Even though mergers and acquisitions (M&A) have been an important element of corporate strategy all over the globe for several decades, research on M&As has not been able to provide conclusive evidence on whether they enhance efficiency or destroy wealth. There is thus an ongoing global debate on the effects of M&As on firms. Mergers and acquisitions have become common in India today. However, very little appears to be known about the long-term post-merger performance of firms in India, and the strategic factors that affect this performance. Our study attempts to fill this gap in knowledge about M&As in India. We have carried out statistical analyses of financial data pertaining to 87 pairs of merged firms. These mergers took place in the period 1996 to 2002. Out of these 87 mergers, 64 are between firms belonging to related industries and 23 to unrelated industries. Stock is the predominant method of payment for the acquired firm (in 76 out of 87 mergers), and transfer of corporate control has taken place in 37 of the 87 mergers. Fourteen of the acquired companies were sick and had been referred to the Board for Industrial and Financial Reconstruction (BIFR) at the time of their merger.
“MERGER AND ACQUISITION WITH REFERNCE TO STEEL INDUSTRY” ABSTRACT Even though mergers and acquisitions (M&A) have been an important element of corporate strategy all over the globe for several decades, research on M&As has not been able to provide conclusive evidence on whether they enhance efficiency or destroy wealth. There is thus an ongoing global debate on the effects of M&As on firms. Mergers and acquisitions have become common in India today. However, very little appears to be known about the long-term post-merger performance of firms in India, and the strategic factors that affect this performance. Our study attempts to fill this gap in knowledge about M&As in India. We have carried out statistical analyses of financial data pertaining to 87 pairs of merged firms. These mergers took place in the period 1996 to 2002. Out of these 87 mergers, 64 are between firms belonging to related industries and 23 to unrelated industries. Stock is the predominant method of payment for the acquired firm (in 76 out of 87 mergers), and transfer of corporate control has taken place in 37 of the 87 mergers. Fourteen of the acquired companies were sick and had been referred to the Board for Industrial and Financial Reconstruction (BIFR) at the time of their merger. The performance of mergers has been gauged in two ways in this study – by determining whether the long-term post-merger financial performance has changed significantly, and by assessing the wealth gains to shareholders of the acquiring, acquired and the combined firms on the announcement of mergers. It is found that the merged firms demonstrate improvement in long-term financial performance after controlling for pre- merger performance, with increasing cash flow returns post merger, at an annual rate of 4.3%. This improved operating cash flow return is on account of improvements in the post- merger operating margins of the firms, though not of the efficient utilization of the assets to generate higher sales. Increase in market power also appears to be driving gains through mergers in India. As far as wealth gains on merger announcement are concerned, only the shareholders of the acquired firms appear to be enjoying significant positive share price returns of 11.6%. The shareholders of the acquiring firms and the combined firms do not seem to be witnessing any significant change in returns. With regard to the strategic factors affecting long-term post-merger financial performance, related mergers seem to be performing 5.4% lower than unrelated mergers. Both the transfer of corporate control from the acquired firm to the acquiring firm, and the business health of the acquired firm are positively related to the long-term post-merger performance of the firms. The relative size of the acquired firm and the method of payment for the acquired firm do not appear to be playing a role in affecting post-merger performance. In the case of the effect of the strategic factors on the wealth gains on merger announcement, we find that the mergers in which there is no transfer of corporate control seem to be conferring significant positive share price returns of 21.1% on the shareholders of the acquired firms. This is not the case for the shareholders of the acquiring firms and the combined firms. In the case of mergers where there is a transfer of management control, none of these three groups of shareholders witnesses any abnormal returns on announcement of the merger. The wealth gains to acquired firm shareholders on announcement of a merger are positively influenced by the relative size and the pre-merger performance of the acquired firm. The transfer of corporate control from the acquired firm to the acquiring firm is negatively associated with these abnormal share price returns. The level of industry-relatedness of the acquired and the acquiring firms, the method of payment for the acquired firm and the business health of the acquired firm do not appear to be playing a role in affecting the share price returns to the acquired firm shareholders, on announcement of a merger. 2 CONTENTS CHAPTER I: INTRODUCTION............................................................................. Background ……………………………………………………………... Objective of the study………………………………………………………… CHAPTER II: LITERATURE REVIEW………………………………………… a) Global steel industry……………………………………………………….. b) Tata Vs Corus…………………………………………………………….. c) Arcellor Vs Mittal……………………………………………………… CHAPTER III: RESEARCH METHODOLGY…………………………………. CHAPTER IV: DESCRIPTIVE WORK................................................................ a) Valuation of merger and acquisition ……………………………………. b) Tata Vs Corus – Visionary deal or Costly blunder …………………… c) Arcellor-Mittal Vs Tata-Corus ….………………………………….. d) Competition analysis of steel industry…………………………………… e) SWOT Analysis…………………………………………………………. f) Expected growth………………………………………………………….. g) Factors holding back Indian steel industry…………………………………. h) Recent financial crisis & Indian steel industry……………………………. i) Five-Force analysis of steel industry CHAPTER V: CONCLUSIONS AND RECOMMENDATIONS………………. REFERENCES 3 LIST OF TABLES AND FIGURES LIST OF FIGURES Page no. Figure 1…………….World steel production………………………………………….25 Figure 2…………… Global steel capacity……………………………………………26 Figure 3…………… Indian steel capacity…………………………………………….28 Figure 4…………… Indian steel production………………………………………….29 Figure 5……………. Indian steel consumption………………………………………30 Figure 6…………… Motives…………………………………………………………44 Figure 7…………… Procedure of valuation……………………………………….. .46 Figure 8…………… Financing Merger………………………………………………47 Figure 9……………..Key sector growth………………………………………………64 List of Tables Table 1………………Steel production share……….…………………………………27 Table 2………………Steel consumption share………………………………………..27 Table 3………………Tata steel capacity……………………………………………...32 Table 4………………Global steel output……………………………………………..51 Table 5………………Global steel ranking……………………………………………53 Table 6……………….Tata-Corus Present capacity…………………………………..54 Table 7……………….Tata-Corus projected capacity………………………………...54 Table 8……………….Corus Financials………………………………………………56 4 CHAPTER 1: INTRODUCTION 5 Background Mergers and acquisitions (M&A) and corporate restructuring are a big part of the corporate finance world. Every day, investment bankers arrange M&A transactions, which bring separate companies together to form larger ones. When they're not creating big companies from smaller ones, corporate finance deals do the reverse and break up companies through spin-offs, carve-outs or tracking stocks. Not surprisingly, these actions often make the news. Deals can be worth hundreds of millions, or even billions, of dollars or rupees. They can dictate the fortunes of the companies involved for years to come. For a CEO, leading an M&A can represent the highlight of a whole career. And it is no wonder we hear about so many of these transactions; they happen all the time. Next time you flip open the newspaper’s business section, odds are good that at least one headline will announce some kind of M&A transaction. Sure, M&A deals grab headlines, but what does this all mean to investors? To answer this question, this report discusses the forces that drive companies to buy or merge with others, or to split-off or sell parts of their own businesses. Once you know the different ways in which these deals are executed, you'll have a better idea of whether you should cheer or weep when a company you own buys another company - or is bought by one. You will also be aware of the tax consequences for companies and for investors Defining M&A The Main Idea one plus one makes three: this equation is the special alchemy of a merger or an acquisition. The key principle behind buying a company is to create shareholder value over and above that of the sum of the two companies. Two companies together are more valuable than two separate companies - at least, that's the reasoning behind M&A. This rationale is particularly alluring to companies when times are tough. Strong companies will act to buy other companies to create a more competitive, cost-efficient company. The companies will come together hoping to gain a greater market share or to achieve greater efficiency. Because of these potential benefits, target companies will often agree to be purchased when they know they cannot survive alone. 6 Distinction between Mergers and Acquisitions Although they are often uttered in the same breath and used as though they were synonymous, the terms merger and acquisition mean slightly different things. When one company takes over another and clearly established itself as the new owner, the purchase is called an acquisition. From a legal point of view, the target company ceases to exist, the buyer "swallows" the business and the buyer's stock continues to be traded. In the pure sense of the term, a merger happens when two firms, often of about the same size, agree to go forward as a single new company rather than remain separately owned and operated. This kind of action is more precisely referred to as a "merger of equals." Both companies' stocks are surrendered and new company stock is issued in its place. For example, both Daimler-Benz and Chrysler or Arcellor and Mittal ceased to exist when the two firms merged, and a new company, DaimlerChrysler and Arcellor-Mittal, was created. In practice, however, actual mergers of equals don't happen very often. Usually, one company will buy another and, as part of the deal's terms, simply allow the acquired firm to proclaim that the action is a merger of equals, even if it's technically an acquisition. Being bought out often carries negative connotations, therefore, by describing the deal as a merger, deal makers and top managers try to make the takeover more palatable. A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly - that is, when the target company does not want to be purchased - it is always regarded as an acquisition. Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees and shareholders. Synergy 7 Synergy is the magic force that allows for enhanced cost efficiencies of the new business. Synergy takes the form of revenue enhancement and cost savings. By merging, the companies hope to benefit from the following: Staff reductions - As every employee knows, mergers tend to mean job losses. Consider all the money saved from reducing the number of staff members from accounting, marketing and other departments. Job cuts will also include the former CEO, who typically leaves with a compensation package. Economies of scale - Yes, size matters. Whether it's purchasing stationery or a new corporate IT system, a bigger company placing the orders can save more on costs. Mergers also translate into improved purchasing power to buy equipment or office supplies - when placing larger orders, companies have a greater ability to negotiate prices with their suppliers. Acquiring new technology - To stay competitive, companies need to stay on top of technological developments and their business applications. By buying a smaller company with unique technologies, a large company can maintain or develop a competitive edge. Improved market reach and industry visibility - Companies buy companies to reach new markets and grow revenues and earnings. A merge may expand two companies' marketing and distribution, giving them new sales opportunities. A merger can also improve a company's standing in the investment community: bigger firms often have an easier time raising capital than smaller ones. That said, achieving synergy is easier said than done - it is not automatically realized once two companies merge. Sure, there ought to be economies of scale when two businesses are combined, but sometimes a merger does just the opposite. In many cases, one and one add up to less than two. Sadly, synergy opportunities may exist only in the minds of the corporate leaders and the deal makers. Where there is no value to be created, the CEO and investment bankers - who have much to gain from a successful M&A deal - will try to create an image of enhanced value. The market, however, eventually sees through this and penalizes the company by assigning it a discounted share price. We'll talk more about why M&A may fail in a later section of this tutorial. 8 Varieties of Mergers From the perspective of business structures, there is a whole host of different mergers. Here are a few types, distinguished by the relationship between the two companies that are merging: Horizontal merger - Two companies that are in direct competition and share the same product lines and markets. Vertical merger - A customer and company or a supplier and company. Think of a cone supplier merging with an ice cream maker. Market-extension merger - Two companies that sell the same products in different markets. Product-extension merger - Two companies selling different but related products in the same market. Conglomeration - Two companies that have no common business areas. There are two types of mergers that are distinguished by how the merger is financed. Each has certain implications for the companies involved and for investors: Purchase Mergers - As the name suggests, this kind of merger occurs when one company purchases another. The purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable. Acquiring companies often prefer this type of merger because it can provide them with a tax benefit. Acquired assets can be written-up to the actual purchase price, and the difference between the book value and the purchase price of the assets can depreciate annually, reducing taxes payable by the acquiring company. We will discuss this further in part four of this tutorial. Consolidation Mergers - With this merger, a brand new company is formed and both companies are bought and combined under the new entity. The tax terms are the same as those of a purchase merger. 9 Acquisitions An acquisition may be only slightly different from a merger. In fact, it may be different in name only. Like mergers, acquisitions are actions through which companies seek economies of scale, efficiencies and enhanced market visibility. Unlike all mergers, all acquisitions involve one firm purchasing another - there is no exchange of stock or consolidation as a new company. Acquisitions are often congenial, and all parties feel satisfied with the deal. Other times, acquisitions are more hostile. In an acquisition, as in some of the merger deals we discuss above, a company can buy another company with cash, stock or a combination of the two. Another possibility, which is common in smaller deals, is for one company to acquire all the assets of another company. Company X buys all of Company Y's assets for cash, which means that Company Y will have only cash (and debt, if they had debt before). Of course, Company Y becomes merely a shell and will eventually liquidate or enter another area of business. Another type of acquisition is a reverse merger, a deal that enables a private company to get publicly-listed in a relatively short time period. A reverse merger occurs when a private company that has strong prospects and is eager to raise financing buys a publicly-listed shell company, usually one with no business and limited assets. The private company reverse merges into the public company, and together they become an entirely new public corporation with tradable shares. Regardless of their category or structure, all mergers and acquisitions have one common goal: they are all meant to create synergy that makes the value of the combined companies greater than the sum of the two parts. The success of a merger or acquisition depends on whether this synergy is achieved. Valuation Matters 10 Investors in a company that is aiming to take over another one must determine whether the purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth. Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can. There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them: 1. Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers: Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be. Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to- sales ratio of other companies in the industry. 2. Replacement Cost In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop. 3. Discounted Cash Flow (DCF) A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation + amortization of goodwill – 11 capital expenditures – cash taxes - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method. Synergy: The Premium for Potential Success For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy. Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy: In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which discussed often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short. What to Look For - It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria given as below. A reasonable purchase price - A premium of, say, 10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires 12 synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests. Cash transactions - Companies that pay in cash tend to be more careful when calculating bids and valuations come closer to target. When stock is used as the currency for acquisition, discipline can go by the wayside. Sensible appetite – An acquiring company should be targeting a company that is smaller and in businesses that the acquiring company knows intimately. Synergy is hard to create from companies in disparate business areas. Sadly, companies have a bad habit of biting off more than they can chew in mergers. Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality. Doing the Deal Start with an Offer When the CEO and top managers of a company decide that they want to do a merger or acquisition, they start with a tender offer. The process typically begins with the acquiring company carefully and discreetly buying up shares in the target company, or building a position. Once the acquiring company starts to purchase shares in the open market, it is restricted to buying 5% of the total outstanding shares before it must file with the SEC. In the filing, the company must formally declare how many shares it owns and whether it intends to buy the company or keep the shares purely as an investment. Working with financial advisors and investment bankers, the acquiring company will arrive at an overall price that it's willing to pay for its target in cash, shares or both. The tender offer is then frequently advertised in the business press, stating the offer price and the deadline by which the shareholders in the target company must accept (or reject) it. The Target's Response Once the tender offer has been made, the target company can do one of several things: Accept the Terms of the Offer - If the target firm's top managers and shareholders are happy with the terms of the transaction, they will go ahead with the deal. 13 Attempt to Negotiate - The tender offer price may not be high enough for the target company's shareholders to accept, or the specific terms of the deal may not be attractive. In a merger, there may be much at stake for the management of the target - their jobs, in particular. If they're not satisfied with the terms laid out in the tender offer, the target's management may try to work out more agreeable terms that let them keep their jobs or, even better, send them off with a nice, big compensation package. Not surprisingly, highly sought-after target companies that are the object of several bidders will have greater latitude for negotiation. Furthermore, managers have more negotiating power if they can show that they are crucial to the merger's future success. Execute a Poison Pill or Some Other Hostile Takeover Defense – A poison pill scheme can be triggered by a target company when a hostile suitor acquires a predetermined percentage of company stock. To execute