The Hindu Business Line : Putting up iron-clad defences

Restructuring, technology upgradation and downsizing have helped steel companies greatly improve their operational efficiency and profitability. Now, with the ongoing consolidation in the sector, domestic majors are lining up big expansion and investment plans, and are adopting a new model to go about it.

It is not the first time that the steel sector is making bold expansion plans and lining up aggressive investments. A recap to the mid-1990s brings to mind similar ambitious projects outlined by the steel sector then. That these projects failed for various reasons is a different story. Nearly a decade later, the steel majors are upbeat again. Will it be different this time? What has changed for the steel sector between the 1990s and now? With consolidation gaining momentum in the global market, are Indian companies ready for the next big leap?

Steel majors plan to spend about Rs 1,25,000 crore over the next 10 years on expansion. SAIL, the country's largest steelmaker, has charted out a Rs 37,000-crore plan for increasing capacity from 14.5 million tonnes per annum (MTPA) to 22.5 MTPA over the next five years. Tata Steel — the largest private sector company — proposes to increase capacity five-fold over the next decade at an investment of Rs 67,000 crore . And Jindal, Essar and Ispat have announced investments totalling to about Rs 35,000 crore.

In the mid-1990s, when the steel majors were in expansion mode, as new capacities were created, the economy went into a tailspin and the steel cycle took a downturn. The consequent glut in the market depressed prices of the metal, affecting the profitability of the steel companies and throwing their expansion plans out of gear.

On a different wicket

This time around, steel companies appear to be on a firmer wicket. At the macro level, the steel demand is expected to remain buoyant over the next few years, on the back of the Government's thrust on infrastructure and strong demand from the automobile and consumer durables sectors. The domestic demand is likely to grow at a CAGR of about six per cent over the next 15 years, translating into consumption of about 85 million tonnes (MT) by 2020. The current expansions would take the total capacity to about 80 MT, leaving a deficit of 5 MT. Hence, from a long-term perspective, these planned capacity increases make sense.

Vital micro level indicators also present a better, healthier picture. Cleaner balance-sheets, improving operational contours, superior product mix, phased expansion and strategic intent to go global are the key differentiators that point to an encouraging outlook. SAIL, for instance, today boasts of a debt-free status. Tata Steel — a cash-rich company — is likely to generate cash flows in the vicinity of Rs 15,000 crore over the next five years. Essar Steel has brought down its level of gearing substantially. The Jindal group's capital restructuring exercise has helped streamline its core businesses and improve its cost structure. While companies now have sufficient headroom to borrow, there is a possibility of equity expansion in Tata Steel and JSW Steel, given the order-of-magnitude jump in capacities.

A notable change over the last few years has been in the product mix. As against semi-finished products, that formed a substantial part of their portfolio a few years ago, steelmakers are now focusing more on value-added products. Their share has been gradually increasing over the last year or so. Apart from fetching them higher realisations, on an average, it is being seen as a strategy to de-risk the earnings of steel producers from price volatility.

Steelmakers are going in for a phased expansion of their capacity — a remarkable shift from their strategy of the 1990s. This staggered approach is likely to reduce the downside risk. One, it gives companies more flexibility to alter plans based on the prevailing market conditions. Two, the financing risk is reduced considerably as funds are raised proportionately without stretching the balance-sheet at one go.

That domestic steelmakers have improved their geographical presence is also a strong positive. Apart from the traditional markets in South Asia, they are now exporting to the US, West Asia and Europe.

Will de-integration work?

Steel majors are now eyeing a new model that involves dispersal of facilities in different regions. Initiated by Tata Steel, the de-integration model is finding favour with other domestic players too. Steel companies are thus considering mining the primary metal in countries rich in raw materials and undertaking processing in growing markets. By adopting such a strategy, they are aiming at a complementary presence in various low-cost manufacturing bases and high-growth markets.

Tata Steel's proposed projects in Iran and South Africa and the acquisition of NatSteel are in line with such a strategy. Having acquired a cold rolling (CR) mill in Indonesia in 2004, Jindal Stainless is now eying two more CR facilities in South-East Asia and Europe in order to absorb its expanded hot-rolled capacity in Hissar, likely to be commissioned by October.

Essar Steel's acquisition of Hy Grade Pellets and Steel Corporation of Gujarat last year was with a view to gaining control over input costs and strengthening the value chain. JSW Steel is also said to be in talks with Corus of the UK for acquiring some of its plants. It plans to manufacture steel slabs in India and take them to Europe for conversion into finished steel.

While such a model is likely to strengthen the downstream operations and offer access to growth markets, there is a problem: It is likely to expose steel companies to geo-political and funding risks while the ability to manage logistics will also be a challenge.

While the pricing environment offers a stable outlook, steel companies have to guard against the rising cost of inputs and logistics in the medium to long term. The extent and ability to control input costs is key for Indian steelmakers. As demand for iron ore (key raw material) is set to rise and the battle hots up for this scarce resource, ensuring backward linkages will prove vital in determining cost structure. Companies such as Tata Steel and SAIL, with ownership of low-cost mines, will have the edge over their counterparts here.

Key challenges

Realising the importance of cutting down logistics costs, Tatas and Essars are investing in ports, roads and rail infrastructure. As freight forms a substantial part of operating costs (12-15 per cent), efficiency of steel companies in managing logistics is going to be crucial.

Further, executing projects of this magnitude calls for greater discipline and strict monitoring. Cost and time over-runs have affected the viability of steel projects in the past. We believe the execution risk remains high for the projects announced by SAIL and Jindal group.

Apart from the above, the ability to successfully integrate global operations and fund expansions at low cost and minimum risk will also prove challenging.

Defences at home

Global consolidation in the industry is slowly gaining momentum, in large part due to the audacious takeover bid mounted by steel tycoon L. N. Mittal for Arcelor of Europe.

Soon after the Mittal-Arcelor merger, it was the turn of OneSteel — the second largest Australian steelmaker — to announce a deal to buy out Smorgon Steel, its nearest peer and third largest steel producer in Australia. The steel sweepstakes now points to the next five players — Nippon Steel, JFE Steel, ThyssenKrupp, Baosteel and Posco — which are likely to pursue consolidation strategies if they are to compete with the Mittal-Arcelor combine on a somewhat equal footing.

Back home, steel majors appear to be in defensive mode. Acknowledging that the domestic steel sector remains vulnerable, companies have mounted defences as a pre-emptive measure to ward off any takeover attempts.

Soon after Mr Mittal spelt out his plans of entering the Indian market, the promoters of Tata Steel hiked their stake in the company to 33 per cent from 26 per cent, ensuring that management control remained with the Tata group.

Except for the Tatas, promoters of all other frontline steel companies have well over 40 per cent in their respective companies. While the promoters' holding in Essar Steel is close to 75 per cent, in JSW Steel the promoters hold about 50 per cent of equity.

What such actions broadly indicate is that Indian companies, irrespective of size, may not be immune to the emerging trend of global consolidation. In this backdrop, Tata Steel's long-held advantage of being the world's lowest-cost producer and one of the top three in terms of profit per tonne of steel sold, makes it vulnerable to a takeover. However, with the outlook for steel now looking up, defensive measures by Indian promoters may be justified.