It was like David courting Goliath when Tata Steel, India’s largest private sector steel producer, made an $8.1 billion bid in October for Corus, an Anglo-Dutch company four times its size. But Corus accepted Tata Steel’s offer, and no serious rival bid is yet in sight, although Brazil’s Companhia Siderurgica Nacional (CSN), similarly sized with 5.8 million tons of capacity, is rumored to be weighing one.
Tata Steel’s case for the acquisition is that its low-cost plants in India would use Corus’s finishing plants to supply and expand the latter’s high-end customer franchises in Europe. Tata Steel has the same strategy for 1.8 million tons at NatSteel in Singapore and Millennium Steel in Thailand, companies it has bought over the past two years for a combined $653 million. Tata Steel’s higher efficiency pitch to Corus was self-evident. Although its $5 billion in revenues are a quarter of Corus’s $19.4 billion, Tata Steel generates $1.5 billion a year in operating profits on a capacity of 5 million tons, while Corus’s 18 million tons brings home only $1.9 billion.
The Corus takeover catapults Tata Steel from its current 65th place among global steel producers to the No. 5 spot with a combined capacity of 23.5 million tons. Others ahead of it are Arcelor-Mittal (110 million tons), Japan’s Nippon Steel (32 million tons); South Korea’s Posco (30.5 million tons) and JFE of Japan (29.9 million tons). Excluding Corus, Tata Steel has plans to raise its Indian capacity to 30 million tons by 2015.
If Tata Steel closes the Corus deal next January, it will be the biggest international acquisition so far by an Indian company, and it will happily coincide with Tata Steel’s 100th anniversary. (It will also be the Tata Group’s 22nd foreign acquisition since 2005.) While Tata Steel now has tremendous growth opportunities, it also faces significant challenges. Maintaining its low-cost advantages by securing captive raw materials as it expands capacity is one; another is tempering its bet on the current high steel prices with the prospect that they could soften over time. Imminent consolidation in China, the rise of new rivals as a result of consolidation, and cartelization among the top producers are transforming the global steel business. What will all these factors mean for the Tata Steel-Corus merger? India Knowledge at Wharton spoke with Wharton professors and steel industry experts for glimpses of what lies ahead.
Driven by Threat
The current round of global steel consolidation has an unfamiliar ring, notes Paul Tiffany, adjunct professor of management at Wharton and senior lecturer at the University of California’s Haas School of Business in Berkeley. “It’s interesting that the consolidation in the steel industry is driven not by market opportunity but by the threat of the industry going out of business,” says Tiffany, who consults with U.S. Steel and authored the 1998 book, The Decline of American Steel: How Management, Labor and Government Went Wrong.
Tiffany says that at first sight, steel is “not a naturally global industry,” without the economic argument of brands that can sell across countries. “Steel is an undifferentiated commodity in many respects,” he says. “Steel is what economists call a producer good. The major users for steel are the automobile industry and the construction industry, and brand doesn’t matter much.” Tiffany says the industry’s underlying dynamics fly in the face of notions of globalization. “One problem with steel is that its bulk and weight tend to minimize how far you can export it,” he says. Tata Steel has been actively promoting a handful of steel brands, which account for about a sixth of its revenues.
Tiffany believes that the global consolidation in steel is really a big bet that Chinese demand will remain vibrant, and that some of the emerging markets in Eastern Europe and India will continue to grow. “The price now for steel — for sheets — is about $600 a ton; five years ago it was $300,” he says. “Both Tata-Corus and Mittal-Arcelor are betting that prices will remain strong in what is a classic cyclical industry.” The questions the industry faces, according to Tiffany, are: How long and how deep is the demand from China, and will India and Russia really begin to make a major investment in infrastructure, such as highways in rural areas?
Peter Fish, managing director at MEPS (International), a steel consulting firm in Sheffield, U.K., is a long-time Corus watcher. He predicts that a decline in steel prices could benefit Tata-Corus. “Prices in the U.S. are already on the way down. In Europe, they will turn down by the end of the year. They could fall by more than 10% during the year,” he says. “When prices drop, obviously the companies that will survive the best will be those that are most competitive. If you have cheap raw materials available, you have a better opportunity to survive the difficult times.”
Tata Steel’s managing director, B. Muthuraman, is confident that steel prices will stay firm in the near term. But he expects them to fall from current levels of about $550 a ton (for hot rolled coils) and stabilize at about $450 a ton over the next five to six years. Even at that lower level, Tata Steel stands to benefit hugely. At a media conference late last month, Tata Steel executives put the company’s cost of production at about $150 a ton, and the industry average at $330-$340 a ton.
Fish attributes the softening in steel prices to oversupply. He says customers have been buying ahead of impending price increases and perceived shortages in availability. But now, he says, most users have built sufficient inventories and will probably only order what they need immediately.
Tata Steel cannot bank wholly on steel prices remaining strong, says Tiffany. “If Tata wants to invest billions of dollars to build steel mills in India to supply Europe, it is a huge bet. How long will the price be high? And for how long will India’s costs be low?” he asks. He points out that in China’s Guangdong province — its industrial heartland — “inflation is going wild” and the country is losing investment to Vietnam because of rising prices. “That’s going to happen in India too.”