its defense, the target company grants all shareholders - except the acquiring company - options to buy additional stock at a dramatic discount. This dilutes the acquiring company's share and intercepts its control of the company. Find a White Knight - As an alternative, the target company's management may seek out a friendlier potential acquiring company, or white knight. If a white knight is found, it will offer an equal or higher price for the shares than the hostile bidder. Mergers and acquisitions can face scrutiny from regulatory bodies. For example, if the two biggest long-distance companies in the U.S., AT&T and Sprint, wanted to merge, the deal would require approval from the Federal Communications Commission (FCC). The FCC would probably regard a merger of the two giants as the creation of a monopoly or, at the very least, a threat to competition in the industry. Closing the Deal Finally, once the target company agrees to the tender offer and regulatory requirements are met, the merger deal will be executed by means of some transaction. In a merger in which one company buys another, the acquiring company will pay for the target company's shares with cash, stock or both. A cash-for-stock transaction is fairly straightforward: target company shareholders receive a cash payment for each share 14 purchased. This transaction is treated as a taxable sale of the shares of the target company. If the transaction is made with stock instead of cash, then it's not taxable. There is simply an exchange of share certificates. The desire to steer clear of the tax man explains why so many M&A deals are carried out as stock-for-stock transactions. When a company is purchased with stock, new shares from the acquiring company's stock are issued directly to the target company's shareholders, or the new shares are sent to a broker who manages them for target company shareholders. The shareholders of the target company are only taxed when they sell their new shares. When the deal is closed, investors usually receive a new stock in their portfolios - the acquiring company's expanded stock. Sometimes investors will get new stock identifying a new corporate entity that is created by the M&A deal. Break Ups As mergers capture the imagination of many investors and companies, the idea of getting smaller might seem counterintuitive. But corporate break-ups, or de-mergers, can be very attractive options for companies and their shareholders. Advantages The rationale behind a spin-off, tracking stock or carve-out is that "the parts are greater than the whole." These corporate restructuring techniques, which involve the separation of a business unit or subsidiary from the parent, can help a company raise additional equity funds. A break-up can also boost a company's valuation by providing powerful incentives to the people who work in the, making it more difficult to attract interest from institutional investors. Meanwhile, there are the extra costs that the parts of the business face if separated. When a firm divides itself into smaller units, it may be losing the separating unit, and help the parent's management to focus on core operations. Most importantly, shareholders get better information about the business unit because it issues separate financial statements. This is particularly useful when a company's traditional line of business differs from the separated business unit. With separate financial disclosure, investors are better equipped to gauge the value of the parent corporation. The parent company might attract more investors and, ultimately, more capital. Also, separating a subsidiary from its parent can reduce internal competition for corporate funds. For investors, that's great news: it curbs the kind of negative internal wrangling that can 15 compromise the unity and productivity of a company. For employees of the new separate entity, there is a publicly traded stock to motivate and reward them. Stock options in the parent often provide little incentive to subsidiary managers, especially because their efforts are buried in the firm's overall performance. Disadvantages That said, de-merged firms are likely to be substantially smaller than their parents, possibly making it harder to tap credit markets and costlier finance that may be affordable only for larger companies. And the smaller size of the firm may mean it has less representation on major indexes synergy that it had as a larger entity. For instance, the division of expenses such as marketing, administration and research and development (R&D) into different business units may cause redundant costs without increasing overall revenues. Restructuring Methods There are several restructuring methods: doing an outright sell-off, doing an equity carve-out, spinning off a unit to existing shareholders or issuing tracking stock. Each has advantages and disadvantages for companies and investors. All of these deals are quite complex. Sell-Offs A sell-off, also known as a divestiture, is the outright sale of a company subsidiary. Normally, sell-offs are done because the subsidiary doesn't fit into the parent company's core strategy. The market may be undervaluing the combined businesses due to a lack of synergy between the parent and subsidiary. As a result, management and the board decide that the subsidiary is better off under different ownership. (IPO) of shares, amounting to a partial sell-off. A new publicly-listed company is created, but the parent keeps a controlling stake in the newly traded subsidiary. A carve-out is a strategic avenue a parent firm may take when one of its subsidiaries is growing faster and carrying higher valuations than other businesses owned by the parent. A carve-out generates cash because shares in the subsidiary are sold to the public, but the issue also unlocks the value of the subsidiary unit and enhances the parent's shareholder value. The new legal entity of a carve-out has a separate board, but in most carve-outs, the parent retains some control. In 16 these cases, some portion of the parent firm's board of directors may be shared. Since the parent has a controlling stake, meaning both firms have common shareholders, the connection between the two will likely be strong. That said, sometimes companies carve- out a subsidiary not because it's doing well, but because it is a burden. Such an intention won't lead to a successful result, especially if a carved-out subsidiary is too loaded with debt, or had trouble even when it was a part of the parent and is lacking an established track record for growing revenues and profits. Carve-outs can also create unexpected friction between the parent and subsidiary. Problems can arise as managers of the carved-out company must be accountable to their public shareholders as well as the owners of the parent company. This can create divided loyalties. Spin-offs A spin-off occurs when a subsidiary becomes an independent entity. The parent firm distributes shares of the subsidiary to its shareholders through a . Since this transaction is a dividend distribution, no cash is generated. Thus, spin-offs are unlikely to be used when a firm needs to finance growth or deals. Like the carve-out, the subsidiary becomes a separate legal entity with a distinct management and board. Besides getting rid of an unwanted subsidiary, sell-offs also raise cash, which can be used to pay off debt. In the late 1980s and early 1990s, corporate would use debt to finance acquisitions. Then, after making a purchase they would sell-off its subsidiaries to raise cash to service the debt. The raiders' method certainly makes sense if the sum of the parts is greater than the whole. When it isn't, deals are unsuccessful. Equity Carve-Outs More and more companies are using equity carve-outs to boost shareholder value. A parent firm makes a subsidiary public through a raider’s initial public offering stock dividend meaning they don't grant shareholders the same voting rights as those of the main stock. Each share of tracking stock may have only a half or a quarter of a vote. In rare cases, holders of tracking stock have no vote at all. Like carve-outs, spin-offs are usually about separating a healthy operation. In most cases, spin-offs unlock hidden shareholder value. For the parent company, it sharpens management focus. For the spin-off company, management doesn't have to compete for the parent's attention and capital. Once they are set free, managers can explore new opportunities. Investors, however, should beware of 17 throw-away subsidiaries the parent created to separate legal liability or to off-load debt. Once spin-off shares are issued to parent company shareholders, some shareholders may be tempted to quickly dump these shares on the market, depressing the share valuation. Tracking Stock A tracking stock is a special type of stock issued by a publicly held company to track the value of one segment of that company. The stock allows the different segments of the company to be valued differently by investors. Let's say a slow-growth company trading at a low (P/E ratio) happens to have a fast growing business unit. The company might issue a tracking stock so the market can value the new business separately from the old one and at a significantly higher P/E rating. Why would a firm issue a tracking stock rather than spinning-off or carving-out its fast growth business for shareholders? The company retains control over the subsidiary; the two businesses can continue to enjoy synergies and share marketing, administrative support functions, a headquarters and so on. Finally, and most importantly, if the tracking stock climbs in value, the parent company can use the tracking stock it owns to make acquisitions. Still, shareholders need to remember that tracking stocks are price-earnings ratio class B Why They Can Fail It's no secret that plenty of mergers don't work. Those who advocate mergers will argue that the merger will cut costs or boost revenues by more than enough to justify the price premium. It can sound so simple: just combine computer systems, merge a few departments, use sheer size to force down the price of supplies and the merged giant should be more profitable than its parts. In theory, 1+1 = 3 sounds great, but in practice, things can go awry. Historical trends show that roughly two thirds of big mergers will disappoint on their own terms, which means they will lose value on the stock market. The motivations that drive mergers can be flawed and efficiencies from economies of