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    ae 32 . + 1 a Rosario Acero S.A. eri Aa A Br in Boenos Aire, reflectig on the future of the small sie! mil be owned. The inital | years of Rosario Acero S.A., the former Rosario Works of Giganto Acero S.A., had = an tHe das fk a as ae ng eee ome Sb = ey le a ig aes Stee i res Sore fe polly aeeniorirreprenerep my nea oper x the company's total sales, and arguing with local bankers over the value of receiv- ables due from customers facing possible bankruptcy. Now, after six profitable quarters, the company prepared to issue its first long~ term securities since its incorporation in 1993. The concern that Este faced in March 1997 was the type of capital to acquire. The company’s size—revenues were below ‘$35 million pesos*—definitely limited options, but Este, as majority shareholder and board chair of Rosario Acero $.A.’s board of directors, wanted to consider all the options available at the time. Este had engaged Raul Martinez, an independent financial consultant, 10 investi- ‘gate a private placement of eight-year senior notes with warrants. Mastine's initial report stated that Rosario Acero S.A. could raise its required $7.5 million at a coupon rate of 13 percent. Another option Este was interested in evaluating was an initial — public offering of Rosario Acero S.A’s stock through a local investment bank. And { perhaps now was the time to sell the entire company to another firm. “Acero Spanish for sce... stands fr sociedad anonimo, the equivalent of oxporation, The Argentine peso was xed at 1:1 exchange rate with he U.S. dalla Loeal convention was to indicate ‘the curteny with he dolar sign. “This case adapts an err study writen by Renee Weaver and revised by Casey Optic under the direction of Robert F Bruner Iwas writen a a basis for cls dincosion rater thant lsat effective oc ineective handling ofan administrative situation. All names and aan data have been disguised. Copyright © 1998 i by the University of Virginia Darden School Foundation, Charlotesvil, VA. All rights reserved. To onder } copies, send an e-mail sles @ dadenpublishing com. No part ofthis publicaion may be reproduced, ‘Stored ina retival system, ated in spreadsheet, or ranamted in any form or by any means—eletronic mechanical, photocopying, recording, or otherwise—ithou the permission of the Darden Schoo Founda tion. Rev. 1205. { 2 Part Six Management ofthe Corpote Capital Stacture Just two days after Christmas 1992, Giganto Acero announced the closing of 15 ‘unprofitable business units, among which was the Rosario, Argentina, plant, operated by Giganto Acero since 1932. In April 1993, Pablo Este, a Rosario native, Harvard Business School graduate, and successful small business entrepreneur, was introduced by Rosario civic leaders to members of the plant's top management. After reviewing the situation, Este agreed to commit the necessary capital, time, and managerial expertise to save the operation and make the mill a viable company in Rosatio. Giganto Acero would remain an important customer. After brief negotiations, Este and ‘a group investment partners purchased the assets of the plant for $14 million, the bulk ‘of which was financed by seller notes from Giganto Acero—Este and his partners invested only $250,000 in the equity of the firm, The plant began operating as Rosario Acero S.A. in July 1993. Product Lines and Sales ‘Taking advantage of existing facilities and numerous opportunities to cut costs, Rosario's management positioned the company as a niche player in the industry Rosario Acero S.A. sold a variety of cast- and fabricated-steel products to over 35, steel and other heavy-industry customers. The percentage of sales in each major prod- ‘uct category for the years 1994-1996 is shown in Exhibit 1. Six product managers Jocated in Rosario oversaw each of six product categories: rolling mill rolls, steel cast- ings, staves, mill liners, continuous caster rolls, and miscellaneous products. The com- pany employed five outside salespersons on straight salary, who were located in Buenos Aires and Rosario, Argentina; Montevideo, Uruguay; Sao Paulo, Brazil; and Santiago, Chile ‘The vast majority of the company’s sales were to integrated steel producers (Giganto Acero and Brasilia Metal together accounted for 65 percent of sales in 1994; 49 percent in 1995; and 42 percent in 1996) and to mini-mills. Those buyers were very different types of customers, The integrated producers tended to multisource orders, which made them less price-sensitive consumers than mini-mills; they also tended to place more value on their long-standing supplier relationships, Mini-mills tended to be price sensitive, and though they relied on a single supplier, they were ‘more likely to consider purchasing from suppliers outside of Mercosur.’ “The company’s chief product was rolling mill rolls, which were like rolling pins found in a kitchen, Those rolls were sold in pairs, and were used to squeeze moving slabs of hot or cold steel into a certain shape and a specific thickness. Rolling mill rolls accounted for nearly half of the firm’s net sales in 1996, The company estimated its gross margins on this product at 32 percent, The company ranked itself second in the Mercosur market for rolling mill rolls, with a 17 percent share. °pterconur was the Sout American fee ra association formed bya wea among Argentina, Brazil, nd ‘Uruguay, Bs FEBEE RS a5 and ing ail, we 32 Rosario Ace SA. Continuous caster rolls were used to channel molten steel as it was cooled dur- ing the casting process.* Repair and remachining of caster rolls was required on a regular basis. Rosario Acero S.A. provided the refurbishment, in addition to prepa- ration of new rolls, to its customers who did not have the in-house capability to refurbish rolls. Company officials estimated gross margins on continuous caster rolls ft 12 percent. The market for new rolls in Mercosur was approximately $25 million in 1996, so Rosario’s sales gave it about a 13 percent share. Rosario Acero S.A. produced both machined (finished) and nonmachined (rough) steel castings in a variety of sizes from 1,500 to 45,000 kilograms for a diverse group of customers, including steel makers, cement producers, shipbuilders, ‘automotive manufacturers, extrusion-pess operators, and rock and coal crushers. One example of steel castings was the slag pot, a steel vessel used to receive the impu- rities thrown off from blast furnaces and reheating furnaces. The company estimated the total potential slag-pot market in Mercosur at $5 million, of which its share in the manufacture of small pots (those under 30,000 kilograms) was 80 percent, Overall, {gross margins on rough castings were approximately 18 percent; gross margins on finished castings Were just 2 percent Mill liner was a rolled-steel liner plate and Tift-bar used in industrial grinding ‘machines for grinding cement, pulverizing coal, and grinding high-silica sand for glass production. Rosario Acero S.A. produced mill liners from purchased parts at gross margins of 40 percent. Facilities and Operations All of Rosario Acero S.A.’s production took place at the company’s sole facility Rosario, Argentina. The plant housed two electric furnaces used t© melt scrap metal for production (for a total melting capacity of 61,000 kilograms). All melting and pouring was done from 17:00 to 9:00 on weekdays, or on weekends, to minimize energy costs. This practice saved an estimated $50,000 in monthly electricity costs. Factory overhead accounted for 63 percent of Rosario Acero S.A.’s cost of goods sold. Plant equipment and facilities had been well maintained under Giganto Acero's ownership, with capital spending totaling over $25 million from 1976-1989. Capital spending by Rosario Acero S.A. totaled $3 million from 1993 to March 1997, with ‘additional spending planned from a portion of the long-term capital to be raised. Rosario Acero $.A. relied on one primary source, located in Buenos Aires, for the scrap metal used in its production of rolls and castings. Exhibit 2 lists serap prices during the recent year. Within the structure of Rosario Acero S.A.’s costs, direct mate- rials including scrap accounted for 26 percent of the cost of goods sold in 1996, “Molin deel would be poured int rectangular boxes where it would harden into ste ingots. This process ‘was own a casting the sce. More generally, there were two Ways shape sts: (1) bed, seh, cil, Gill, or squeeze tender pressure or (2) pour into a preforms mold where t would harden into the ‘ost shape—she lane was casting SMicining was the process of shaping theses rough cuting o eiling ax Pat Six Management of the Corporate Capital Strcture As of the end of 1996, the company’s plant operated seven days a week on three shifts, with an hourly work force of 816. The unionized work force, (40 percent semi- skilled, 60 percent skilled), eared an average hourly wage of $3.75 during 1996. Direct labor aceounted for 11 pesvent of Rosario Acero S.A’s cost of goods sold in 1996, All hourly employees were represented by the Union de Obreros Metalurgicos (Metalworkers’ Union) under a contract that expired in June 1998. The hourly wage rate for comparable work was $4.25. Union leaders had told Pablo Este that the hourly