Tata Steel’s stated argument, however, is rooted in its captive iron ore and coal resources. The distribution of the world’s iron ore resources strengthens that case. The world’s top five iron ore producers control an overwhelming 90% of the market, according to a Tata Steel presentation. In contrast, the top five steel producers command less than 20% of the world market. What’s clear in those numbers is the relatively low bargaining power of steel producers vis-à-vis their ore suppliers. Producers without captive raw materials have been hit hard in the past two years, a Tata Steel document shows. Between 2003 and 2005, iron ore prices have doubled from $39 to $80 a ton; hard coking coal from $46 to $125 a ton; and semi-soft coal from $31 to $115 a ton. Muthuraman says Tata Steel’s plan is to ensure that as it expands capacity, its requirements of iron ore and coal come from captive sources.
That scenario reinforces Tata Steel’s case that the company’s advantage lies in its access to low-cost raw materials like iron ore and coking coal. A September 2006 analysis from Enam Research reveals a steep advantage for Tata Steel: Its iron ore and coal costs add up to only $81 a ton, while they are $231 for JSW Steel and $196 for the Steel Authority of India Ltd., two other large Indian steel producers.
“The Tata-Corus deal is different because it links low-cost Indian production and raw materials and growth markets to high-margin markets and high technology in the West,” says Phanish Puranam, professor ofstrategic and international management at the London Business School, who is also associated with the school’s Aditya Birla India Centre. He adds that the cost advantage of operating from India can be leveraged in Western markets, and “differentiation based on better technology from Corus can work in the Asian markets.”
Corus could not have found a match like Tata Steel within Europe, says Fish. “Most steel companies match their production facilities to their finishing facilities,” he says. “So you don’t find [surplus] semi-finished capacity in Europe. Also, it’s just not available cheaply in Europe. And even if it were, the European producers would still be paying the prevailing market price for iron ore and coal.”
At first sight, the freight cost element seems daunting in shipping semi-finished slabs from Tata Steel’s Indian or South East Asian facilities to Corus in Europe. Muthuraman puts forth a different perspective: He says instead of importing ore, Corus would ship in semi-finished steel slabs, and explains that freight costs are lower for steel than for ore. Muthuraman reckons the freight cost for steel slabs at about $30 a ton from Mumbai to Chicago, hinting that it would cost less to Corus’s sites. Fish, too, doesn’t see freight costs as a big worry for the Tatas, and says it’s all along been a factor in steel pricing. Tiffany says it costs $100 a ton to ship steel from China to the U.S.
“Most steel consumption, except for recent times, has been in the industrialized countries. It’s only recently that China has become a major consumer,” says Fish. “Now, none of the main consuming countries has any raw material to make steel; virtually every company has had to get it from remote places. There’s iron ore sitting in Brazil, Australia, India and Russia. But Brazil, India and Russia consume a small portion of the global consumption.”
Penetrating the CXO Suite
Tata Steel, too, may have found it difficult to penetrate the lucrative construction, packaging and automobile markets in Europe without Corus’s help to open doors. Saikat Chaudhuri, Wharton professor of management, says opportunities are plenty for steel companies that meet quality standards, especially since many of them have faced “difficulties precisely in getting access to the CXO suite, which is dominated by the IBMs and the Accentures of the world; many others don’t have the pedigree.” If Tata steel meets the technical specifications of customers and at a slightly lower cost, it can break into that market more easily with Corus in tow.
Chaudhuri points out that most of the steel market is based on tenders, which is much easier to tap than consulting or advisory contracts. “Consulting contracts are a limited set, and relationships drive that business,” he says. “The steel business is controlled more by capacity and cost of production, reliability and supply chain management as opposed to branding, relationship management and other front-end work,” he says. “The Tatas have a reasonably good name; they definitely have pedigree, and they do have quality consciousness in whatever they produce.”
Another factor that will have implications for the global steel industry — including Tata and Corus — is the inevitable consolidation within China, according to Tiffany, who notes that China has some 800 steel mills, of which 133 are integrated producers. “There is bound to be consolidation in China,” he says. “The reason there are so many integrated firms in China is because the highway system is not yet large enough to allow a handful of firms to dominate. Every area now needs a steel mill.”
The upshot is that some Chinese steel giants are emerging. “Baosteel is the largest (capacity: 23 million tons a year), but it has only about 8% market share in its own country, and it’s the fifth largest steel firm in the world,” says Tiffany. “That’s unheard of, to be so small in your home market and still be that big on a global scale. Once China’s transportation system is in place, consolidation will occur, and Baosteel will probably end up being dominant.” He says by 2015, China is expected to overtake the U.S. in freeway mileage.
The emerging economies will increasingly dominate world steel demand, Tiffany adds, simply because the fundamental infrastructure is already in place in the developed world. “Once a nation really industrializes, you can’t replace that market,” he says. “In the U.S., for example, per capital demand for steel peaked in the 1950s. It has been going downhill ever since.”