scale may prove elusive. In many cases, the problems associated with trying to make merged companies work are all too concrete. Flawed Intentions 18 For starters, a booming stock market encourages mergers, which can spell trouble. Deals done with highly rated stock as currency are easy and cheap, but the strategic thinking behind them may be easy and cheap too. Also, mergers are often attempt to imitate: somebody else has done a big merger, which prompts other top executives to follow suit. A merger may often have more to do with glory-seeking than business strategy. The executive ego, which is boosted by buying the competition, is a major force in M&A, especially when combined with the influences from the bankers, lawyers and other assorted advisers who can earn big fees from clients engaged in mergers. Most CEOs get to where they are because they want to be the biggest and the best, and many top executives get a big bonus for merger deals, no matter what happens to the share price later. On the other side of the coin, mergers can be driven by generalized fear. Globalization, the arrival of new technological developments or a fast-changing economic landscape that makes the outlook uncertain are all factors that can create a strong incentive for defensive mergers. Sometimes the management team feels they have no choice and must acquire a rival before being acquired. The idea is that only big players will survive a more competitive world. The Obstacles to making it Work Coping with a merger can make top managers spread their time too thinly and neglect their core business, spelling doom. Too often, potential difficulties seem trivial to managers caught up in the thrill of the big deal. The chances for success are further hampered if the corporate cultures of the companies are very different. When a company is acquired, the decision is typically based on product or market synergies, but cultural differences are often ignored. It's a mistake to assume that personnel issues are easily overcome. For example, employees at a target company might be accustomed to easy access to top management, flexible work schedules or even a relaxed dress code. These aspects of a working environment may not seem significant, but if new management removes them, the result can be resentment and shrinking productivity. More insight into the failure of mergers is found in the highly acclaimed study from McKinsey, a global consultancy. The study concludes that companies often focus too intently on cutting costs following mergers, while revenues, and ultimately, profits, suffer. Merging companies can focus on integration and cost-cutting so much that they neglect day-to-day business, thereby prompting nervous customers to flee. This loss of revenue momentum is one 19 reason so many mergers fail to create value for shareholders. But remember, not all mergers fail. Size and global reach can be advantageous, and strong managers can often squeeze greater efficiency out of badly run rivals. Nevertheless, the promises made by deal makers demand the careful scrutiny of investors. The success of mergers depends on how realistic the deal makers are and how well they can integrate two companies while maintaining day-to-day operations. 20 Objective of the Study Gain an in-depth knowledge about various corporate valuation techniques. Critically examine the rationale behind the acquisition of Corus by Tata Steel. Understand the advantages and disadvantages of cross-border acquisitions. Understand the need for growth through acquisitions in foreign countries. Study the regulations governing mergers & acquisitions in the case of a cross-border acquisition. Get insights into the consolidation trends in the Indian and global steel industries. 21 Literature Review – The steel industry THE GLOBAL STEEL INDUSTRY The current global steel industry is in its best position in comparing to last decades. The price has been rising continuously. The demand expectations for steel products are rapidly growing for coming years. The shares of steel industries are also in a high pace. The steel industry is enjoying its 6th consecutive years of growth in supply and demand. And there is many more merger and acquisitions which overall buoyed the industry and showed some good results. The subprime crisis has lead to the recession in economy of different Countries, which may lead to have a negative effect on whole steel industry in coming years. However steel production and consumption will be supported by continuous economic growth. CONTRIBUTION OF COUNTRIES TO GLOBAL STEEL INDUSTRY Fig-1 22 The countries like China, Japan, India and South Korea are in the top of the above in steel production in Asian countries. China accounts for one third of total production i.e. 419m ton, Japan accounts for 9% i.e. 118m ton, India accounts for 53m ton and South Korea is accounted for 49m ton, which all totally becomes more than 50% of global production. Apart from this USA, BRAZIL, UK accounts for the major chunk of the whole growth. The steel industry has been witnessing robust growth in both domestic as well as international markets. In this article, let us have a look at how has the steel industry performed globally in 2007. Capacity: The global crude steel production capacity has grown by around 7% to 1.6 bn in 2007 from 1.5 bn tonnes in 2006. The capacity has shown a growth rate of 7% CAGR since 2003. The additions to capacity over last few years have ranged from 36 m tonnes in 2004 to 108 m tonnes in 2007. Asian region accounts for more than 60% of the total production capacity of world, backed mainly by capacity in China, Japan, India, Russia and South Korea. These nations are among the top steel producers in the world. Fig-2 23 Production: The global steel production stood at 1.3 bn tonnes in 2007, showing an increase of 7.5% as compared to 2006 levels. The global steel production showed a growth of 8% CAGR between 2003 and 2007. China accounts for around 36% of world crude steel production followed by Japan (9%), US (7%), Russia (5%) and India (4%). In 2007, all the top five steel producing countries have showed an increase in production except US, which showed a decline. Rank Country Production (mn tonnes) World share (%) 1 China 489 36.0% 2 Japan 120 9.0% 3 US 98 7.0% 4 Russia 72 5.0% 5 India 53 4.0% 6 South Korea 51 3.5% Source: JSW Steel AR FY08 Table-1 Consumption: The global steel consumption grew by 6.6% to 1.2 bn tonnes as compared to 2006 levels. The global finished steel consumption showed a growth of 8% CAGR, in line with the production, between the period 2003 and 2007. The finished steel consumption in China and India grew by 13% and 11% respectively in 2007. The BRIC countries were the major demand drivers for steel consumption, accounting for nearly 80% of incremental steel consumption in 2007. Rank Country Consumption (mn tonnes) World share (%) 1 China 408 36.0% 2 US 108 9.0% 3 Japan 80 6.7% 4 South Korea 55 4.6% 5 India 51 4.2% 24 6 Russia 40 3.3% Source: JSW Steel AR FY08 Table-2 Outlook: As per IISI estimates, the finished steel consumption in world is expected to reach a level of 1.75 bn tonnes by 2016, growth of 4% CAGR over the consumption level of 2007. The steel consumption in 2008 and 2009 is estimated to grow above 6% Indian Steel Industry India, which has emerged among the top five steel producing and consuming countries over the last few years, backed by strong growth in its economy. Capacity: Steel capacity increased by 6% to 60 m tonnes in FY08. It registered a robust growth of 8% CAGR between the period FY04 and FY08. The capacity expansion in the country was primarily through brown field expansions as it requires lower investments than a greenfield expansion. Fig-3 Production: Steel production has registered a growth of 6% to reach a level of 54 m tonnes in FY8. The production has grown nearly in line with the capacity expansion and registered a growth of 7% CAGR with an average capacity utilization of 92% between the period 25 FY04 and FY08. India is currently the fifth largest producer of steel in the world, contributing almost 4% of the total steel production in world. The top three steel producing companies (SAIL, Tata Steel and JSW Steel) contributed around 45% of the total steel production in FY08. Fig-4 Consumption: Steel consumption has increased by 10% to 51.5 m tonnes in FY08. Consumption growth has been exceeding production growth since past few years. It grew at a CAGR of 12% between FY04 and FY08. Construction & infrastructure, manufacturing and automobile sectors accounted for 59%, 13% and 11% for the total consumption of steel respectively in FY08. Although steel consumption is rapidly growing in the country, the per capita steel consumption still stands at 48 kgs. Moreover, in the rural areas in the country, it stands at a mere 2 kg. It should be noted that the world’s average per capita steel consumption was 189 kg and while that of China was 309 kg in 2007. 