The collapse of steel producer and iron ore miner Arrium Ltd (ASX: ARI) into voluntary administration today should not come as a surprise.

In 2011, we said that Arrium was not a good investment for a number of reasons.

In February 2012, we again highlighted several major issues the company faced, but in 4 years, those issues got worse instead of disappearing.

Those issues include:

  • At the time, Arrium (then called Onesteel) had $2.4 billion of debt, but its return on equity and asset ratios were both below 4%. The company was paying higher rates on its debt, and that’s a deadly sign because it meant Arrium was going backwards not forwards. If a company can’t generate a higher return on its capital than its cost of capital, it’s headed for disaster.
  • Cheap imported steel had put pressure on Arrium’s margins, and it was uncompetitive (despite claims that it was producing a higher-quality product).
  • The nature of Arrium’s business meant that it was hugely capital intensive, and the company was forced to spend much of its cash flow maintaining its operations, rather than expanding and improving its business, or paying down debt. After four years, the company still has $2.4 billion of debt.
  • The move into iron ore production, when iron ore prices were already heading down, was doomed from the start.

While it was fairly obvious to some outsiders, it clearly wasn’t to management, and despite their efforts, it has all come to nothing.

Arrium is likely to be broken up and the parts sold off (those that can). The one shining light is the Moly-Cop business which primarily makes the steel grinding balls for use in the mining industry for crushing rocks.

But we’ll have to wait and see whether Arrium’s bankers get anything back from their investment. According to some reports Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) are owed a combined $1 billion, with ANZ having the largest exposure. The problem for the banks is that their loans were unsecured, so they’ll have to stand in line with all other unsecured creditors to receive whatever the administrator judges to be best.

Foolish takeaway

In investing, beating the market not only means picking high quality, growing companies, but it also means avoiding the potholes like Arrium. Fund Manager Allan Gray Australia held 15.6% of the company in early September 2015, although managed to sell most (all?) of its position in February 2016. Which goes to show that even the professional investors get it wrong sometimes.

 

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.