The Hindu Business Line : Tata Steel: Hold

For Tata Steel, the move into Europe appears to fit well with its global strategy. As consolidation gathers momentum, the Tata Steel-Corus combine holds significant growth potential.

Tata Steel's Jamshedpur plant

Tata Steel's acquisition of Corus of the UK (subject to approvals and completion) clearly reinforces the strategic logic dictating `consolidation' in the highly fragmented steel industry, the foundation for which was laid by the historic merger of Arcelor and Mittal Steel. For Tata Steel, which has been pursuing inorganic growth in the Asian region for a while, the move into Europe appears to go well with its strategy of global growth.

For shareholders, remaining invested in the stock appears an appropriate strategy, as the benefits of potential synergies are likely to flow, post-2009. In the near term, earnings are likely to remain flat or grow moderately on a larger base.

What it means for Tata Steel?

Mr Ratan Tata, Chairman, Tata Sons, and Mr James Leng, Chairman Corus Group

The deal is likely to confer three principal benefits on Tata Steel: Larger scale, strong downstream business operations, and cross-fertilisation of R&D capabilities. The acquisition of Corus would propel Tata Steel to the position of the world's fifth largest steel-maker with a combined capacity of about 23 million tonnes, from its 56th position now.

Access to European markets, however, remains the larger attraction. Corus, which controls about 50 per cent of the UK steel market (volume terms), is likely to offer Tata Steel the direct distribution gateway into the European markets, where the latter currently does not have a presence.

More important, it is likely to strengthen its value-added portfolio of steel products, as Corus is the market leader in packaging materials, even while it has a strong presence in auto and construction sectors.

Tata Steel, which has been sourcing technology from Corus, is now likely to derive the direct benefits of latest technologies and R&D capabilities of Corus.

Strategic rationale

Tata Steel's de-integration strategy (making primary metal in low-cost countries and having finishing facilities in end-user markets) explains the strategic logic behind the acquisition. Its earlier two acquisitions of NatSteel and Millennium Steel were also carried out with a similar intent. For Corus, the high operating cost has been the principal factor affecting its profitability.

This, perhaps, explains the reason for its low EBITDA (earnings before interest, taxes, depreciation and amortisation) margin at about 8 per cent vis-à-vis 14 per cent for its European peers. This is in stark contrast to Tata Steel's margins at over 30 per cent and a low-cost manufacturing base.

Steel slabs rolling out of Corus' Port Talbot Works in South Wales, UK.

Further, Corus has high exposure to spot prices and a higher operational gearing among the larger European steel companies. In contrast, Tata Steel has about 70 per cent of its supplies routed through long-term contracts. The combine is, thus, likely to reduce the element of volatility associated with pricing.

Tata Steel's production cost at about $160 (or Rs 7,200) per tonne is one of the lowest in the world. Corus has steel plants spread across the UK, the Netherlands, Germany, France, Norway and Belgium with the cost of production almost twice as that of Tata Steel. However, the jewel in Corus's crown is its 6.5 million-tonne integrated facility at Ijmuiden in the Netherlands, which has the lowest production cost in Europe.The larger and the significant aspect, however, pertains to cost synergies associated with the acquisition. While the larger scale of the combined entity does offer synergies in procurement, distribution and logistics, it is not clear as to how and over what time period, the production costs are likely to come down. Though Tata Steel eventually plans to export slabs and billets from its plants in India to Corus' facilities, it has ruled out such a mechanism for the first three years, post-completion of acquisition. On the back of this, we believe the benefits of cost synergies are likely to be reflected only, post 2009.

A stretched balance-sheet

The acquisition is in the form of an all-cash deal with total outgo for Tata Steel at $8.23 billion (or about Rs 37,000 crore). This is to be funded by a combination of equity and debt.

The equity contribution from Tata Steel is going to be $3.88 billion (or about Rs 17,500 crore). While this consists of utilisation of cash, preferential allotment of shares to Tata Sons — its principal promoter and unused borrowings of about $50 million (or Rs 225 crore), the exact break-up is not yet clear.

Tata Steel has about Rs 4,500 crore in general reserves, Rs 3,500 crore in operating cash flows, liquid investments of about Rs 2,000 crore and Rs 3,500 crore in group companies (market value). This totals up to Rs 13,500 crore.

The gap

Even assuming the full utilisation of this amount and with about Rs 3,000 crore coming from Tata Sons, it remains to be seen where the balance Rs 1,000 crore is likely to come from. Considering the outlay of Rs 35,000 crore for its domestic projects, the possibility of equity expansion remains fairly high.

On the other hand, debt of $5.63 billion (or Rs 25,000 crore) proposed to be raised through Tata Steel UK (its indirect subsidiary in the UK) is likely to push the debt-equity ratio to 3:1 from about 0.3:1 now. The interest outgo for Tata Steel is also likely to remain high and, hence, sustaining the pace of cash flow generation remains a challenge.

Valuations

The valuation for the acquisition works out to 7.9 times the EBITDA. This appears reasonably high compared to 5.4 times EBITDA, that Mittal Steel paid to buy out Arcelor. However, we believe enterprise value (EV) per tonne is a better metric for valuing the takeover of a steel company.

The EV per tonne in this case works out to about $540 per tonne against Tata Steel's $780 per tonne for its domestic business. The global steel market has seen deals struck in the $ 650-$950 per tonne range. Considering this and the access to growth markets that Tata Steel is likely to get, the valuation appears fair.

The combined entity is expected to generate an EBITDA margin of 25 per cent over the next few years from 14 per cent now. Over the near-to-medium term, we expect consolidated margins to remain in the 15-18 per cent range.

We, thus, view the deal as value-accretive in the long term for Tata Steel and, hence, recommend staying invested with the stock.

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