26 Fig-5 Trade equations: India became net importer of steel in FY08 with estimated net imports of 1.9 m tonnes. In the past few years, its exports have remained at more or less the same levels while on the other hand, imports have increased on the back of robust demand and capacity constraints in the domestic markets. The imports showed a growth of around 48% while exports declined by around 6% in FY08. Outlook: As per IISI estimates, the demand for steel in India are expected to grow at a rate of 9% and 12% in 2008 and 2009. The medium term outlook for steel consumption remains extremely bullish and is estimated at an average of above 10% in the next few years. Tata Vs Corus Corus The Corus was created by the merger of British Steel and Dutch steel company, Hoogovens. Corus was Europe’s second largest steel producer with a production of 18.2 million tonnes and revenue of GDP 9.2 billion (in 2005). The product mix consisted of Strip steel products, Long products, Distribution and building system and Aluminum. With the merger of British Steel and Hoogovens there were two assets the British plant asset which was older and less productive and the Dutch plant asset which was regarded as the crown jewel by every one in the industry. They have union issues and are burdened with more than $ 13 billion of pension liabilities. The Corus was making only a profit of $ 1.9 27 billion from its 18.2 million tonnes production per year (compared to $ 1.5 billion form 8.7 million tone capacity by Tata). The Corus was having leading market position in construction and packaging in Europe with leading R&D. The Corus was the 9th largest steel producer in the world. It opened its bid for 100 % stake late in the 2006. Tata (India) & CSN (Companhia Siderurgica Nacional) emerged as most powerful bidders. CSN (Companhia Siderurgica Nacional) CSN (Companhia Siderurgica Nacional) was incorporated in the year 1941. The company initially focused on the production of coke, pig iron castings and long products. The company was having three main expansions at the Presidente Vargas Steel works during the 1970’s and 1980’s. The first completed in the year 1974, increased installed capacity to 1.6 million tons of crude steel. The second completed in 1977, raised capacity to 2.4 million tons of crude steel. The third completed in the year 1989, increased capacity to 4.5 million tons of crude steel. The company was privatized by the Brazilian government by selling 91 % of its share. The Mission of CNS is to increase value for the shareholders. Maintain position as one of the world’s lowest-cost steel producer. Maintain a high EBITDA and strengthen position as a global player. CNS is having fully integrated manufacturing facilities. The crude steel capacity was 5.6 million tons. The product mix consisted of Slabs, Hot and Cold rolled Galvanized and Tin mill products. In 2004 CSN sold steel products to customers in Brazil and 61 other countries. In 2002, 65 % of the steel sales were in domestic market and operating revenues were 70 %. In 2003, the same figures were 59 % and 61 % and in 2004 the same figures were 71% and 73 %. The principal export markets for CSN were North America (44%),Europe(32%) and Asia(11%). Tata Steel Tata steel, India’s largest private sector steel company was established in the 1907.The Tata steel which falls under the umbrella of Tata sons has strong pockets and strong financials to support acquisitions. Tata steel is the 55th in production of steel in 28 world. The company has committed itself to attain global scale operations. Production capacity of Tata steel is given in the table below:- Table-3 The product mix of Tata steel consist of flat products and long products which are in the lower value chain. The Tata steel is having a low cost of production when compared to Corus. The Tata steel was already having its capacity expansion with its indigenous projects to the tune of 28 million tones. Indian Scenario After liberalization, there have been no shortages of iron and steel materials in the country. Apparent consumption of finished (carbon) steel increased from 14.84 Million tonnes in 1991-92 to 39.185 million tonnes (Provisional) in 2005-06. The steel industry which was facing a recession for some time has staged a turn around since the beginning of 2002. Demand has started showing an uptrend on account of infrastructure boom. The steel industry is buoyant due to strong growth in demand particularly by the demand for steel in China. The Steel industry was de-licensed and de-controlled in 1991 & 1992 respectively. 29 Today, India is the 7th largest crude steel producer of steel in the world. In 2005-06, production of Finished (Carbon) Steel was 44.544 million tonnes. Production of Pig Iron in 2005-06 was 4.695 Million Tonnes. The share of Main Producers (i.e. SAIL, RINL and TSL) and secondary producers in the total production of Finished (Carbon) steel was 36% and 64% respectively during the period of April-November, 2006. Corus decides to sell Reasons for decision: Total debt of Corus is 1.6bn GBP Corus needs supply of raw material at lower cost Though Corus has revenues of $18.06bn, its profit was just $626mn (Tata’s revenue was $4.84 bn & profit $ 824mn) Corus facilities were relatively old with high cost of production Employee cost is 15 %( Tata steel- 9%) Tata Decides to bid: Reasons for decision: Tata is looking to manufacture finished products in mature markets of Europe. At present manufactures low value long and flat steel products while Corus produces high value stripped products A diversified product mix will reduce risks while higher end products will add to bottom line. Corus holds a number of patents and R & D facility. Cost of acquisition is lower than setting up a green field plant and marketing and distribution channels Tata is known for efficient handling of labour and it aims at reducing employee cost and improving productivity at Corus It had already expanded its capacities in India. It will move from 55th in world to 5th in production of steel globally. Tata Steel Vs CSN: The Bidding War There was a heavy speculation surrounding Tata Steel's proposed takeover of Corus ever since Ratan Tata had met Leng in Dubai, in July 2006. On October 17, 2006, Tata Steel made an offer of 455 pence a share in cash valuing the acquisition deal at US$ 7.6 billion. Corus responded positively to the offer on October 20, 2006. 30 Agreeing to the takeover, Leng said, "This combination with Tata, for Corus shareholders and employees alike, represents the right partner at the right time at the right price and on the right terms." In the first week of November 2006, there were reports in media that Tata was joining hands with Corus to acquire the Brazilian steel giant CSN which was itself keen on acquiring Corus. On November 17, 2006, CSN formally entered the foray for acquiring Corus with a bid of 475 pence per share. In the light of CSN's offer, Corus announced that it would defer its extraordinary meeting of shareholders to December 20, 2006 from December 04, 2006, in order to allow counter offers from Tata Steel and CSN... Financing the Acquisition By the first week of April 2007, the final draft of the financing structure of the acquisition was worked out and was presented to the Corus' Pension Trusties and the Works Council by the senior management of Tata Steel. The enterprise value of Corus including debt and other costs was estimated at US$ 13.7 billion The Integration Efforts Industry experts felt that Tata Steel should adopt a 'light handed integration’ approach, which meant that Ratan Tata should bring in some changes in Corus but not attempt a complete overhaul of Corus'systems (Refer Exhibit XI and Exhibit XII for projected financials of Tata-Corus). N Venkiteswaran, Professor, Indian Institute of Management, Ahmedabad said, “If the target company is managed well, there is no need for a heavy- handed integration. It makes sense for the Tatas to allow the existing management to continue as before. The Synergies Most experts were of the opinion that the acquisition did make strategic sense for Tata Steel. After successfully acquiring Corus, Tata Steel became the fifth largest producer of steel in the world, up from fifty-sixth position.There were many likely synergies between Tata Steel, the lowest-cost producer of steel in the world, and Corus, a large player with a significant presence in value-added steel segment and a strong distribution network in Europe. Among the benefits to Tata Steel was the fact that it would be able to supply semi-finished steel to Corus for finishing at its plants, which were located closer to the high-value markets. 31 The Pitfalls Though the potential benefits of the Corus deal were widely appreciated, some analysts had doubts about the outcome and effects on Tata Steel's performance. They pointed out that Corus' EBITDA (earnings before interest, tax, depreciation and amortization) at 8 percent was much lower than that of Tata Steel which was at 30 percent in the financial year 2006- 07. The Road Ahead Before the acquisition, the major market for Tata Steel was India. The Indian market accounted for sixty nine percent of the company's total sales. Almost half of Corus' production of steel was sold in Europe (excluding UK). The UK consumed twenty nine percent of its production. After the acquisition, the European market (including UK) would consume 59 percent of the merged entity's total production. 32 Arcellor- Mittal Deal A new steel giant is to be created out of a bitter battle, after Arcelor formally agreed on a €26.5 billion takeover by rival Mittal Steel. The deal combines Arcelor - a symbol of successful, pan-European cooperation and economic revival, with operations that span Luxembourg, Belgium, France and Spain - with a fast- growing conglomerate founded by the India-born Lakshmi Mittal, who built a fortune turning around sick steel plants in rapidly expanding markets from Trinidad to Kazakhstan. The deal, valued at $33.1 billion, is the latest sign that shareholder activism is marching through the once staid and sleepy boardrooms of Europe. The agreement to pair with Mittal caps a wrenching turnaround for Arcelor's management, which once dismissed Mittal as a "company of Indians" but was forced to backtrack after shareholders threatened to revolt. Politicians in Europe who once criticized Mittal have remained mum in recent days, and the merger brings hope that protectionist barriers against such deals may be eroding in Europe. Mittal is paying €40.37 a share for Arcelor, nearly double what the company was trading at when Mittal first made an offer in January. The new company named Arcelor-Mittal and headquartered in Luxembourg. Joseph Kinsch, chairman of Arcelor, is chairman of the new company, and succeeded by Mittal when Kinsch retires next year. "It's been a long struggle," for investors and Mittal board member. "Now that we have had an opportunity to be inside, with management’’.The deal would create "global leadership in steel" not just by ton but by value. Getting to this point has involved a bruising fight for both sides. Mittal first made an unexpected €18.6 billion offer for Arcelor and was swiftly and harshly rebuked by Arcelor management and a chorus of European politicians who criticized everything from his grammar to his Indian origins to the quality of his company's steel. Arcelor's bare- knuckled defense strategy included refusing to meet with Mittal until a string of demands were met, and simultaneously orchestrating a €13 billion deal with Severstal of Russia to keep him away. 33 The case…… Mittal makes surprise €18.6 billion bid for Arcelor in January 2006 Arcelor management announce large dividend Arcelor makes very positive profit report, which is later found to be inflated Arcelor makes rosy forecast for future performance Arcelor management and European politicians criticize Mittal Arcelor management refuses to meet with Mittal until a string of demands were met Arcelor tries to get Luxembourg government to write a takeover law