Is the Corus acquisition by Tata Steel a defining moment for the company as made out to be? Or is it a disaster in the making for Tata Steel? By Rex Mathew.

After four months of twists and turns, Tata Steel has won the race to acquire Corus Group. The bidding war between Tata Steel and Brazilian company CSN was riveting and ended in a rapid-fire auction. Initial reactions to the deal are highly diverse and retail investors are completely puzzled by the market reaction.

Going by the stock market reaction yesterday, the acquisition is a big blunder. The stock tanked 10.5 per cent after the deal was announced and another 1.6 per cent today. Investors are worried about the financial risks of such a costly deal.

Media reaction to the deal has been just the opposite. Almost all the reports were adulatory while editorials praised the coming of age of Indian industry. A prominent financial daily presented the deal almost as revenge of the natives against the old colonial masters with a picture of London covered in our national colours.

Its editorial warned the market 'not to bet against Tata', citing the previous instances when sceptics were proved wrong by the group. Official reaction has been no different and the finance minister even offered all possible help to the Tata Group.

Is the acquisition too costly for Tata Steel? Is price the only criterion while evaluating an acquisition? Should managers focus on keeping shareholders happy after every quarter or should they focus on the long-term, big picture? These are tough questions and, unfortunately, answers would be clear only after many years - at least in this case.

When could the steel cycle turn?
The last few years were some of the best ever for the global steel industry as robust demand from emerging economies like China pushed up prices. Profits of steel manufacturers across the globe swelled and their market capitalisations have multiplied many times.

How long will the good times last? Tata Steel believes the steel cycle is in a long-term up trend and the risk of a downturn in prices is low. In fact, managing director B Muthuraman said the global steel industry might witness sustained growth as during the 30-year period between 1945 and 1975.

The massive post-war infrastructure build-up in Western countries led to the sustained steel demand growth in that period. The coming decades would see similar infrastructure spending in emerging economies and steel demand would continue to grow, according to this view.

The International Iron and Steel Institute (IISI), a respected steel research body, corroborates this in its outlook. The growth in demand for global steel would average 4.9 per cent per year till 2010 according to the IISI. Between 2010 and 2015, demand growth is expected to moderate to 4.2 per cent per annum according to IISI forecasts. Much of this demand growth would come from China and India, where the IISI estimates growth rates to be 6.2 per cent and 7.7 per cent annually from 2010 to 2015.

Now lets consider steel prices. Expectations of sustained demand growth have already led to massive capacity additions, mostly in emerging markets. Chinese steel capacity has expanded significantly over the last decade while a large number of mega steel plants are being planned in India. Capacity additions by Russian and Brazilian steelmakers would also be significant in future as they have access to raw material.

Would the capacity additions outrun the demand growth and lead to subdued steel prices? Under normal circumstances, that could have been a very strong possibility. But many industry leaders believe that the global steel industry would see a structural shift in the coming years.

Some of the inefficient steel mills in mature markets would face closure while others would shift production to high value-added products using unfinished and semi-finished steel supplied by steel mills in locations like India, Russia and Brazil with access to raw material. This would limit aggregate supply growth and keep prices stable in future.

Major global steel makers are also not unduly worried about the possibility of large-scale exports from China, which would depress international steel prices. Chinese capacity is expected to continue to grow in the coming years, but so would the demand.

Besides, Chinese steel plants are not expected to emerge very efficient as they depend on imported raw materials, which limit their pricing power. Many steel analysts expect significant consolidation in the Chinese steel industry as margins erode further in future. The Chinese government has already started squeezing the smaller units by withdrawing their raw material import permits.

The need for scale
Going by the IISI forecasts, global steel demand would be 1.32 billion tonnes by 2010 and 1.62 billion tonnes by 2015. Even Arcelor-Mittal, the largest global steel player by far, has a present capacity, which is just 6.8 per cent for projected demand in 2015. To maintain its current share, Arcelor-Mittal would have to add another 50 million tonnes of capacity by then. This confirms the view that there is still considerable scope for consolidation in the steel industry.

As the industry consolidates further, Tata Steel - even with its planned greenfield capacity additions - would have remained a medium-sized player after a decade. This made it absolutely vital that the company did not miss out on large acquisition opportunities. Apart from Corus, there are not many among the top-10 steel makers, which would become possible acquisition targets in the near future.

With Corus in its fold, Tata Steel can confidently target becoming one of the top-3 steel makers globally by 2015. The company would have an aggregate capacity of close to 56 million tonnes per annum, if all the planned greenfield capacities go on stream by then.

