Cash flow must be sufficiently good every year, and better in the good years

The inherent cyclicality of the business at stainless steel producer Outokumpu calls for limited financial leverage, in contrast to the past higher levels. Paired with an improved cost base and operating performance, this gives room for recurring payouts, the company’s CFO Pia Aaltonen-Forsell (PAF) tells Johan Trocmé (JT) in the latest Nordea On Your Mind. She emphasises that funding sources should be diversified, and don’t assume that we will simply return to the buoyant market conditions of the past decade.

JT: Outokumpu has historically operated with much higher leverage than today, but in 2021 you embarked on a new strategy which included ambitions for much lower leverage. Could you tell us a bit about what prompted the strategic review, your key considerations for new targets and how you decided on the new levels?

PAF: I joined Outokumpu four years ago, under our previous CEO Roeland Baan. We worked for a year together before he left the company, which gave me time to observe and to acquaint myself with how our business behaves and performs in different stages of a business cycle. That time did not yet see the impact from the COVID-19 pandemic, but was characterised by cyclical headwinds for the steel industry. When our current CEO Heikki Malinen joined in 2020, he naturally wanted to review and evaluate the company's strategy, and it was very helpful for me that I had this prior period to form a view of what could make sense for us financially.

Our business is capital-intensive and inherently cyclical. All companies and businesses have been affected by external shocks in the past decade. We are no different, but we have to acknowledge that we also have a lot of fixed costs and hence a high operational leverage. We have big production facilities which require big investments. We are, however, disciplined in minimising fixed costs, achieving a good capacity utilisation in our plants remains perhaps the most critical driver of our profitability and returns. There were a lot of established views on how to optimise this within the company, but we modelled it very thoroughly based on historical performance and forward projections. Many of our 'gut feelings' were corroborated by this analysis, and others had to be modified, based on the quantitative evidence. With these findings, we had to think long and hard about how to run a business with a typical demand cycle of four years and a significant level of operational volatility. Should there even be financial leverage in such a business, and if so, what level could be suitable? We all know there are benefits with financial leverage, such as lower cost than equity and tax deductibility of interest costs. But we needed to ask ourselves if we had a business in such stormy waters that adding financial leverage would risk rocking the boat too much. And the arrival of the COVID-19 pandemic sharpened this question even further.

Once we had determined the operationally volatile nature of our business, we had the first piece of the puzzle to conclude that we should not have high financial leverage. The second piece of this puzzle was to see the need to improve our business and reduce its fixed cost base, giving us more of a buffer to cope with swings in profitability and generate positive operating cash flows also during difficult periods. We needed to ensure that we could afford core investments and make tax and interest payments also during the weaker years, and generate strong cash flows during the upswings. From the starting point we were at, it was clear to us that we needed to both reduce leverage and improve margins by reducing our fixed costs. We had the luxury of being able to zoom out and evaluate from a clean sheet perspective. And we also sounded out some key investors and big shareholders, asking for their view on how best to manage risk and create value for them over time. Their feedback helped shape our strategy and targets, as have research and data. One example is the aim to have a recurring ordinary dividend which can be expected also during difficult years, which we have understood to be an important tool for attracting long-term shareholders who are not just trading in out of the company's shares to play cyclical momentum.

JT: With the quick progress you made with the new strategy, you started buying back shares in late 2022 and you have reviewed your dividend policy. As you know from our 2019 NOYM report How to pay it out, we are really interested in the topic of payouts to owners. Could you share a bit of your thinking on how much capital to distribute to shareholders, and how? Is optimising the cost of capital a key consideration?

PAF: The way we see it, our business has to have a cash flow which is sufficiently good every single year, but then particularly good in the favourable years. Being able to show this profile, even for a cyclical business, should allow us to offer stability in our ordinary dividend. As I said, we understand that investors seem to value this stability, and it is a concrete commitment to return capital. And then we can use other tools to pay capital to our shareholders, as circumstances allow. This year, we proposed our ordinary dividend to be EUR 0.25 per share, and we have also proposed an extra dividend of EUR 0.10. This is on top of the EUR 100m share buyback programme we initiated in November 2022. This gives us flexibility to vary payouts beyond the ordinary dividend we have committed to.

We also need to consider that Outokumpu has an outstanding convertible bond maturing in 2025, which could be converted into some 40 million new shares. The strike price for conversion is around EUR 3, so currently it seems likely that it will be repaid with new shares. This made it even more natural for us to seek a share buyback mandate, as we can use the excess cash we have available to buy the shares we will likely need to repay the bond at maturity. For us, securing this and 'making good' on our higher-leverage past is a priority before pursuing major investments in the final phase of our new strategy.