shutting out Mittal Arcelor unions fear job cuts, reduction in social standards Arcelor managers fear Mittal will shift emphasis from long- to short-term goals Arcelor commits to buy North American steel company that will cause Mittal anti-trust problems o Agreement contains clause making it costly to not go through with sale Arcelor made €13 billion deal with Severstal of Russia, including break-up fee of €140 million Arcelor, Mittal, and Severstal engage in heavy advertising, meetings with investors and politicians Arcelor arranges for shareholder meeting where Severstal deal would be approved unless 50% plus one of shareholders were present and voted it down, an unusually high percent. The meeting isn’t scheduled until after Severstal deal has been nearly finalized. Mittal raises offer to €26.5 billion, and agreed to cede some management control and family voting rights o nearly double the price per Arcelor share Arcelor was trading at prior to Mittal’s bid in January 34 Arcelor’s institutional shareholders and hedge funds voice disapproval in Severstal deal, support Mittal deal o Arcelor management fears shareholders will vote down share buyback necessary for Severstal deal to go through o Shareholders threaten to oust Arcelor management and sue Arcelor board Six percent of Arcelor shareholders sued Arcelor’s board for selling for too low a price o Unlikely to succeed, given very high premium on Arcelor shares relative to pre-takeover-battle price Arcelor-Mittal sells valuable Maryland steel mill in August 2007 to satisfy U.S. anti-trust authorities 35 CHAPTER – 3: RESEARCH METHODOLOGY 36 Research Methodology Most sciences have their own specific scientific methods, which are supported by methodologies (i.e., rationale that support the method's validity). The social sciences are methodologically diverse using qualitative, quantitative, and mixed- methods approaches. Qualitative methods include the case study, phenomenology, grounded theory, and ethnography, among others. Quantitative methods include hypothesis testing, power analysis, Ratio analysis, observational studies, re sampling, randomized controlled trials, regression analysis, multilevel modeling, and high-dimensional data analysis, among others. Types of Research The research study under consideration is exploratory type. Basically there are two broad kinds of researches Exploratory Research : This seeks to discover new relationships. Conclusive Research : It is designed to help executive choose the various Course of action. As research design applicable to exploratory studies are different from objectives firmly in mind while designing the research. Which searching for hypothesis, exploratory designs are appropriate; when hypothesis have been established and are to be listed, conclusive designs are needed. It should be noted however, that the research process tends to become circular over a period of time. Exploratory research may define hypothesis, which are then tested by conclusive research; but a by product of the conclusive research may be a suggestion of a new opportunity or a new difficulty. Other characteristics of exploratory research are flexibility and ingenuity, which characterize the investigation. As we proceed with the investigating it must be on the alert to recognize new ideas, as it can then swing the research in the new direction until they 37 have exhausted it or have found a better idea. Thus they may be constantly changing the focus of invest as new possibilities come to attention. It should be added here that formal design in the researcher is the key factor. Study of secondary sources of information. The reason for selecting this mode of research for this type is that it’s a probably quickest and most economical way for research to find possible hypothesis and to take advantage of the work of to others and utilize their own earlier efforts. Most large companies that have maintained marketing research programs over a number of years have accumulated significant libraries of research organizations furnishing continuing data. Procedure As it is a secondary research, all the data is selected after rigorous analysis of articles from newspapers, magazines and internet. All the research collected is done by professional analyst across the world and is compiled in this project to understand the financial and business impact of merger and acquisition more effectively. 38 CHAPTER 4: DESCRIPTIVE WORK 39 Valuation of Merger and acquisition A merger is a combination of two corporations in which only one corporation survives and the merged corporation goes out of subsistence. Alternatively, in merger two corporations combine and share their resources in order to accomplish mutual objectives and both companies bring their own shareholders, employees, customers and the community at large. Acquisition takes place when one firm is purchasing the assets or shares of another company. Mergers are often categorised as horizontal, vertical, or conglomerate. A horizontal merger is one that takes place between two firms in the same line of business whereas vertical merger involves companies at different stages of production. The buyer expands backwards in the direction of the source of the raw material or forward in the direction of the customer. The last one, i.e., conglomerate merger involves companies in unrelated line of business. This distinction is very much necessary to make and understand the reasons for the mergers. The scale and the pace at which merger activities are coming up are remarkable. The recent booms in merger and acquisitions suggest that the organisations are spending a significant amount of time and money either searching for firms to acquire or worrying about whether some other firm will acquire them. Also, mergers are regarded as one of the activities the purpose of business expansion or a measure of external growth in contrast to internal growths. The recent phenomenon booms in mergers and acquisitions would increase at a much faster rate in near future because the world markets are becoming more integrated because of open trade policies and hence more and more companies are adopting and forming strategic alliances in order to compete in the competitive world and to maintain there market shares. Merger and acquisition decision is an investment decision. This is the most important decision, which influences both the acquiring firm and the target firm, which is to be acquired. An organization cannot make that crucial decision without incisive analysis by financial planners and corporate managers. The acquiring firm must correctly value the 40 firm to be acquired and the acquired firm must get the returns for the goodwill they have created over the years in the market. Growth through acquisition is occurring in an unprecedented number of companies today as strategic acquisitions replace the once- prevalent hostile takeovers by corporate raiders. In the current business environment, it is vital to understand how to blend strategic and financial concepts to evaluate potential acquisitions. Motives The findings from the theoretical material and the empirical investigation will be analyzed both horizontally and vertically according to the following: - Fig-6 There are two types of motives involved in merger and acquisition and these are Explicit and Implicit motives. Explicit Motives Synergy: Synergy means that the merged firm will have a greater value than the sum of its parts as a result of enhanced revenues and the cost base. Economies of Scale: Economic of scale refer to the reduction in unit cost achieved by producing a large volume of a product. Horizontal mergers aim at 41 achieving economies of scale. This phenomenon continues while the firm grows to its optimal size, after which a firm experiences diseconomies of scale. Economies of Vertical Integration: Economies of vertical integration are achieved in vertical mergers. It makes coordination of closely related operating activities easier. Entry to New Markets and Industries: A firm that wants to enter a new market but lacks the know-how can do so through the purchase of an existing player in that product or geographical market. This makes the two firms worth more together than separately. Tax Advantages: Past losses of an acquired subsidiary can be used to minimize present profits of the parent company and thus lower tax bills. Thus, firms have a reason to buy firms that have accumulated tax losses. Diversification: One of the reasons for conglomerate mergers is diversification of risk. There are two types of risks associated with businesses- systematic and unsystematic risk. Systematic variability cannot be removed by diversification and hence mergers are not able to eliminate this risk. Though, unsystematic risk can be spread through mergers. Managerial Motives: The management team of the acquiring firm tends to benefit from the merger activity. The four most important managerial motives for merger are empire building, status, power and remuneration. Implicit Motives Hubris: It is like a maturity test for the owners and the company boards of directors when they see the opportunity to form a new business cycle. Excess of Money: When a company has excess of money, the question of what to do with it eventually comes up and this leads towards merger and acquisition. 