Rusal to meet its debt obligations.
Yet the company, and its bankers, remain confident, at least in public. 'The directors have reasonable grounds to believe that the company will be able to comply with the relevant performance targets, covenants and restrictions under the terms of the debt restructuring agreements,' the prospectus declares.
In predicting that it will be able to meet its debt obligations, Rusal relies for its baseline scenario on price forecasts derived from the aluminium futures market and from forward foreign exchange contracts on the US dollar-rouble exchange rate.
What's more, Rusal argues that the price of aluminium and the value of the rouble tend to be correlated. In other words, any decrease in its US dollar revenues resulting from a fall in the aluminium price will tend to be offset by a corresponding drop in the US dollar cost of its rouble-denominated expenses.
Unfortunately for Rusal, forward curves tend to be a lousy predictor of actual market prices and it is doubtful whether the recent correlation between the aluminium price and the rouble will continue.
First, let's tackle the aluminium price. Based on the forward curve, Rusal projects the price rising from US$2,136 a tonne early last month to almost US$2,300 in 2013. Some analysts would argue this projected price rise is too modest. Given strong demand from China and economic recovery in the developed world, they expect a greater increase.
Recent market performance would appear to support that view. At US$2,268 yesterday, the spot price for the metal is already up 6 per cent from the date Rusal compiled its projections.
But whether the price can go on rising is doubtful. As the first chart below illustrates, the aluminium industry is plagued by overcapacity, largely due to massive expansion in China. With the price at these levels, smelters are restarting idled capacity. This means the stocks held by the world's exchanges are unlikely to fall from current high levels (see the second chart) which will tend to impose a ceiling on further price increases.
As a result, a report compiled last month for the commodities arm of investment bank BNP Paribas, which is acting as book runner on the Rusal deal, contends that 'aluminium prices at about US$2,250 a tonne defy logic'.
'With the market awash with excess metal held both on exchange and on off-market, mushrooming Chinese production capacity and new supply from the Middle East coming online very soon, prices ought to be nearer US$1,900,' it argues.
If prolonged, a fall of such magnitude in the aluminium price would be bad news for Rusal. According to the prospectus, it would leave the company in breach of its debt covenants - unless it were to be rescued by a simultaneous decline in the value of the rouble.
This is unlikely. At almost US$120 billion in 2008, it is Russia's petroleum exports that drive the rouble (see third chart), not its aluminium exports. Now, with energy prices rising and hot money cascading into Moscow's markets, the rouble looks set to appreciate over the medium term.
Central bank intervention might slow the process, but even so Morgan Stanley's foreign exchange analysts expect the rouble to rise against the US dollar by 8 per cent this year compared with 2009, and by a further 3.5 per cent in 2011.
For investors in Rusal, a weakening aluminium price and a strengthening rouble is the worst possible scenario, simultaneously eating into revenues while bumping up costs and making it impossible for the company to meet its debt obligations. Either Rusal would be forced into a breach of covenant - a technical default - or it would be forced to sell prized assets to pay down debt. Either way, the outlook would be bleak indeed for the company's unfortunate shareholders.