The elation about Tata Steel's acquisition of Corus masks serious concerns about the financial implications for Tata Steel.
AFTER months of speculation, Tata Steel, the biggest Indian private steel producer, and a part of the Tata Group, one of India's oldest and most respected corporates, announced on October 20 that it was in the process of acquiring Corus Group Plc. Everything about the deal was stunning.
The takeover, which is expected to be completed by January 2007 for a consideration of about $8.1 billion, will be the biggest overseas buyout by an Indian company. The combine will become one of the biggest steel producers in the world. Almost overnight, Tata Steel will leapfrog in the global ranking from about the 50th to the ninth position among the steel majors of the world. Tata Steel's acquisition is thus akin to a minnow swallowing a whale. Although this is a brave move, there appears to be considerable scepticism, not only in Jamshedpur, the home base of the pioneer of the Indian steel industry, but also among steel industry analysts.
Corporate India welcomed the deal wholeheartedly. "India Inc.", they claimed, had come of age. They pointed out that the Tata deal had, in one fell swoop, doubled the overseas investments made by Indian corporates in the last five years. They said the deal, which broke the billion-dollar barrier, would pave the way for the advance of Indian companies on the global stage. Commerce Minister Kamal Nath, who earlier this year intervened on behalf of L.N. Mittal with the French government when he attempted to acquire Arcelor, said that the deal demonstrated the rising strength of Indian industry to fight on foreign terrain.
Tata Steel, which first set up a modern steel mill almost a century ago, is among the lowest-cost producers of steel in the world. Much as the company would like the world to believe that this is because of the way it manages its business, the general consensus is that this is mainly because of the company's access to good quality iron ore and coal close to its production base.
Corus' roots trace back to the Thatcherite revolution in Britain, which resulted in the privatisation of British Steel, in 1988, resulting in British Steel Plc. The private company merged with Koninklijke Hoogovens, a Dutch steel company, to form Corus in 1999.
The basis of the scepticism lies in the fact that although Tata Steel is a highly profitable company, Corus, a larger company, is clearly the less profitable one. In 2005, Corus' operating income was about $108 a tonne of steel it produced. The same year, Tata Steel earned $280 for every tonne of steel it produced. The critical point is that the merged entity's operating income, on a pro forma basis, would be about $146 a tonne. From a Tata viewpoint this implies that the profitability from operating a much bigger asset base will halve after the takeover. Even though the stock market is not the best barometer of happenings in the real world, its reaction to the takeover does suggest that the market perceives that Tata Steel's profitability is likely to be seriously eroded as a result of the takeover. Significantly, even as the Sensex breached the 13,000 mark on October 30, the price of the Tata Steel scrip fell; it was down by 10 per cent when compared with its highest level in the preceding three months.
B. Muthuraman, managing director, Tata Steel, said that there are "tremendous synergies" between the two companies, although he could not quantify these. There is also the possibility of Tata Steel supplying slabs, which are at the lower end of the value chain, for finishing at Corus' mills, which are located closer to the high-value markets.
Although sceptics question Tata Steel's ability to supply slabs or other semi-finished steel products, given its own capacity constraints, those defending the deal point to the fact that Tata Steel is set to increase capacities. First, it is to increase capacity at its existing location from 5.3 million tonnes to 6.8 million tonnes in the next few months. Second, it plans to increase capacity at the Jamshedpur plant to 10 million tonnes per annum within a "few years", according to a Tata Steel official. Third, the company has a memorandum of understanding (MoU) with the State government in Jharkhand, which is well endowed with iron and coal reserves, to set up a 12-million-tonne plant, not far from its existing plants in Jamshedpur. Fourth, it is also establishing a 5-million-tonne plant in Chhattisgarh. Fifth, Tata Steel is setting up a 6-million-tonne plant in Kalinga Nagar in Orissa, where recently there were protests by tribal people resulting in deaths in police firing. Finally, the company has acquired steel-making assets in Singapore and Thailand, which aim at feeding steel demand in the fast growing East Asian market.
For the acquisition, Tata Steel will make an equity contribution of $2.056 billion (Rs.9,300 crores) through its subsidiary, Tata Steel Asia Holdings Pte. The latter would raise debts amounting to $1.824 billion. The equity and debt, amounting to $3.88 billion (Rs.17,500 crores), will be provided to Tata Steel UK Ltd., which is the Special Purpose Vehicle.
Since Corus' enterprise value has been estimated at $10.26 billion (Rs.46,121.9 crores) - including its debts amounting to $2.5 billion - the remaining amount needed for the acquisition, amounting to $6.3 billion, will be raised as debt by Tata Steel UK Ltd.
In the jargon of financial analysts, a deal such as this is a "leveraged buyout". The debt is to be backed and serviced by cash flows from Corus. Obviously, the deal is highly leveraged as the net debt-equity ratio is 2.74:1, compared with the 1:1 ratio that Tata Steel normally has. Although the equity contribution is not very high for a cash-rich company such as Tata Steel, the company's projects on the anvil are expected to cost it about Rs.65,000 crores in the next five or six years. The risk with such a buyout is that it piles the debt burden on the target company. There is a danger that if the market declines, its cash flows may be impaired, resulting in defaults on the loans.
A senior Tata Steel official told Frontline that the mood in Jamshedpur "is not one of undiluted joy" about the acquisition. He said: "Instead of asking why Tata Steel is buying Corus, it would be more meaningful to ask, why is Corus selling out?" It is well known that Corus has been on the lookout for a buyer. Its share price has increased sharply during the past year; if this cannot be attributed to performance, it usually indicates that the company is a potential target for a takeover. In fact, there were several contenders for Corus. But why would Corus want to sell if, as the Tatas see it, it has great value?
The Tata Steel official said that coal and iron reserves in the company's captive mines would last 40-50 years at the current capacity level of 5.3 million tonnes.
However, these will dwindle faster when the company scales up its steel production capacity. If these reserves are depleted, there is no guarantee that the quality of new mines would be as good. In that situation, Tata Steel would lose access to raw materials, the critical advantage that guarantees its status as a low-cost producer.
Speaking to Frontline, a senior official in the Steel Ministry said that Corus probably saw the Tata acquisition as the "best opportunity to make an exit". He said: "Corus does produce high-quality first-class products, they are nevertheless high cost. It does not have access to iron and coal mines, which is a handicap. It has mastered certain technologies and, in fact, sells them. But there will be a time, not very far into the future, when Corus facilities will have to be replaced."
He said that Tata Steel's argument that the deal would enable it to sell semi-finished products in markets of advanced countries "does not sound convincing".
He argued that the differential between slab prices and hot-rolled, orupstream, product prices was low. The differential, he said, did not make it worthwhile for Tata Steel to ship slabs to the overseas market. In fact, selling slabs supplied by Tata Steel in the advanced markets might be beneficial to Corus, but it would be against the interests of Tata Steel. "I do not see a win-win situation for the two companies," he said.
"Competition is not about merely market shares: there are other dimensions as well. Size gives large companies the clout to get things done, on the terms they find most advantageous," he argued. Being big enables them to get a railway link to their preferred locations, gain access to high-quality collieries and iron ore mines on attractive terms, and enjoy a host of advantages that would not be available to smaller companies.
"The Tatas", he said, "see that they are no longer unique. Their bigger rivals can obtain the same advantages they now enjoy."
To be fair to the Tatas, they have been unable to allay these fears as freely as they would have liked because of the confidentiality clauses built into the terms of the agreement for the acquisition.
Nevertheless a dose of scepticism is in order, given the euphoria that has greeted the acquisition.