42 Steps Involved in an Acquisition Valuation Procedures for Analyzing Valuation of the Firm Fig-7 43 An acquisition valuation programme can be segregated into five distinct steps like: Step 1: Establish a motive for the acquisition. Step 2: Choose a target. Step 3: Value the target with the acquisition motive built in. Step 4: Choose the accounting method for the merger/acquisition - purchase or pooling. Step 5: Decide on the mode of payment - cash or stock. Evaluations Implicit Motives Financing Mergers Fig-8 The triangle in the figure provides a view of acquisition financing mechanism. As the options for financing the acquisition would increase, the layers in the triangle would also increase. But the basic question that arises or the consideration that comes is whether the transaction should be made in cash or stock as it has different effect on the various stakeholders of both the organizations the acquiring firm as well as the target firm. The 44 influence of method of payment on post-merger financial performance is ambiguous. Post merger performance maybe affected by the means of payment in the takeover. There are mainly two ways, in which mergers can be financed, Cash Stock Using cash for payment helps the acquirer's shareholders to retain the same level of control over the company. Another obvious reason of financing mergers through cash is the simplicity and preciseness that gives a greater chance of success. Another advantage of using cash to the target's shareholders is that it is more certain in its value. Also, the recipients can spread their investments by purchasing a wide-ranging portfolio. There is also a disadvantage to target shareholders. They may be liable to pay capital gains tax. This is payable when a gain is realized. Estimating Cost When the Merger is financed by Stock The cost depends on the value of the shares in the new company received by the shareholders of the selling company. Cost = N * P of AB - PV of B Where, N = the number of shares received by the sellers P of AB = price per share of the merged firm PV of B = present value of B (selling firm) Workings of Mergers Merger accounting A merger can be either treated as a purchase or a pooling of interests. Under this method, assets of the acquired firm must be reported at the fair market value on the books of the acquiring firm. Under this method, goodwill, which is the excess of the purchase price over 45 the sum of the fair market values of the individual assets acquired, is generated. Under the second method, pooling of interests, the assets of the merged firm are valued at the same level as they were carried out in acquired and acquiring firms. Tax Considerations An acquisition can be taxable or tax-free. In a taxable acquisition, shareholders of the selling firm are treated for tax purposes as having sold their shares and are liable to pay tax on any capital gains or losses. In a tax-free acquisition, the selling shareholders are viewed as exchanged their old shares for similar ones, and they do not experience any capital gains or losses. The taxes paid by the merged firm also depend on the tax-status of the acquisition. There is no revaluation of assets in a tax-free acquisition, whereas, in a taxable acquisition, the assets are devalued and any increase or decrease is treated as a taxable gain or loss. The Impact of Mergers Mergers have a universal impact, practically everyone from society, shareholders, employees, and directors to financial institutions. Society can benefit from the merger if it results in producing goods at low costs due to economies of scale or improved management. The acquiring shareholders usually get poor returns and therefore very small average gains. However, target shareholders usually gain from mergers, as the acquirers have to pay a substantial premium over the pre-bid share price to convince target shareholders to sell. Employees may gain or lose from a merger activity. Mergers generate significant gains to the target firm's stockholders and buyers generally break even, there are positive benefits from mergers. The yardstick to measure a successful merger is the profit level. Profitability is the only overall significant identifier. 46 Tata - Corus: Visionary deal or costly blunder? After four months of twists and turns, Tata Steel has won the race to acquire Corus Group. The bidding war between Tata Steel and Brazilian company CSN was riveting and ended in a rapid-fire auction. Initial reactions to the deal were highly diverse and retail investors were completely puzzled by the market reaction. Going by the stock market reaction, the acquisition was a big blunder. The stock tanked 10.5 per cent after the deal was announced and another 1.6 per cent. Investors were worried about the financial risks of such a costly deal. Media reaction to the deal had been just the opposite. Almost all the reports were adulatory while editorials praised the coming of age of Indian industry. A prominent financial daily presented the deal almost as revenge of the natives against the old colonial masters with a picture of London covered in our national colours. Its editorial warned the market 'not to bet against Tata', citing the previous instances when skeptics were proved wrong by the group. Official reaction had been no different and the finance minister even offered all possible help to the Tata Group. Was the acquisition too costly for Tata Steel? Was price the only criterion while evaluating an acquisition? Should managers focus on keeping shareholders happy after every quarter or should they focus on the long-term, big picture? These are tough questions and, unfortunately, answers would be clear only after many years - at least in this case. When could the steel cycle turn? The last few years were some of the best ever for the global steel industry as robust demand from emerging economies like China pushed up prices. Profits of steel manufacturers across the globe swelled and their market capitalizations have multiplied many times. 47 Global Steel output (in million tonnes) Country 2005 2006 % change China 355.8 418.8 17.7 Japan 112.5 116.2 3.3 US 94.9 98.5 3.8 Russia 66.1 70.6 6.8 South Korea 47.8 48.4 1.3 Germany 44.5 47.2 6.1 India 40.9 44.0 7.6 Ukraine 38.6 40.8 5.7 Italy 29.4 31.6 7.5 Brazil 31.6 30.9 (2.2) World production 1,028.8 1,120.7 8.9 Table-4 How long will the good times last? Tata Steel believes the steel cycle is in a long-term up trend and the risk of a downturn in prices is low. In fact, managing director B Muthuraman said the global steel industry might witness sustained growth as during the 30-year period between 1945 and 1975. The massive post-war infrastructure build-up in Western countries led to the sustained steel demand growth in that period. The coming decades would see similar infrastructure spending in emerging economies and steel demand would continue to grow, according to this view. The International Iron and Steel Institute (IISI), a respected steel research body, corroborates this in its outlook. The growth in demand for global steel would average 4.9 per cent per year till 2010 according to the IISI. Between 2010 and 2015, demand growth is expected to moderate to 4.2 per cent per annum according to IISI forecasts. Much of this demand growth would come from China and India, where the IISI estimates growth rates to be 6.2 per cent and 7.7 per cent annually from 2010 to 2015. Now let’s consider steel prices. Expectations of sustained demand growth have already led to massive capacity additions, mostly in emerging markets. Chinese steel capacity has 48 expanded significantly over the last decade while a large number of mega steel plants are being planned in India. Capacity additions by Russian and Brazilian steelmakers would also be significant in future as they have access to raw material. Would the capacity additions outrun the demand growth and lead to subdued steel prices? Under normal circumstances, that could have been a very strong possibility. But many industry leaders believe that the global steel industry would see a structural shift in the coming years. Some of the inefficient steel mills in mature markets would face closure while others would shift production to high value-added products using unfinished and semi-finished steel supplied by steel mills in locations like India, Russia and Brazil with access to raw material. This would limit aggregate supply growth and keep prices stable in future. Major global steel makers are also not unduly worried about the possibility of large-scale exports from China, which would depress international steel prices. Chinese capacity is expected to continue to grow in the coming years, but so would the demand. Besides, Chinese steel plants are not expected to emerge very efficient as they depend on imported raw materials, which limit their pricing power. Many steel analysts expect significant consolidation in the Chinese steel industry as margins erode further in future. The Chinese government has already started squeezing the smaller units by withdrawing their raw material import permits. The need for scale Going by the IISI forecasts, global steel demand would be 1.32 billion tonnes by 2010 and 1.62 billion tonnes by 2015. Even Arcelor-Mittal, the largest global steel player by far, has a present capacity, which is just 6.8 per cent for projected demand in 2015. To maintain its current share, Arcelor-Mittal would have to add another 50 million tonnes of capacity by then. This confirms the view that there is still considerable scope for consolidation in the steel industry. 49 Global steel ranking Company Capacity (in million tonnes) Arcelor - Mittal 110.0 Nippon Steel 32.0 Posco 30.5 JEF Steel 30.0 Tata Steel - Corus 27.7 Bao Steel China 23.0 US Steel 19.0 Nucor 18.5 Riva 17.5 Thyssen Krupp 16.5 Table-5 As the industry consolidates further, Tata Steel - even with its planned greenfield capacity additions - would have remained a medium-sized player after a decade. This made it absolutely vital that the company did not miss out on large acquisition opportunities. Apart from Corus, there are not many among the top-10 steel makers, which would become possible acquisition targets in the near future. 