Rosario Acero

Case 32 - Rosario Acero S.A

Back in April of 1993, Pablo Este, a small business entrepreneur, agreed to take on the operations of a small steel mill located in Rosario, Argentina. This business was being shut down by larger player, Giganto Acero, after they announced the closing of 15 of their unprofitable business units. Pablo Este took on the necessary capital, time, and management to save the operation. Pablo purchased the plant for $14 million, mainly financed by seller notes from Giganto. With Giganto still remaining an important customer, the new plant began operating in July of 1993. By taking advantage of existing facilities and cutting costs, Rosario was positioned as a niche player in the industry. Rosario sold a variety of cast and fabricated steel products to over 35 other firms, as well as other customers.

Close to half of Rosario Acero’s sales were to two large steel producers (Giganto Acero and Brasilia Metal - 42% in 1996). The company's main product was rolling-mill rolls, which also accounted for nearly half of the firm’s net sales in 1996 and 17% market share.  In terms of cost of goods sold, factory overhead accounted for 63%, direct materials 26%, and direct labor 11%. Rosario relied on only one metal scrap supplier located in Buenos Aires. The company plant employed 816 hourly workers and operated seven days a week, from 17:00 to 9:00, in order to cut costs by $50,000 annually.

In 1996 the steel industry performed well with moderate profitability for the year. This success was related to recent capacity cutbacks, and newly integrated modernization programs. Along with this, the birth of the Mercosur trade group allowed further trade between Argentine, Brazilian, and Uruguayan firms. Forecasts for the industry were favorable for 1997, as well as the next three to five years as long as they could stay competitive. Economists and institutions were forecasting annual rates of inflation to be 2.5 - 4%, and real GNP to grow 1.5 - 6%.

After six profitable quarters, Rosario was preparing to issue its first long term securities in order to finance its growth. Rosario was seeking $7.5 million in long-term capital, with plans to place $4.8 million towards paying down the companies present working capital line of credit, $975K towards repaying long term debt set to mature in 1997, and $1.725 million towards capital and general improvements. Along with this Rosario hoped to analyze external markets for expansion purposes. The company would retain its $5 million working line of credit. The concern that Pablo faced was the decision as to what type of capital he should use to finance this. After sitting down with his financial consultant, Raul Martinez, Martinez suggested one option of financing to be a private placement of eight-year senior notes with warrants. The purchasers were two Spanish investors. Fees associated with the placement would be $52,000. Their second financing alternative being considered was an Initial Public Offering. Fees expected with an IPO were to be 8% in a guaranteed underwriting. Although there was a third option to sell Rosario’s operations, this was not a very admirable option by management.

        The IPO market looked to be in recovery after experiencing both the ‘peso crash’ of 1994, and the tequila effect looming over it. This lead to a growing interest for equity investment in Argentina. With the number of IPO’s still low in numbers, this was a great opportunity for any firm to create some hype in the market. At this time many of the stable and mature industries were appealing to investors.

        To begin our analysis, we started out by making several assumptions. We assumed the Argentine peso was fixed at a 1:1 exchange rate with the U.S. dollar throughout our analysis. Another important assumption we made is that the firm would not have to raise more money until after 2002. We assumed the uses for the funds raised are reflected in the current forecast performed by Martinez. We recognized three areas of risk at the beginning of our analysis. These being a change in growth, a change in labor price, and a change in scrap price. We performed scenario analyses to determine the sensitivity of these inputs on Rosario’s financial performance. The growth factor will be determined by the economy and the level of competition Rosario faces over the next several years. The change in labor price per hour will change due to the current labor contract expiring in 1998. We assumed the union will be able to negotiate a price of at least $4.25/hour, the industry average. Also, we are considering the variability of scrap price in our scenarios. Rosario is currently buying their scrap from one supplier, increasing the level of sensitivity.

        We first analyzed the debt and warrants alternative. The estimated WACC for issuing debt equals 9.97%. We then forecasted the income statement using specific assumptions. We altered our case to account for changes in growth, labor price, and scrap price. Labor price and scrap price both effect the cost of goods sold. Our base scenarios uses a growth rate of 10.3%, labor price/hour of $4.25, and the current scrap price of $139.50. This gives us an average EPS from 1997 to 2002 of 6.78, growing from $4.79 in 1997 to $10.00 in 2002. We plugged these EBIT numbers into our DCF analysis and found the equity value of the firm to be $21.05. The base case gives positive outlook for the firm and the current shareholders, who recently purchased shares for $9.00. We also evaluated the firm using best and worst case scenarios. In the best case we assumed labor prices would remain at $3.75 and the scrap price would drop to $93.50. This is the lowest scrap price Rosario has seen in the past year. We also assumed growth would extend up to 12%. In this scenario, the average earnings per share over the next six years equals $17.70. We also analyzed a worst case scenario for Rosario. In this case the firm would only reach growth of 8.5%, labor cost/hour of $4.36, and the past years highest scrap price of $159.50. This scenario hurts the firm financials causing the average EPS to drop to $2.44. (Exhibit 4)