Overview -- We are removing our ratings on Sault Ste. Marie, Ont.-based Essar Steel Algoma Inc. (ESA) from CreditWatch, where they had been placed with developing implications April 5, 2012. -- At the same time, we are affirming all our ratings on ESA, including our 'CCC+' long-term corporate credit rating. The outlook is developing. -- The removal from CreditWatch reflects our view of the completion of ESA's two-year US$350 senior secured term loan, with the proceeds subsequently being used to repay and terminate the company's US$300 million senior secured revolving credit facility. -- The developing outlook indicates that we could raise the ratings if a sustained rally in the steel market in the next 6-12 months were to support an expedited refinancing process on ESA's current debt obligations. Alternatively, we could lower the ratings if a mediocre steel environment limits the company's progress in refinancing debt maturities due after mid-2014. Rating Action On Sept. 26, 2012, Standard & Poor's Ratings Services removed its ratings on Sault Ste. Marie, Ont.-based Essar Steel Algoma Inc. (ESA) from CreditWatch, where they had been placed with developing implications April 5, 2012. At the same time, Standard & Poor's affirmed its ratings on ESA, including its 'CCC+' long-term corporate credit rating. The outlook is developing. Our removal of the ratings from CreditWatch reflects our view of the completion of ESA's two-year US$350 senior secured term loan, with the proceeds subsequently being used to repay and terminate its US$300 million senior secured revolving credit facility. Rationale The ratings on ESA reflect what Standard & Poor's views as the company's highly leveraged financial risk profile, featuring a less-than-adequate liquidity position, a large debt burden, and thin coverage ratios; coupled with a vulnerable business risk profile that features an exposure to volatile end markets and limited operating diversity. These risks, in our opinion, are somewhat counterbalanced by the company's better-than-average cost profile. We believe that the corporate credit rating on ESA depends heavily on two largely uncontrollable external factors--steel prices and debt markets. While the outlook for North American steel appears to have recovered modestly from recent trough levels, ESA's profitability and leverage depend almost entirely on further upswings in steel prices to support its heavy debt burden. Secondly, we expect that working-capital funding and long-term cash flow predictability will be overshadowed by challenges associated with the company's reliance on volatile capital markets to refinance several tranches of debt beginning in September 2014. Our base operating assessment for ESA through fiscal 2014 (the company's fiscal year-end is March 31) incorporates the following assumptions: -- Our economists' latest expectations for global growth; -- ESA's fiscal 2013 steel production is largely similar to the steel production it achieved in fiscal 2012, with somewhat tighter operating margins; -- Large steel producers manage output in a manner that would progressively cut steel supply to counter any downward pricing momentum; and -- The above operating expectation would lead to ESA generating a debt-to-EBITDA leverage ratio above 7.0x and a funds from operations interest coverage of about 1.0x through fiscal 2014. We view the company's business risk profile as vulnerable. ESA manufactures primarily commodity flat-rolled carbon steel, which makes up about 80% of total shipments and competes in cyclical and capital-intensive end markets. Nearly all of ESA's production is sold at spot prices, which increases its margins relative to its peers in periods of strong steel prices, but exposes it to rapid declines in volume, operating rate, and profitability during periods of weak demand. ESA's business risk profile is constrained, in our view, by its limited operating diversity as a single-site producer of commodity sheet and plate products in the volatile North American steel market. The company has been operating only one of its blast furnaces, blast furnace No. 7, since a sharp drop in steel prices in 2009. Operating one blast furnace--the key facility of an integrated steel mill--exposes ESA to some operating risk, which was highlighted by two outages at this blast furnace in the past few years. Although the company used insurance proceeds to offset the lost production, any prolonged breakdowns can strain cash flow to the extent that management restarts its dormant blast furnace No. 6 to offset the lost production time. Liquidity Standard & Poor's views ESA's overall liquidity as less than adequate despite a sources-to-uses liquidity ratio that is above 1.2x in the next 12 months. Our assessment of the company's liquidity incorporates the following assumptions: -- The company's 1.2x sources-to-uses ratio is not likely sustainable beyond 12 months. We expect the ratio to decline well below 1.0x by September 2013, as we incorporate the maturity of the US$350 million senior secured term loan in September 2014 as a source of cash; -- Refinancing pressures could escalate further in 2014 as close to US$785 million in senior notes (due in the first half of 2015) joins the aforementioned senior secured term loan in the near-term maturity horizon; -- ESA's relatively weak standing in the credit markets means it must rely on favorable capital market conditions to address its refinancing needs; -- An inability to absorb high-impact, low probably events (such as a weak capital markets environment); and -- We do not incorporate any parental support from Essar Steel Holdings Ltd. Although the newly established senior secured term loan has a borrowing base, it contains no financial covenants that would directly restrict access to the cash balances that are now on ESA's balance sheet. Recovery analysis Standard & Poor's rates ESA's US$750 million senior secured notes 'B' (two notches above the corporate credit rating on the company), with a recovery rating of '1', indicating our expectations of very high (90%-100%) recovery in the event of default. We rate the company's US$384.7 million senior unsecured notes 'CCC' (one notch below the corporate credit rating on ESA), with a recovery rating of '5', indicating our expectations of modest (10%-30%) recovery in a default scenario. Outlook The developing outlook on ESA indicates that Standard & Poor's could raise or lower the ratings over a period of up to two years depending on the progress the company makes in addressing its upcoming debt maturities. We could raise the ratings if the company performs much stronger than our base case operating expectations in the next several quarters with its debt-to-EBITDA leverage ratio declining to about 5x with positive free operating cash flows that supplement its liquidity position. In our view, this could improve ESA's reception in the capital markets with refinancing transactions occurring well ahead of mid-2014. Alternatively, we could lower the ratings on ESA if its weak profitability restricts the company's access to capital markets. We believe that ESA will have a limited opportunity to refinance upcoming debt maturities, the success of which will depend heavily on contemporary steel prices and capital markets conditions. Related Criteria And Research -- Methodology and Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- General Criteria: Use Of CreditWatch And Outlooks, Sept. 14, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- General Criteria: How Standard & Poor's Uses Its 'CCC' Rating, Dec. 12, 2008 Ratings List Essar Steel Algoma Inc. Ratings Removed From CreditWatch And Affirmed/Recovery Ratings Unchanged To From Corporate credit rating CCC+/Developing/-- CCC+/Watch Dev/-- Senior secured B B/Watch Dev Recovery rating 1 1 Senior unsecured CCC CCC/Watch Dev Recovery rating 5 5 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.