employees would demand a beiter-than-compettive contract atthe expiration of the current contract—this was to compensate the employees for staying with the firm through its difficulties” ‘The company also operated with 118 athministraive employees, and a new CEO, Enrique Salazar, was appointed in May 1996 to assume operational responsibility under Pablo Este. Other members of senior management under Giganto Acero’s ‘ownership held the same positions now, with the exeeption of the former company president, who had resigned in February 1997. ‘Six top managers other than Este held 25 percent of the stock outstanding tthe end of 1996, Este held 58 percent. Este’s investment partners held the balance of the shares outstanding. ‘The Steel Industry in 1997 In 1996, the Argentine steel industry enjoyed a moderately profitable year. Several factors accounted for this turnaround in the industry. First, capacity cutbacks and mod- cenization programs of the past half decade paid off; the industry reached 80 percent capacity in 1996, with utilization for high-demand items near 100 percent. In addi- tion, the birth of the Mercosur trade group promoted more trade by Argentine firms ‘with customers in Brazil and Uruguay. Forecasts for 1997 and the next three 10 five years were favorable, but were con- tingent on producers continuing their recent efforts to remain competitive in the indus- ty. Domestic steel shipments were estimated to be 70 million metric tons, slightly below 1996 becauise of cutbacks in inventories rather than lower consumption. Imports Were expected to continue their decline from the 1996 level of 20 million metric tons to less than 19 million tons in 1997. Rosario Acero 8.A.’s Outlook Rosario Acero S.A.’s revenues and earnings had grown since the company began oper- ations in July 1993, The company’s balance sheets and income statements for this period are provided in Exhibits 3 and 4. Management predicted continued growth into the new century, with different product lines growing, at different rates. Annualized rates of growth from 1996 to 2002 were projected by product line as follows: The nancial forecsts by Pablo Ese ssmed modest increases in wage rts, consistent with expectations for competitive market conditions din arly firm EO, itty o's any the the eral vod ent Adi Jus- bly nts this into zed Case 32 Rosario Aen SA. 483 1996 Sales 1996-2002 Projected Product Line (in miions) Growth Rate Fling mil ros 3160 139% Castings 90 14 Slag pots 14 198 a ners 18 145 Continuous caster rls 33 87 Fabricated and other 35 68. Total Se48 Average 10.2% In addition to continuing to serve present customers, Este wanted the company to pursue customers outside Mercosur. As yet, management had taken no action to investigate extemal markets, largely because of capital constraints on the firm. Rosario Acero S.A.’s Financing Alternatives “Management sought $7.5 million in long-term capital for three purposes in early 1997: (1) $48 million to pay down the company’s present working-capital line of credit, (2) $975,000 to repay long-term debt that would mature in mid-1997, and (3) the remaining $1,725,000 for capital improvements and general purposes. The company ‘would retain its recently negotiated $5 million working-capital line of credit with Banco de So! of Buenos Aires. This line, at 2 percent above the local lending base rate, was not secured by any collateral,” although Este had given a personal guarantee backed by specific commercial real estate he owned. The banker had emphatically stated that an increase in the line of eredit and the release of Este from his guaran- tee would be out of the question without more long-term capital to support the loan, as well as a longer record of successful financial performance ‘The private placement of eight-year notes recommended by Raul Martinez. would have the terms set forth in Exhibit 5. The potential purchasers were two Spanish investment funds. The fee associated with issuing the placement through Martinez ‘would be $52,000. The prospective investors demanded warrants with the debt, ‘because of the firm's small size, relatively high leverage, and the absence of a long history of operating profitability. Martinez explained that the warrants were a kicker that increased the effective return to the investors. The covenants associated with this placement had yet to be negotiated. The Spanish investors told Martinez that the min- imum acceptable EBIT coverage ratio (ie., EBIT divided by interest expense) would bbe 2.0. As a foundation for valuing the warrants, Martinez estimated the average volatility of peer steel companies’ shares at 0.35, Martinez had also determined that in several recent comparable private placements of debt, the effective annual cost of ie custom of extending workng-capital loans clean (i, unsecured bythe firm's receivables and inven toy) was dc tothe dificltis in Argentina ia geting a perfected in, and ling mew paperwork to keep up the lena he iventry and receivables rolled over an Six Management of the Corporate Capital Sucre the financing to the issuer had been between 14 percent and 16 percent, which rep- resented a huge premium over the Argentine base lending rate of 8.5 percent. 