Steel industry heads for shake-out

Nearly three-fourths of the listed steel firms trading at a big discount to their enterprise value

The steel industry is ripe for a shake-out. Nearly three-fourths of the listed steel makers are trading at a big discount to their enterprise value and debt on their books, putting them in debt trap. Most stressed are medium and small size firms that expanded aggressively during pre-2008 boom funded through debt. For example, Chhattisgarh-based Monnet Ispat’s market capitalisation of Rs 480 crore is just 5 per cent of its total debt at the end of FY13.

Odisha-based Adhunik Metaliks’ market value is now down to Rs 364 crore against its total debt of around Rs 5,000 crore. It’s even worse for Varun Industries that came out with its initial public offer in 2007. At its current stock price, the company’s market capitalisation is now less than one percent of its total debt, making it financially insolvent. (See table)At operating level too, most of these companies are grappling to make two ends meet.

Poor steel demand and fall in realisations has led to a sharp decline in operating profits while interest payment continue to mount. In the first nine months of FY14, interest outgo ate-up near two-third of Adhunik Metaliks operating profit. The ratio is one-third in case of Monnet Ispat, while Electrosteel Steel reported operating losses against interest obligations of Rs 128 crore during April-December 2013 period. Mumbai-based Mukand operating profit fell short of interest payments.

At the end of FY13, 98 steel makers with market capitalization of Rs 100 crore and more were cumulatively sitting on total debt worth Rs 2.5 lakh crore against their combined market capitalization of Rs 1.3 lakh crore. Over three-fourth of the industry’s market cap is accounted for by top four steel makers – Tata Steel, JSW Steel, SAIL and Jindal Steel and Power. Their share in industry’s revenues and debt is however much lower at around 55 per cent and 66 per cent respectively.

Experts say the widening gap between market value and assets on ground (enterprise value) makes smaller companies ripe candidates for acquisitions by larger peers. Best acquisitions targets are those that either produce value added products or have access to raw materials. “A company which is into speciality products are good acquisition targets as it would enable acquirer to strengthen its forward integration,” said Vikram Dhawan, director-wealth management, Equentis Capital.

A case in point of JSW Steel’s recent acquisition of 50 per cent stake in Vallabh Tinplate that gave former an entry in tinplate segment. Similarly in 2010, JSW Steel acquired Ispat Industries making an entry into value added products such as galvanised steel, colour coated steel and cold rolled steel among others. In late 2012, Uttam Galva acquired majority stake in loss making Lloyd Steel for Rs 257 crore to emerge an integrated manufacturer of value added steel. Lloyd Steel since renamed to Uttam Value Steel makes HR coils using pig-iron sourced from Uttam Galva.Lenders are also encouraging take-over in the hope of recovering their money stuck-up in loss making firms. “The steel sector is under stress no doubt, especially the small and medium sized companies. Take-over by larger companies is one the many options that we are looking at while restructuring their stressed balance sheets,” said an official from Indian Overseas Bank.

However, it’s not an easy choice for the acquirer, given an oversupply in the domestic steel market. “If the company makes intermediate products then the acquirer will assess the upfront cost of acquisition against post-acquisition investment in turning around the operations and the additional debt that it added to their books,” said Abhisar Jain, analyst with Centrum Broking. Uttam Glava Steel for instance plans to invest Rs 380 crore in turning around Lloyd Steel operations.

Some of the small companies are profitable at operating level but are saddled with huge debt, while some others have valuable asset but is making losses at operational level. In such cases acquirers will have to look into financial restructuring of these companies or improve their operati onal performance to turn them around.

Experts say that companies like Usha Martin, Uttam Galva, Electrosteel Steel, Godawari Power and Visa Steel among others seem to be some of the ripe candidates for such acquisitions as they either have good assets or they are doing well at the operational level. “A lot depends on the business model of the small company. If the company has some raw material linkage then an acquistion makes sense as it will strengthen the back-end of the acquirer else it will just add capacity without any raw material to feed it,” said the official with Ernst & Young.

Despite the availability of suitable candidates for acquisition, shutdowns more than take-overs is the fate of smaller companies in near future, industry officials said. “There is already an overcapacity in steel at present plus investment is also stalled. In such a scenario acquistions may not happen,” said Revathi Kasture head-macro industry research of CARE Ratings.“All big companies are engaged in their own capex. There is no one to acquire these small companies,” said Jain of Centrum.