Present tense, but future perfect

The global buys may strain Hindalco & Tata Steel's short-term outlook, but the big picture is positive.

There's an old market dictum about mergers: "Sell the predator and buy the prey." It's a good thumb-rule for traders. The initial reaction to a merger announcement is usually a jump in the price of the target coupled to a dip in the price of the buyer.

The Hindalco -Novelis and Corus-Tata Steel deals have both conformed to this. There are several parallels in that both deal feature large Indian metal players buying out even bigger international metal players.

Both deals are all cash rather than share-swap and both are being made at what seems like a peak in the respective metals commodity cycles.

The initial reaction to the first Tata Steel bid for Corus was positive. But the stock crashed once the deal came through, months later, at a price some 30 per cent higher than the original bid. In the days since the deal was announced, Tata Steel's share price is down by 14.8 per cent.

The reaction to the Hindalco announcement was even more sharply negative. The stock has tanked 12.7 per cent since the announcement. Again, this was an all-cash deal but there are other key differences in the merger profiles.

Corus seems marginally profitable; Novelis is cash-positive but running losses. Novelis with its rolled aluminium capacity is more of a downstream play for Hindalco than Corus is for Tata Steel.

Assuming efficiency gains, if aluminium prices fall, Novelis' margins improve and that could smoothen out cycle effects for Hindalco. Corus works best for Tata if steel prices stay as high as possible.

Both deals can be justified as long-term plays on two grounds alone. One is that it would cost more to set up equivalent replacement capacity. The second is that it widens and deepens the footprint of the buyer in an important market. In both cases, the market may legitimately worry if the buyer has paid too much.

It will impact short-term profitability and it could drown balance-sheets in debt. Both companies will arrange financing through special purpose vehicles but that only provides a certain cosmetic cut-off. Ultimately, a large debt has to be assumed in both cases, and it can only be worked off if the mergers result in genuine gains.

The time horizon is several years - far too long for any normal investor to have felt comfortable. The hard-nosed reaction would be, disinvest and wait for a year or two to see if things are working out. You will get a chance to buy at better valuations because the short-term price movements are unlikely to be positive.

At the least, the shares will under-perform the indices for a significant period. Tata Tea is a case in point. Although the Tetley and Energy Brands deals are dwarfed by Corus/ Novelis, the argument remains the same. "Tea" has not offered great returns though it hasn't done terribly badly.

There are a few other interesting points. An all-cash deal normally indicates a higher level of confidence than a share-swap offer. Mathematically an all-cash transfer means that the new owners reap all the benefits and incur all the risks.

In a share-swap, the risks and rewards are apportioned according to swap ratios and prevailing prices. In these two cases however, Tata Steel and Hindalco had little choice. A share-swap offer would have been legally tricky and unacceptable for various reasons.

The second point is the hard factor of metal cycles. Commodity buyouts tend to work best if they're done in a recession. Market valuations can easily swing 300 per cent during a full cycle.

Hindalco has mitigated that risk somewhat by going downstream but Corus works in any reasonable timeframe only under the assumption that the steel cycle will stay strong. If steel prices drop, this deal will be a significant drag on the finances of the entire Tata Group just as the AVB group will have problems managing if Novelis goes off-target.

A third point is currency risk. The deals put a collective $18 billion at stake. That, in itself, is large enough to influence rupee movement. If growth remains strong and the rupee stays stable, currency risk is less of an issue. But in the past 10 years, the rupee has dipped an average of 2.5-3 per cent per annum against a hard currency basket. Factor that in, and we're pushing the repayment envelope a little further.

Ultimately, I think that both groups have the skills, resources and balance-sheets to absorb the new buys. But it will take a long time to prove this and small shifts in the global economy could drive them close to breaking strain.