'A second financing alternative that Este considered was an initial public offering (IPO) of the company's stock. While the 233,000 shares of stock currently out- standing were not presently traded, six senior managers had been offered (and had accepted) a chance to invest three times since the company’s inception at prices as follows:* December 1994: 15,480 shares at $3.00/share January 1995; 14,220 shares at $4.00%share December 1996: 28,550 shares at $9.00%share “Those purchases accounted for management's 25 percent equity interest inthe firm. Fees associated with the IPO were expected to be about 8 percent, but they could be as low as 2 percent if a “best efforts” placement was selected rather than a guat~ anced underwriting. Public trading ofthe stock would have implications for the shares held by top management and Este. For instance, Este wanted to see the issue open at ‘price higher than the $9 that managers had most recently paid for their shares of Rosario Acero S.A. For this reason, he had concluded thatthe size of the issue would have to be determined after a market value had been placed on the company. “The IPO market had recovered modestly since the Mexican peso crash of Novem- ber 1994, By March 1997, the stock market had rebounded from the tequila effect of the peso erash. The Merval Index had risen over the previous three years, suggesting a growing optimism among equity investors in Argentina. The market for IPOs was following the same recovery route, although the volume of IPOs was still relatively Tight. “The success of IPOs in recent months ad depended a great deal on the quality ‘of the offering: issues in more stable and mature industries that appealed tothe know!- cdgeable investors fared better than media and communications issues. A number of | the recent [POs involved privaizations of state-owned enterprises. Other IPOs were spinoffs from larger industrial groups who sought to rationalize their operations. One | event example was a spinoff of a subsidiary involved in a commodity fertilizer busi ness that brought $22 per share on 11 million shares, surpassing expectations of $17 {0 $20 8 share set for the issue prior to the November crash, In contrast was a retailer's | first issue that had been planned for the end of November 1996. The company had ‘expected to issue $9 million in equity, but it was forced to look elsewhere for funds ‘when it could not locate another underwriter after its frst banker withdrew. Pablo Este had recently entertained the idea of selling Rosario Acero to another concer, although no specific price had been estimated forthe company at that time. ‘This option could be considered in more detail this time, as a means of obtaining funds or issuing stock to the public. “To value Rosario Acero S.A., Este had forecast the financial performance of the firm under either financing option, the debt and warrants issue (Exhibits 6, 7, and 8) The number of shares curently outstanding (233,00), included those recent shar sales. ing ut ld lity her ing the 8) Case 32 Rosario AceOSA 435 ‘or the equity issue (Exhibits 9, 10, and 11). Also, he obtained average valuation mul- tiples for mini-mills from a recent investment report. Those multiples indicated an average equity value of 1.5 times book value, 21 times 1996 earnings, and 18 times cestiniated 1997 earnings. Este also gathered information on several publicly held steel producers in Mercosur that were somewhat similar to Rosario Acero S.A. This infor- ‘mation is Contained in Exhibit 12. He wondered whether to simply average the results of all the peers given in that exhibit, or to exclude any. Picasso Acero, for instance, had experienced a turbulent year due to a strike and vandalism at its plant. Based on his own experience with leveraged buyouts (LBO), Este believed that @ potential LBO purchaser might place a value on the company’s equity by using a multiple of four times EBIT and then subtracting the total debt Tnterest rates over the past few years are provided in Exhibits 13 and 14, Research, by Raul Martinez revealed