Cost of capital is of course a factor in our strategy. My CFO brain emphasises that debt has a lower cost than equity, and that there are benefits from having leverage. But it is one out of many considerations, and it comes further down the list after ensuring that our level of financial risk is a good match with the operating leverage and volatility in our business. Despite a negative impact on our cost of capital, we were quite happy to accumulate cash during the COVID-19 pandemic, given the great macroeconomic uncertainty we were facing at the time. There are still significant risks to the economy, but today we consider them more manageable. And this is why we were comfortable launching a EUR 100m share buyback programme.

JT: We have had a decade of ultra-low interest rates and funding costs versus earlier historical levels, and generally strong capital markets. Do you think large corporates have grown accustomed to seeing this as the new normal? Could there be a need to view re-financing, interest rate and liquidity risks in a new light?

PAF: Ten years is a very long time, and there are of course treasury people and CFOs out there who have worked 20 years or more and remember a notion of normal which meant less forgiving market conditions than what we have had in the past decade. It has in many ways been an extraordinary time, and I think it is probably fair to describe it as an addiction we developed, getting used to cheap and ample funding. Cash flow has rarely been a real constraint, and interest rates have almost been a non-issue. Today's environment is totally different. If you have a more strained balance sheet, having to pay interest rates of 7% or 8% will make a real difference in your P&L. The impact becomes so visible that it markedly increases the pressure to deliver cash flow and capital discipline and profitability. And the threshold for it to actually become financially dangerous for the companies is much lower. We will absolutely have to think in new – or old, if you will – ways about what are normal funding market conditions.

I think there is also a tendency out there to expect that this tougher market environment we now face is an anomaly which will pass. It is probably natural and human nature to see something suboptimal as abnormal and temporary, and that normality will be a more favourable state again. But I think it would be risky to simply assume that this will happen. While there may not be further waves of energy or food price inflation, there are other potential drivers for more inflation going forward. Heavily globalised corporate supply chains will likely at least regionalise going forward, as geopolitical tension related to, for example, Russia, Iran and China will not simply vanish. Ever lower cost sourcing may therefore not suppress inflation in the years ahead, like it has for decades historically. We may simply have to get used to a world with a bit more inflation and higher interest rates than we got used to in the past decade.

OUTOKUMPU'S NET DEBT AND LEVERAGE

JT: How would you typically see the choice between different funding sources, such as drawn and undrawn bank loans, bonds and commercial paper? What is a good mix, and why?

PAF: Above all, we aim for a balanced mix of different funding sources, which spreads the risk and avoids us being too dependent on a single source or counterparty. For a cyclical business like Outokumpu, I see a particular value in having an undrawn credit facility available to deal with any bigger-than-expected downturns or other setbacks. Having good bank relationships is very valuable, where there is more room for flexibility to manage credit when the lenders know us and our business and have good processes and tools for modifying credit or extending additional credit.

The bond market is vital for securing long and attractively priced large corporate funding, and it is important for Outokumpu to have access and the possibility to utilise the market if needed. But having bond investors as counterparts in a situation where the credit needs to be adjusted is usually more complex and challenging than dealing with the banks in your bank group. To be able to tap the bond markets, you need to work on your name recognition and actively market yourself to debt investors.

Our only bond funding is currently our convertible bond. But this is owing to the high leverage we had historically, and what funding sources have made most sense to use in the situation we were in then. Outokumpu's strong financial development has increased access to several funding sources.

JT: Sustainability is clearly a core part of Outokumpu's new strategy and vision; How do you see this playing into your funding going forward? Can you benefit from this in your funding? Will you face additional challenges? Or both?

PAF: In the long term, I think having sustainability integrated into your business will be necessary to qualify for equity capital and funding at all. And you will need to be able to show in a credible and accepted way that you are truly sustainable. Sustainabilitywill not only be about the environment, but importantly also areas such as human rights. Being so-so in any core sustainability areas will not be enough. You will have to be good at them to be able to issue equity or bonds, or borrow from banks. Putting it simply, a good sustainability performance will increasingly be a licence to operate for corporates.

There can absolutely be a direct cost benefit from a strong sustainability profile. In our current RCF (revolving credit facility), a part of the interest margin paid to the banks is determined by how to deliver on a set of sustainability KPIs. I think this is a very good way of putting focus and attention on sustainability. There is a tangible financial incentive for delivering. But it is more about the concept of improving sustainability and making it a priority and include it in everything we do. The number of basis points you can lower your funding cost from this today is not going to be that critical for total shareholder value creation. The value will become painfully evident in the future. We are now living in some sort of transition period. At some point in the future, not being sustainable will mean you are effectively locked out from funding or investment, with dire consequences for the value of your business.