Last week, thousands of Indians didn’t offer prayers for Tata Steel to clinch the deal for the Anglo-Dutch steel maker Corus, as they have for the recovery of hospitalized Bollywood superstars. Nor did they erect 40-foot billboards of a smiling Ratan Tata, chairman of Tata Steel, after he won Corus. And the stock markets were clearly concerned about Tata Steel’s new debt load. But despite all this, euphoria gripped the nation. Finance minister P. Chidambaram offered unspecified help, if needed, to close the deal; fellow steel magnate Lakshmi Niwas Mittal cheered the acquisition, and excited TV newsreaders gushed. India’s first Fortune 500 MNC was born.
Tata Steel’s $12.1 billion Corus deal offers the promise of access to high-end European markets combined with low-cost Indian manufacturing. That same logic of shipping low-cost steel slabs to finishing plants overseas guided its purchase of NatSteel in Singapore and its purchase of a 67% stake in Thailand’s Millennium Steel over the past two years. But tough questions that won’t die in a hurry are being asked about the deal’s high price, the durability of the steel industry’s current boom phase, and the role of China as both a buyer and producer of steel, among other issues. India Knowledge at Wharton spoke with Wharton faculty and other experts about this deal.
Jingoism and a Steel Hero
“It was seen as a watershed deal and a matter of national pride,” says Vivek Gupta, who heads the Indian operations of consulting firm A. T. Kearney as its managing director. “The financials for this deal [require] high performance levels, perfect post-deal execution and sustained high steel prices. It is a risky game and will be okay for Tata as long as the economy is growing and no major bumps occur. If [these bumps] do occur, they can become a challenge, and I am reminded of the high leverage days of the mid-1980s.” Adds Wharton management professor Jitendra Singh: “If the current positive signs continue for some more time, [Tata] should be fine. [But] if we head out into a global recession and demand for steel falls, then it will place a lot of pressure on [the company].”
As it becomes the world’s fifth largest steel producer with a capacity of 25 million tons, Tata Steel seems to have left little room for errors of judgment in reading the global outlook for steel demand, its ability to extract premium prices for finished steel, cost and other synergies with Corus, and integration challenges. When Tata Steel wore out rival bidder CSN of Brazil with its final offer of 608 pence a share, it was nearly 34% higher than its original October 2006 bid. Tata will finance the purchase with $4.1 billion in cash from its group holding company, Tata Sons, and borrowings that will leverage Corus’s assets. Meanwhile, the stock markets shaved 11% off Tata Steel’s share price in the past week, and rating agencies Moody’s and Standard & Poor’s have voiced concerns over the debt load.
Tata Steel managing director B. Muthuraman said in a statement after the January 31 deal that the purchase price puts Corus’s enterprise value at $700-$710 a ton, which compares with today’s costs of $1,200-$1,300 a ton (for a new plant), and would take five or six years to build. He also forecast up to $350 million in savings after about three years from synergies in procuring materials, in marketing and in shared services. Tata Steel’s access to captive sources of raw materials such as iron ore and coking coal also justifies the deal, which he said is in line with its strategy to acquire assets “in countries where raw material is not available but there are markets [that are] either developed, mature or growing.” Tata Steel’s iron ore and coal costs are an estimated $80 a ton, while it is between two and three times that for rivals, according to Enam Research in Mumbai. As a result, Tata Steel claims a production cost of about $150 a ton, while the industry average is about $330.
Even so, Muthuraman admitted that the EBITDA (earnings before interest, tax, depreciation and amortization costs) multiple of nine for the Corus acquisition is “a little higher than the industry average of the last five to six years.” Mittal’s $34 billion acquisition of Arcelor last June was at an EBITDA multiple of 4.3, while the industry median (excluding Tata-Corus) is at about five. Ratan Tata, in fact, indicated that he had provided for more bidding room in the deal. “We had taken a view that we would not go beyond a point… We did not reach that point,” he was quoted as saying. “Had we reached that point, we would have walked away. Overbidding or not is subjective when it comes to a judgment call.”
“I take that at face value,” says Singh of Tata’s statement that the price was well within the maximum price Tata Steel was willing to pay for Corus. “Ratan Tata is a responsible and a highly capable individual, and he has done remarkable things with the Tata Group in the years after 1991,” the year he took control of the group from the legendary J. R. D. Tata. “We have to recognize that while we have a financial valuation for a particular asset, the value of that asset may be greater for some companies to acquire and less for other companies….Above the financial value, it may have strategic value.”
