Time to prove mettle

Funding the Corus buyout is not going to be cheap for Tata Steel.

Tata Steel may have won the battle for Corus, but the hard work begins now. At 608 pence a share and an enterprise value of $700-710 per tonne, the deal is expensive.

In terms of EV/EBITDA, the multiple for CY2005 is seven times, while for the 12-month ended September 2006, it is nine times. This deal is more expensive in terms of EV/EBITDA going by recent deals in the steel industry.

In terms of EV/tonne too , Tata Steel's price is higher than what Arcelor commanded, at $586 a tonne. In the Mittal Steel-Arcelor deal, the EV/EBITDA was 6.2 times.

Also, in case of Mittal Steel-Arcelor, the deal involved a share swap along with cash. In this case, it is an all-cash deal. The deal involves a huge amount of borrowing on the Tata Steel balance sheet as also an equity dilution. So, it is no surprise to see the Tata Steel stock getting hammered by over 10 per cent on Wednesday.

On paper, the synergies appear great. If Tata Steel were to set up a greenfield plant, it would cost $1200-1300 per tonne. Along with cheaper per tonne assets, Tata Steel will also gain from Corus' brand equity, value-added product mix and deep customer relationships.

More importantly, Corus needs low-cost slabs, which Tata Steel can supply. When cost efficiencies come about in three years, the combine will save $350 million a year.

Funding this acquisition is not going to be cheap for Tata Steel. Of the $4.1 billion (Rs 18,000 crore) that it requires as equity contribution to the SPV, the company has $1 billion in place.

The next round of dilution could bring in further capital, which will be used to fund a part of this investment. Beyond that, Tata Steel has a low gearing of 0.26, so it can raise another Rs 8,000 crore, without the gearing going out of whack.

At the SPV, the debt burden of $8 billion will mean an interest outgo of $500 million (at around 6 per cent interest). Corus had an EBITDA of 1.68 billion for the 12-month ended September 2006, and as long as steel prices sustain, servicing the $8 billion debt should not be an issue. However, if steel prices fall even by 10 per cent, Corus will find it difficult to pay off the interest.

Meanwhile in the December 2006 quarter, Tata Steel was only able to partially leverage improved steel prices on a y-o-y basis, owing to a rising operational cost structure.

As a result, the company has grown its operating profit by 28.1 per cent y-o-y to Rs 1,783.6 crore in Q3 FY07, as compared to a 20.8 per cent growth in net sales to Rs 4,469 crore.

Its operating profit margin also improved 230 basis points y-o-y to 39.9 per cent in the last quarter. In contrast, SAIL had grown its operating profit margin by 810 basis points y-o-y to 28.5 per cent in Q3 FY07.

Tata Steel's net realisations improved by an estimated 8.4 per cent y-o-y to Rs 36,211 per tonne in the last quarter. However, the company had to also grapple with rising input costs such as other expenditure and staff cost in the last quarter.

In contrast, SAIL was able to leverage the 15.2 per cent y-o-y improvement in its net realisations to Rs 28,456 per tonne in the last quarter, thanks to better cost controls.

At its current price, the stock trades at 6.5 times estimated FY07 earnings and 6.8 times FY08 earnings, without considering the Corus impact.

With contributions Shobhana Subramanian and Amriteshwar Mathur