Morningstar is initiating credit coverage of Xstrata with an issuer rating of BBB-. While Xstrata has been, on average, immensely profitable in the multiyear boom for commodity prices, its assets aren't particularly cost-advantaged. Consequently, relative to peers, the firm's balance sheet is less insulated from negative swings in commodity prices. This characteristic and Xstrata's demonstrated appetite for big acquisitions represent our primary concerns from a credit perspective.
Xstrata's credit metrics have moved around quite a bit over the past decade, as the firm has passed through several cycles of balance sheet leveraging and deleveraging. As commodity prices marched upward, the strategy of debt-financed acquisitions worked remarkably well. Things changed with the onset of the global financial crisis and subsequent collapse in commodity prices, leaving Xstrata in a precarious position heading into 2009, as debt had swelled to $17.5 billion from $3.3 billion three years prior. Thanks to an equity raise in the first quarter of 2009 and an across-the-board recovery in commodity prices, Xstrata escaped the sticky situation.
Barring a return to the price environment of early 2009 or an acquisition on par with the $18.8 billion Falconbridge deal in 2006, Xstrata's mines should generate more than enough free cash flow to keep bondholders comfortable. Yet given the significant uncertainty regarding intermediate-term commodity prices (an OECD double dip or Chinese real estate crash would mean real trouble) and management's penchant for deal-making, we must seriously consider these possibilities in assessing Xstrata's credit quality. Owing to a less advantaged overall cost position than many of its peers, Xstrata has less margin for error: A period of persistently weak commodity prices accompanied by an ill-timed and overpriced acquisition would seriously stress the firm's balance sheet.
Read Introducing Morningstar's Corporate Credit Ratings for more information on our methodology.
