Tarnished Metal: A Japanese Credit Play

As Chinese headwinds buffet Asia, and as the global steel industry staggers in step with the Middle Kingdom, conditions are looking ripe to get short the investment-grade debt of Japan’s second- and third-largest steelmakers, JFE Holdings and Kobe Steel. Despite the serious equity collapse the two companies have suffered as a result of adverse macro forces, their bonds are defying gravity and their CDS spreads are far tighter than any comparable firm’s. There looks to be a lot of room to go on this one, and not much risk.

A big price disconnect between two major Japan steelmakers' equity and debt has created a short opportunity.

Times are not good in the steel business, no matter where you are in the world. After a decade-long super-cycle driven by China’s explosive growth, things have unwound quickly. A global economy makes for global problems, especially when a sector relies on one major power with a huge population, massive industrial capacity, and some of the world’s lowest labor costs and where an accelerating slowdown has slammed the brakes on domestic consumption and a panicky government now has an incentive to export, export, export. The industry has certainly caught pneumonia from China’s sneeze, and regional exporters are feeling the heat to the biggest degree. JFE Steel and Kobe Steel, Japan’s second- and third-largest steelmakers, are perhaps most vulnerable to China contractions — they have the largest shares of the Chinese export market in Japan. The two companies put up disastrous numbers at the end of 2015, and revised massively downward their forecasts for 2016. Yet their debt still trades at blithely high levels, suggesting that the bond market has not yet priced in the grim financial reality. No doubt the structure of the Japanese domestic bond market has helped prop the bonds up for the moment, but markets have a long history of overpowering irrational buying at artificially high levels. Given the outlook, it may be time to get short both JFE’s and Kobe’s investment-grade debt. The downside seems big with not a lot of risk even in the best of circumstances.

The main macro driver here, as noted, is China. The forward picture there looks grimmer daily, as more and more worrying economic data confirm the country is in the grip of a massive slowdown. Old-line industrials are down big overall, with steel near the head of the pack. Indeed, 2015 was the first year since 1991 in which Chinese mills — responsible for roughly half of global supply — cut production in the face of sluggish domestic demand. Steel is currently the victim of weak fundamentals as well as a political commitment by the country’s leadership to move China away from a production-driven economy to a consumption-driven one. And while they have stepped down the former, as recent headlines suggest, they haven’t quite managed to magic up the latter. The story of China’s massive overcapacity, opaque policy, financial chaos, and economic lethargy is well-known by now: some analysts even predict as sharp as a five percent drop in demand over the course of the coming year. And though China Inc. is shutting capacity, it has not been fast enough to offset the existent glut of supply, which is being dumped as aggressively as possible in the export market adding more pressure on steel producers outside of the Middle Kingdom. Hot rolled steel futures have collapsed since the start of 2015, dropping 36 percent to $398.

So what does this mean for the Japanese duo? Kobe, with a current market cap of 310 billion JPY, in its December results saw EBITDA down 15 percent year-on-year and a decline of nearly 36 percent year-on-year for operating profit. More crucially, perhaps, its full-year forecast was down almost 46 percent as against its previous full-year results and down almost 28 percent as against its previous full-year predictions. On its balance sheet, Kobe wrote off five billion JPY on raw materials in iron and steel and upped its provision for bad debt from China and southeast Asia to 13 billion JPY at its troubled Kobelco heavy machinery subsidiary. Net income is predicted to go negative by management to the tune of 20 billion JPY, against a previous positive forecast of 86 billion JPY. JFE, with a market capitalization of 811 billion JPY, put up similarly bad results. EBITDA year-on-year was down 21 percent, operating profit was down nearly 50 percent over the same time span, and it revised its forecast downward by roughly 60 percent. It still looks set to be in the black in the next six months, but its forecast is down by 50 percent, from 50 billion JPY to 25 billion JPY. In a corporate culture marked by major social pressure to underpromise and overperform, this miss is even bigger than it looks: the intangible effect it will have on sentiment could be a force multiplier.

Neither company inspires confidence that they have much of a strategy for pulling together a turnaround, even against a dire backdrop. Kobe’s CEO Hiroya Kawasaki has put together a literal Five-Year Plan (the latest in a series) starting in fiscal 2016 and ending as fiscal 2020 ends. It makes much of a proposed build-out of Kobe’s power-generating segment to take advantage of rising electricity rates and co-ventures in (gulp) China, neither of which seems likely to help the company come back. JFE’s corporate vision relies on the bump to domestic demand hoped to come from Shinzo Abe’s “national resilience” spending plan as well as the 2020 Summer Olympics, set for Tokyo — along with a significant slate of overseas joint ventures. Again, the domestic initiatives seem unlikely to move the needle and whatever value the foreign components may add will be exposed to the significant drag outlined above.

Not surprisingly, both stocks have cratered of late. JFE is down 55 percent over the past eight months; Kobe is down 62 percent over the same period. But the bonds continue to defy gravity. Kobe’s 1.217 percent five-year note changes hands at 103.9 with a yield to maturity of .52 percent; JFE’s 1.326 percent note is at 106.6 with a yield to maturity of .07 percent. Compare that with world’s largest steelmaker ArcelorMittal’s 3 percent five-year note, now changing hands at 81.3 cents on the dollar with a yield to maturity of almost 7.5 percent. The mispricing of JFE and Kobe debt starts to look painfully clear.
All the more so given that Arcelor and Kobe have an identical debt-to-EBITDA at 3.1x, and JFE is far more relatively encumbered at 5.12x — and Arcelor faces far less direct exposure to Chinese headwinds than either Kobe or JFE. Consider also U.S. counterparts U.S. Steel and AK Steel. Their five-year notes trade respectively at 50.2 with a 17.8 percent yield and a 35.6 with a 34.1 percent yield.