Neat strategic fit
Corus, being the second largest steelmaker in Europe, would provide Tata Steel access to some of the largest steel buyers. The acquisition would open new markets and product segments for Tata Steel, which would help the company to de-risk its businesses through wider geographical reach.

A presence in mature markets would also provide Tata Steel an opportunity to go further up the value chain as demand for specialised and high value-added products in these markets is high. The market reach of Corus would also help in seeking longer-term deals with buyers and to explore opportunities for pushing branded products.

Corus is also very strong in research and technology development, which would add to the competitive strength for Tata Steel in future. Both companies can learn from each other and achieve better efficiencies by adopting the best practices.

But at what cost?
Now that Tata Steel has achieved its strategic objective of becoming one of the major players in the global steel industry and steel demand growth is likely to be robust over the next decade, has the company paid too much for Corus? Even those analysts and industry observers who agree on the positive outlook for steel demand growth and the need to achieve scale believe so.

The enterprise valuation of Corus at around $13.5 billion appears too steep based on the recent financial performance of Corus. Tata Steel is paying 7 times EBITDA of Corus for 2005 and a higher 9 times EBITDA for 12 months ended 30 September 2006. In comparison, Mittal Steel acquired Arcelor at an EBITDA multiple of around 4.5. Considering the fact that Arcelor has much superior assets, wider market reach and is financially much stronger than Corus, the price paid by Tata Steel looks almost obscenely high.

Tata Steel's B Muthuraman has defended the deal arguing that the enterprise value (EV) per tonne of capacity is not very high. The EV per tonne for the Tata-Corus deal is around $710 is only modestly higher than the Mittal-Arcelor deal. Besides, setting up new steel plants would cost anywhere between $1,200 and $1,300 per tonne and would take at least five years in most developing countries.

But, are the manufacturing assets of Corus good enough to command this price? It is a well-known fact that the UK plants of Corus are among the least efficient in Europe and would struggle to break even at a modest decline in steel prices from current levels.

Recent financial performance of Corus would dent the hopes of Tata Steel shareholders even further. EBITDA margins, after adjusting for one-time incomes, have steadily declined over the last 3 years. For the 9-month period ended September 2006, EBITDA margins of Corus were barely 8 per cent as compared to around 40 per cent for Tata Steel.

The price of an asset is more a factor of its future earnings potential than its past earnings record. Operating margins of Corus can be significantly improved if Tata Steel can supply slabs and billets. Tata Steel is targeting consolidated EBITDA margins of around 25 per cent as and when it starts supplying crude steel to Corus. If the company can sustain such margins on the enlarged capacities, it would be quite impressive.

But that is a long way off as Tata Steel would have sufficient crude steel capacity only when its proposed new plants become operational. Till then, the company is targeting to maximise gains through possible synergies between the two operations, which are expected to yield up to $350 million per annum within three years.

In the meanwhile, Tata Steel has to make sure that cash flows from Corus are sufficient to service the huge amount of debt, which is being availed to finance the acquisition. According to the details available so far, Tata Steel would contribute $4.1 billion as equity component while the balance $9.4 billion, including the re-financing of existing debt of Corus after adjusting for cash balance, would be financed through debt. The debt facilities are believed to be structured in such a way that they can be serviced largely from the cash flows of Corus.

Interest rates on credit facilities for such buy-outs are often higher than market rates because of the risks involved. At an expected interest rate of 7 per cent per annum, the interest outgo alone would be over $650 million per year. Along with repayment of principal, the annual fund requirement to service this debt would be around $1.5 billion - assuming a 10-year repayment horizon.

The current cash flows of Corus are barely sufficient to cover this, even after considering the synergy gains. If international steel prices decline even modestly, Tata Steel would have to dip into its own cash flows or find other sources like an equity dilution to service the debt.

Besides, funds may also be required for upgrading some of the Corus plants to improve efficiencies. Tata Steel would have to manage all this without jeopardising its greenfield expansion plans which may cost a staggering $20 billion over the same 10-year period.

No wonder investors are deeply worried!

To its credit, the Tata Steel management has acknowledged that it would not be an easy task to manage the next five years when Corus would have to hold on to its margins without the help of cheaper inputs supplied by Tata Steel. If the group can survive this initial period without much damage, life may become much easier for the Tata Steel management.

Investors would consider Corus a a burden for Tata Steel until such time there is a perceptible improvement in its margins. That would keep the Tata Steel stock price subdued and any decline in steel prices would have a disproportionately negative impact on the stock.

However, long-term investors would appreciate that right now steel manufacturing assets are costly and Corus was a prized target which made it even more costly. With the strategic importance of such a large deal in mind, Tata Steel management has taken the plunge.

If it can pull it off, even after a decade, the Corus acquisition would become the deal, which would transform Tata Steel.