Recent Capital Allocation Decisions by an Indian Steel Major – An Analysis | Multi-Act

Steel’s Recent Capital Allocation Decisions - An Analysis

One of India’s largest steelmakers recently acquired the assets of a competitor, an insolvent domestic steelmaker under Insolvency & Bankruptcy Code proceedings (“IBC company”). The acquisition comes at a time when the steel company is restructuring its operations in Europe, which it acquired 10 years ago, supposedly at the peak of the business and valuation cycle. However, the company has suffered since 2007 due to this debt-funded venture in Europe and yet continues to use significant leverage, as its recent buyout indicates.

A Quick Look at the Company’s Financial Performance in Europe and Impairments Taken

  • European operations have barely earned positive EBITDA, even after ignoring all impairments and restructuring charges recorded during its history. As a result, its net worth is negative, and interest coverage is low.

Steel Analysis - Company Annual ReportsSource: Company Annual Reports

Steel Analysis - Company Annual Report-1Source: Company Annual Reports

  • Since the acquisition, the company has incurred a significant capital expenditure in its European operations, and charged almost an equal amount to impairment:
Particulars2008-2017
Total capex incurred (consolidated)1,107,925
Total capex incurred (standalone)542,515
Capex incurred in overseas entities565,410
Original Acquisition value of Europe unit (for reference)496,000
Overseas capex as % of total assets27.0%
Impairments incurred537,798

Source: Company Annual Reports
Capex for overseas entities relates primarily to Europe.
Impairments include identifiable impairments to Europe operations.

  • The company originally struggled to maintain a pension fund surplus in the European unit. This was resolved during the previous year by a deal with the UK government to take over the pension plan. The company paid GBP 500 million and a 33% stake in its UK subsidiary as a settlement.

Pension Scheme Newsletters; 2016 deficit considers the scenario if the scheme had been bought out on March 31, 2016Source: Pension Scheme Newsletters; 2016 deficit considers the scenario if the scheme had been bought out on March 31, 2016

European Operations are being Spun-off into a JV with German Steelmaker in Order to Deleverage

The company has now entered into definitive agreements with a German steelmaker to combine their European operations in a 50:50 JV. The JV structure would move the combined operations off the balance sheet of both these companies as they would be consolidated under the equity method. The company plans to transfer approximately GBP 2.2 billion of the existing debt to the JV, retaining the balance 4.8 billion, which may be restructured.

The JV is expected to be self-sustaining, requiring no more capital from the parent. In effect, this may isolate European operations into a separate entity.

 

The company is now turning its focus to its Indian operations, where profitability is better. It is acquiring and expanding steel capacity to benefit from rising steel prices. However, this would involve further use of debt:

  • Indian operations have an advantage due to captive raw materials and have thus earned the company good margins and returns over the long term.

RoNW OPM Asset T/O and Total LeverageSource: Company Annual Reports; 2017 and 2018 OPM has been adjusted to exclude the increase in depreciation charge post-revaluation of assets in Indian standalone books.

  • Acquisition of Insolvent Indian Steel Company

A few months ago, the company acquired an insolvent steelmaker in India, under the Insolvency and Bankruptcy Code proceedings, for approximately INR. 350,000 million for a 72.65% stake. The transaction, based on our replacement cost analysis, appears to have been conducted at fair value (not expensive, not distressed). The deal has been funded by 50% debt and 50% internal funds. The acquisition has added 5.6 MTPA of capacity to its Indian operations. Since the IBC company’s assets are located close to the captive raw material mines of our subject acquirer-company, the raw material from these mines would support low-cost operations of the newly acquired assets.

Comparatively, this acquisition is different from the company’s expansion during 2007. Due to the availability of captive raw material resources, the company’s Indian operation is managed by a low-cost steel producer and thus has a better chance of survival during a down cycle.

 

  • Expansion of Existing Steel Capacity by 5 mtpa

The company has also planned to expand its existing steel facility by 5 mtpa, increasing its own capacity from 3 MTPA to 8 MTPA. An estimated INR 235,000 million shall be spent on the expansion over the next 3-4 years.

 

Debt Levels and Years to Repay Debt Remain High Despite Acquisitions/Divestitures

Operating MetricPre-IBC Company AcquisitionPost-IBC Company Acquisition1
(pre-Europe JV)
Post-IBC Company Acquisition2

(post-Europe JV)

Total capacity (mtpa)25.030.631.25
Total Debt/Equity1.52.11.6
Interest coverage (2018 margins)3.92.673.5
Interest coverage (avg. margins)3.51.993.5
Years to repay debt negative FCFnegative FCF30+

1Including entire debt and operations for European operations, and accounting for Indian expansion capex
2Excluding GBP 2.2 bn. of debt, and operational results of European operations, but including Indian expansion capex
Assumptions: Based on realization per ton of 2017 considering prices are near long-term, inflation-adjusted rate, full capacity utilization in standalone entity, 78% utilization for Europe (LT average) and 75% utilization at plants of acquired Indian steelmaker (2010-17 average). Capacity includes a proportionate share of the proposed JV.

 

Conclusion

Effectively, the company is taking steps to divest/restructure its high-debt, low-profitability European operations, and acquire a potentially profitable business in India. However, despite the divestiture and the addition to Indian steel capacity, it could take a long time for the steel major to repay the remaining debt on its balance sheet.

Global steel prices, adjusted for inflation, are already above the mean, and near previous historical highs in nominal terms. (Refer Annexure #2 and #2 below). Since steel is a cyclical industry, a cyclical decline in steel prices could be adverse for the company’s profitability and balance sheet strength.

Note: The above discussion is to showcase the importance of capital allocation and using long-term indicators to understand cyclicality. It should not be construed as investment advice.

 

Annexure: Historical Steel Prices

Annex 1 – International HRC prices:
Suggests limited upside potential in USD terms

International HRC pricesSource: Factset, US Geological Survey Data

Annex 2 – Most regional prices have begun correcting after reaching historical highs in nominal terms:

Most regional prices have begun correcting after reaching historical highs in nominal termsSource: Steel Benchmarker HRB Prices

 

Annex 3 Shorter history, but to the contrary, does show potential upside in INR terms:

Inflation adj Indian Steel Prices (Rs/tonne)Source: CMIE Industry Outlook Data

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