Going forward, Chaudhuri is not too worried about the declining steel demand from the developed world. “Demand from developing countries, such as India, has just begun so I see other opportunities and other emerging markets,” he says. “The supply side is more of a concern, because of China. What is the quality of steel the Chinese are putting out — is it the same type of steel, the same quality [as that of Tata-Corus]? If it is lower-grade steel, the Tata bet would be the right one. They are trying to move up the value chain.”
Another major imponderable is the effect of China’s transition from being a net importer to net exporter of steel. “The main pressure on the Chinese government is to stop the massive investments in new capacity,” Chaudhuri says. “Clearly, even as demand continues to grow, they’ve got to avoid increasing capacity at a faster rate than demand. If they allow that, it is going to create a global problem; it would pose a serious danger to the steel industry.”
The Asian Club?
Cartelization in the global steel industry is another factor that will affect Tata-Corus, says Tiffany. “This is an industry that historically has had lots of collusion. The reason is the very high cost to build a steel mill. And steel is not fungible. Where you build it is where you are. If the market goes down, you have all these fixed costs, so this industry worldwide — starting in Germany in the 1880s — has long promoted the need for a cartelized industry to protect against the downside. So some residue of that is still there.” But Tiffany points out that the newly emerging global players from India, Russia and China have never been part of that inner circle. “The global club has been Western European and American,” he says. “Look at the opposition that the Mittal-Arcelor [merger] faced. The lack of opposition to the Tata-Corus deal is because Tata Steel is paying a good price.”
Newer entrants in the global market, such as Tata-Corus, will need to watch out as consolidation gathers speed. “If a handful of firms dominate global production, it’s easier to engage in cartel-like behavior in market downturns,” says Tiffany. “If you have a global oligopoly — much of the talk today is that you will end up with five or six firms that will dominate the world market — they can make sure that steel prices don’t go dramatically up and down. They will introduce equilibrium.”
But price drops have been less steep in recent cycles compared to earlier years, Fish observes. “We have been witnessing an almost-annual cycle of inventory building and depletion,” he says. “Historically steel mills could buy their way out of trouble; they would just keep reducing prices and continue to produce the same quantity of goods. But now, virtually the whole steel industry is privatized and not in the hands of governments that spend money on allowing their steel companies to keep producing.”
Fish says the “phasing is shortening, the amplitude is reducing” in steel industry cycles. “The mills are getting a little bit more alive to the fact that you have to regulate supply when oversupply becomes a problem,” he says. “And they have been very good at that over the last two cycles.”
Steel producers elsewhere in the world need to factor in other aspects, such as China subsidizing its steel mills, says Tiffany. “A lot of the steel firms are being supported by direct infusions of money in loans which will never be repaid,” he says. “If they didn’t do that, those companies would go out of business.”
At the firm level, Tiffany feels it’s unwise to read too much into the so-called synergies claimed by Tata Steel between Corus and its facilities in India and Southeast Asia. “There may be some increased efficiency, such as in administrative costs, since you don’t have to replicate overheads in a lot of places,” he says, but adds that those are not compelling.
Tiffany also doesn’t see much to be said in favor of R&D investments getting spread over larger revenues after consolidation. “This is an industry that has never spent that much on research and development. There have been two major changes in steel making technology in the last 125 years. In 1880, in Europe, you had the so-called Bessemer, or open hearth process, of making steel. Then in the late 1940s and 1950s, we had the basic oxygen furnace technology that came out of Western Europe as well.”
Chaudhuri says that while Tata-Corus’s advantage lies in low-cost raw materials, “the benefits will come mainly from being a one-stop shop for all kinds of steel, which could help the company get orders from customers across wider geographies.” It would be a case of overstating strengths, if the deal were justified simply on the basis of the sourcing of ore and cost synergies. “It would not make so much sense because then $8 billion is a lot of money to pay, especially when it is all cash,” he says. What he sees as a significant driver is that “they can improve economies of scale and scope and have greater distribution for Tata and Corus products in geographies where they are not present.”
Getting top and middle management teams to work cohesively is often a problem with many M&A deals. Tata Steel plans to induct senior executives from the two companies to sit on each other’s boards as also a core steel team, but otherwise leave the existing Corus management intact. Fears of job losses among Corus’s 43,000 employees have been put off for later, but Tata Steel is not making any assurances, besides contributing to its under-funded pension scheme.
“This merger will require a high level of integration,” says Puranam. “Corus will have to shut down some of its plants in the U.K., and the two parties will have to work together for technology transfer and coordinating supply chains. What works in favor of Tata-Corus is the friendly nature of the deal, and the strong Anglo-Indian link. I believe many Tata Steel managers were trained in the U.K.”
Other less obvious links also exist. In his biography of J. R. D. Tata in Vohuman.org, a publication of the Zoroastrian Educational Institute in Palo Alto, Calif., Meher D. Amalsad recalls that in 1912, the London School of Economics established the Ratan Tata Department (J. R. D. Tata’s father). The following year, that department sought applications for a lecturer’s job, for which two people applied. “One was a young man called Clement Atlee, who, after careful consideration, was selected for this position,” writes Amalsad. “About 32 years later, Atlee became the Prime Minister of Britain.” It was under Atlee’s government that India was granted independence in 1947.