that economists and financial institutions were forecasting annual rates of inflation between 2.5 pervent and 4 percent, and real gross national product (GNP) growth at 1.5 percent to 6 percent Pablo Este was 66 years old and the patriarch of a large extended family, While he had no intention of retiring from Rosario’s board of directors in the near future, hhe was concemed about the liquidity of his valuable investment in the firm. It was important to him and the other equity investors to increase the marketability of Rosario’s common stock. Tempering any momentum to choose the IPO, however, was the cautious sentiment among senior management regarding the impact of any secu- rities issuance on their administrative control of the firm. Este realized that, as the board’s chair, he could easily rely on someone else 10 explore the various options that might be available to Rosario Acero S.A. As the key framer of the company's success so far, however, he had an interest in seeing the board select the alternative that would best assure a continuation of that financial and ‘employment success. With much information in front of him and all of his knowledge Of Rosario Acero S.A. in his head, Pablo Este sat down to determine which long-term financing option he would support. 436 Pat Six Management ofthe Corporate Capital Stractre EXHIBIT 1 | Percontage of Company Sales by Product Line! Feb. Recent Gross 1904 1995190619977 Profit Margins ols 4x OOOOH Castings 2 ar 2 20 18 (ough) 2 (frishod) Cominvous casterrols 4 6 8 6 2 ait inars 5 5 5 2 40 Staves o 3 : 1 Other products 7 a 5 4 80 (emall pots) Services egies slay ecaly siglo xs Tota Fook Too TOR TOOK "Cokmne may not co 100 because of eurdng 4987 perertages base on Dokings as of February 1997 ‘Source: Company recor EXHIBIT 2 | Scrap Prices of Dealer Bundies (price per metric ton delivered from Buenos Aires) Date of Estimate Price Range 12795 $06-$97 196 399-$100 2196 104-5105, 3196 595-$93 4196 $93-$94 5196 s03-s104 596 sniestis, 7196 S115-8118 8196 $119-8120, 9186 $i31-s132 10/86 159-8160 11196 3159-5160, 12186 S144-$145, 197 $139-5140 ‘Sues: Company records. EXH! Cas tie on Tot Pro To Wo cur Tot Lor Tot 8) EXHIBIT 3. | Balance Sheets (pesos in thousands) Case 32. Ronaro Acero S.A, a7 [As of Decomber 31 1994 Cash $19 ‘Accounis receivable 077 Irvertovies 5,188 ‘Other current assets 365 “otal curent assets 9247 Property, plant. & equipment 13.938, Omer 193 “Total assets are Working capital notes payable $4650 Current portion long-term debt 1,708 ‘Accounts payable 3313 Other currant abies 208 “otal current labities 10.473 Long-term debt 11,804 Detered taxes & leasos 312 Total abies 2589 ‘Common stock (par= $1/sh) 210 ‘Adational paid-in capital 71 Fetained earrings 508 Total owners eguity 789 Toil abies & equity Sass ‘Sowce: Company nancial statements 485 Pat Six Management ofthe Corporate Capital Structone EXHIBIT 4 | Income Statements (in thousands of pesos, except per-share data) ‘As of December 31 1904 1995" 1998 Revenues $25,084 $28,605 $34,506 Cost of goods sold (including depreciation)® 18,138 puree 27.854 Seling, general, & administrative 3.598 3767 3.959 Intorest 1,586 1481 4,098 Restructuring expenses 445 142 537 Profit etore tax 1317 (549) 1588 ‘Tax provision (bene) 377 (285) 4 Incame (oss) betore extraordinary item 740 (204) 71584 Extraordinary tom? 265 1.165 179 Net income $1,005, s_901 Earsings per share 3479 5 405 S787 "company ios in 1995 was atibted io sales oe ata rau of sch sre agaist Gigante Acar, which was a major account * C0 neues sapreciton $738,000 n 1964, $876,000 in 1855, nd $835 00 in 1958. ° Eterna income restod tom the fetus of bt, nto appcable Income taxes in 1995 and 1998, reds an income taxes due oat operating os aryoversresutod in xara name In 1804, Source: Company nana satan fleas aprons eee ey EXHIBIT § | Summary of Terms of Proposed Private Placement ‘Matury Warrants Prowsion ‘or Early Rledemption Aegisiration Fights Restrictive Covenants ‘on the Notes $7,500,000 ‘Senior notes with warrants Eight years due 200¢ ‘Second quarter 1997 13% per annum. payable semi-anoualy Interest only forthe ist six years. Mandatory principal payments of $1,875,000 in the seventh year, and $5,625,000 in the eighth year [None for the first six years. Calabe thereatter atthe following redemption prices as a whole oF in pat: Year? 108% Years 100% (no premium) ‘The rites wil be accompani8d by an eight-year nondetachable warrant entiting the holder to purchase 40,000 shates of common stock at an exercise price of $1 par share. The warrant ‘Shares wal be subject to ant-

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