Wharton management professor Paul Tiffany reads Tata’s statement differently. “When Tata said he would have even paid more, I wonder about that,” he says. “Was that simply a statement [made] in the joy of winning or was it indicative of too much emotion triumphing over reason?” Tiffany says he finds the price and the rationale for the Corus acquisition to be “a little dubious…. It’s a very cyclical industry and prices today will not be the price of tomorrow if history is any guide. We are near the peak of the cycle. So, clearly, the price that Tata is paying [for Corus] is a lot more than anyone thought.” The price of hot rolled coil steel — an accepted reference point — is currently at about $550 a ton, and even Muthuraman says he expects it to settle at about $450 a ton in five to six years.
No Way Ahead but Global
A.T. Kearney’s Gupta suggests that if Tata Steel needed to become a global player, it had few other options besides buying Corus. Consequently, “this was a ‘must’ deal” for them. “The current framework in the industry is stacking up towards consolidation,” he says. “You need the power as a supplier with end customers to ensure appropriate pricing. That balance had shifted too far to the customer, and the producers had little pricing power.”
The macro outlook for the steel industry’s fortunes remains positive, says Gupta, adding it has taken some work getting there. “The industry languished in the mid-1980s and the 1990s with all players — especially those in the U.S. — operating with high debts, legacy costs, antiquated plants, no capital dollars and sub-par scale, and finally, high labor costs and wages which were out of line with productivity.” That began changing, says Gupta, when industry leaders such as Mittal embarked upon consolidation to bring scale and profitability. “As they gained scale, this also started to shift the balance back again to the suppliers, as customers had been sourcing them for years and had driven margins down to unsustainable levels.” That tilt has, however, moved somewhat in favor of producers, he adds, especially with buoyant demand from China.
According to Tiffany, pricing power will not automatically flow to Tata Steel with Corus. “I would assume that one of the factors [driving the Corus deal] was the belief that consolidation will give suppliers strength in pricing in a downward cycle,” he says. “That is yet to be seen. This is an industry with a long history of collusion among producers. India may be new to this, and I question the probability of success. The Tatas have a little needle to thread here.”
China on the Balance Beam
There is every chance that China, which is a positive force today for steel demand, could start behaving differently in the years to come, Tiffany suggests. “There is a huge amount of capacity under construction in China that will come on stream in three to five years,” he says, adding that consolidation is imminent in the Chinese steel industry, which has a seemingly unwieldy collection of 800 producers, including some 125 integrated steel companies. “Consolidation will occur, and that will come about with the expansion of the highway and railroad network in China.”
Tata Steel should take note of some other Chinese signs, too, says Tiffany. “China is increasingly looking to be its own supplier as well, and that could have an impact on prices.” He sees a strong likelihood of its demand for steel reducing as its government tries to slow down internal growth in an overheated economy. A big driver here is the prestige associated with the 2008 Beijing Olympics. “The Chinese government does not want to have a crash landing with recession, high levels of unemployment and social unrest when China will be the focus of the world,” says Tiffany.
Singh’s advice is for Tata Steel to focus on issues beyond just the financial with the Corus acquisition. “If you look at the problems that mergers and acquisitions [experience], there is altogether too much attention paid to the financial side, such as valuation and cash flows, and not nearly enough to the softer, non-financial side,” he says. The evidence from M&A activity in Europe and North America suggests that one big reason why many of them didn’t live up to expectations “is precisely that not too much attention was paid to the non-financial aspects.”
The disastrous 1999 marriage of Daimler Benz with Chrysler comes to mind, Singh adds. Besides national cultural differences, the two companies had different organizational cultures and structures, [in addition to different] compensation models, he says. Daimler Benz also adhered to the German practice of having two boards — a management board and a supervisory board with worker participation guaranteed by law. “To imagine that workers would participate on the board of Chrysler was unheard of,” says Singh, adding that Tata Steel should focus on the level of integration required with Corus to realize its desired value from the acquisition.
Ratan Tata has said he is confident the two companies have “a cultural fit and similar work practices.” Nearly 30 years ago, J. R. D. Tata had lured away a young engineer from Corus’s predecessor company, British Steel, to work at Tata Steel. That young Sheffield-educated engineer — Sir Jamshed J. Irani (knighted by the Queen 10 years ago) — was Tata Steel’s managing director until six years ago.