50 Tata Steel - Corus : Present capacity (in million tonnes per annum) Corus Group (in UK and The Netherlands) 19 Tata Steel - Jamshedpur 5 Nat Steel - Singapore 2 Millennium Steel - Thailand 1.7 Aggregate present capacity 27.7 Table-6 Tata Steel - Corus : Projected capacity(in million tonnes per annum) Corus Group (in UK and The Netherlands) 19 Tata Steel - Jamshedpur 10 Tata Steel - Jharkhand 12 Tata Steel - Orissa 6 Tata Steel - Chhattisgarh 5 Nat Steel - Singapore 2 Millennium Steel - Thailand 1.7 Aggregate projected capacity 55.7 Table-7 With Corus in its fold, Tata Steel can confidently target becoming one of the top-3 steel makers globally by 2015. The company would have an aggregate capacity of close to 56 million tonnes per annum, if all the planned greenfield capacities go on stream by then. 51 Neat strategic fit Corus, being the second largest steelmaker in Europe, would provide Tata Steel access to some of the largest steel buyers. The acquisition would open new markets and product segments for Tata Steel, which would help the company to de-risk its businesses through wider geographical reach. A presence in mature markets would also provide Tata Steel an opportunity to go further up the value chain as demand for specialized and high value-added products in these markets is high. The market reach of Corus would also help in seeking longer-term deals with buyers and to explore opportunities for pushing branded products. Corus is also very strong in research and technology development, which would add to the competitive strength for Tata Steel in future. Both companies can learn from each other and achieve better efficiencies by adopting the best practices. But at what cost? Now that Tata Steel has achieved its strategic objective of becoming one of the major players in the global steel industry and steel demand growth is likely to be robust over the next decade, has the company paid too much for Corus? Even those analysts and industry observers who agree on the positive outlook for steel demand growth and the need to achieve scale believe so. The enterprise valuation of Corus at around $13.5 billion appears too steep based on the recent financial performance of Corus. Tata Steel is paying 7 times EBITDA of Corus for 2005 and a higher 9 times EBITDA for 12 months ended 30 September 2006. In comparison, Mittal Steel acquired Arcelor at an EBITDA multiple of around 4.5. Considering the fact that Arcelor has much superior assets, wider market reach and is financially much stronger than Corus, the price paid by Tata Steel looks almost obscenely high. Tata Steel's B Muthuraman has defended the deal arguing that the enterprise value (EV) per tonne of capacity is not very high. The EV per tonne for the Tata-Corus deal was around $710 is only modestly higher than the Mittal-Arcelor deal. Besides, setting up new 52 steel plants would cost anywhere between $1,200 and $1,300 per tonne and would take at least five years in most developing countries. But, are the manufacturing assets of Corus good enough to command this price? It is a well-known fact that the UK plants of Corus are among the least efficient in Europe and would struggle to break even at a modest decline in steel prices from current levels. Recent financial performance of Corus would dent the hopes of Tata Steel shareholders even further. EBITDA margins, after adjusting for one-time incomes, have steadily declined over the last 3 years. For the 9-month period ended September 2006, EBITDA margins of Corus were barely 8 per cent as compared to around 40 per cent for Tata Steel. Corus Financials Year 2004 2005 Jan-Sep 2006 Revenues 18.32 19.91 14.10 EBITDA 1.91 1.86 1.12 EBITDA Margin (%) 10.44 9.34 7.96 Operating Profits 1.30 1.17 0.75 Operating Profit Margin (%) 7.09 5.89 5.29 Net Profit 0.87 0.72 0.25 Net Profit Margin (%) 4.73 3.63 1.77 Figures in $ Billion Table-8 The price of an asset is more a factor of its future earnings potential than its past earnings record. Operating margins of Corus can be significantly improved if Tata Steel can supply slabs and billets. Tata Steel is targeting consolidated EBITDA margins of around 25 per cent as and when it starts supplying crude steel to Corus. If the company can sustain such margins on the enlarged capacities, it would be quite impressive. But that is a long way off as Tata Steel would have sufficient crude steel capacity only when its proposed new plants become operational. Till then, the company is targeting to maximize gains through possible synergies between the two operations, which are expected to yield up to $350 million per annum within three years. In the meanwhile, Tata Steel has to make sure that cash flows from Corus are sufficient to service the huge amount of debt, 53 which is being availed to finance the acquisition. According to the details available so far, Tata Steel would contribute $4.1 billion as equity component while the balance $9.4 billion, including the re-financing of existing debt of Corus after adjusting for cash balance, would be financed through debt. The debt facilities are believed to be structured in such a way that they can be serviced largely from the cash flows of Corus. Interest rates on credit facilities for such buy-outs are often higher than market rates because of the risks involved. At an expected interest rate of 7 per cent per annum, the interest outgo alone would be over $650 million per year. Along with repayment of principal, the annual fund requirement to service this debt would be around $1.5 billion - assuming a 10-year repayment horizon. The current cash flows of Corus are barely sufficient to cover this, even after considering the synergy gains. If international steel prices decline even modestly, Tata Steel would have to dip into its own cash flows or find other sources like an equity dilution to service the debt. Besides, funds may also be required for upgrading some of the Corus plants to improve efficiencies. Tata Steel would have to manage all this without jeopardizing its greenfield expansion plans which may cost a staggering $20 billion over the same 10-year period. No wonder investors are deeply worried! To its credit, the Tata Steel management has acknowledged that it would not be an easy task to manage the next five years when Corus would have to hold on to its margins without the help of cheaper inputs supplied by Tata Steel. If the group can survive this initial period without much damage, life may become much easier for the Tata Steel management. Investors would consider Corus a burden for Tata Steel until such time there is a perceptible improvement in its margins. That would keep the Tata Steel stock price subdued and any decline in steel prices would have a disproportionately negative impact on the stock. However, long-term investors would appreciate that right now steel manufacturing assets are costly and Corus was a prized target which made it even more costly. With the strategic importance of such a large deal in mind, Tata Steel management has taken the plunge. If it 54 can pull it off, even after a decade, the Corus acquisition would become the deal, which would transform Tata Steel. Mittal-Arcelor Vs Tata-Corus The combined entity of Tata-Corus will have a tremendous beneficial reach and scale of 24 million tonne per annum and many synergies, but the market is not willing to wait for the benefits to come through. Besides, at an EV/EBITDA (enterprise value/earnings before interest, tax and depreciation) of more than 8 times CY06 financials on consensus estimates and a replacement value of $679 per tonne, analysts believe the transaction valuation is stretched. In the Mittal Steel-Arcelor deal, the EV/EBITDA was 6.2 times. In terms of EV/tonne too, Tata Steel's price, at $700-710 per tonne is higher than what Arcelor commanded at $586 per tonne. Also, in case of Mittal Steel-Arcelor, the deal involved a share swap along with cash. Tata Steel will have to shell out hard cash for Corus. And that means not just more debt on the Tata Steel balance sheet, but also an equity dilution. The company’s gearing is low at around 0.26:1, so it is in a position to take on debt of around Rs 8,000 crore, without the debt-equity ratio going for a toss. As for the equity dilution, Tata Steel has issued warrants to Tata Sons in July 2006, Tata Sons was issued 2.7 crore shares of Rs 10 each at a price of Rs 516 per share aggregating Rs 1,393 crore. The leading steel groups that follow Arcelor Mittal are quite a distance from owning 50 million tonne capacity each. In an industry with a capacity of nearly 1.3 billion tonne, the ideal scene would be half the capacity being owned by not more than ten groups. Tata Steel's audacious, but successful bid for Corus at an enterprise value of £6.7 million, including debts of £500 million, gives it a capacity of 28 million tonne, including 8.7 mt of its own. But the immediate stock market reaction to Tata Steel running away with the trophy in a head to-head bidding with Brazil's CSN was negative, as market participants thought Corus at 608 pence, representing a premium of 153 pence on the opening offer, was an expensive buy. Whether the Tatas are paying a inflated price for Corus will remain a subject of debate for some time. Ratan Tata is emphatic that he is not paying anything that is beyond prudence. It may not look so at this point, but the acquisition cost for the Tatas will be justified, as the valuation of steel assets around the world will keep on rising. Corus got sold at 9 times its earnings (EBITDA). Some months ago, Mittal muscled his way into 55 Arcelor by paying 6.2 times the target company's earnings. To put it differently, Corus costs the Tatas $700 for each tonne of steel against Mittal's payment of $670 a tonne for Arcelor. But, we know that a recent steel deal in the US were clinched at nearly $1,000 a tonne. COMPETITION ANALYSIS OF STEEL INDUSTRY Concentration Ratio In Economics the concentration ratio of an industry is used as an indicator of the relative size of firms in relation to the industry as a whole. This may also assist in determining the market form of the industry. One commonly used concentration ratio is the four-firm concentration ratio, which consists of the market share, as a percentage, of the four largest firms in the industry. In general, the N-firm concentration ratio is the percentage of market output generated by the N largest firms in the industry. The 4 firm concentration ratio of the Iron and Steel Industry is 71%. This implies that there is oligopoly in the industry as it is dominated my few major players. Major percentage of market output is generated by the 4 largest firms in the industry. Herfindahl Index: The Herfindahl index, also known as Herfindahl-Hirschman Index or HHI, is a measure of the size of firms in relationship to the industry and an indicator of the amount of competition among them. It is an economic concept but widely applied in competition law and antitrust. It is defined as the sum of the squares of the market shares of each individual firm. As such, it can range from 0 to 1 moving from a very large amount of very small firms to a single monopolistic producer. Decreases in the Herfindahl index generally indicate a loss of pricing power and an increase in competition, whereas increases imply the opposite. 56 Value of Herfindahl index for Indian Steel Industry is .2470. It implies that the competition in the steel industry is medium to high and high concentration. MERGERS AND ACQUISITIONS Active mergers and acquisitions (M&A s) among players were indicative of the consolidation dynamics within the steel industry globally. Consolidation among top steel companies would continue in 2008 since industry players are engaged in an unfettered rush for scale. In so doing steelmakers are pursuing two main objectives: by purchasing additional production capacity they aim to both improve their cost structure and increase their market clout. The merger of the world’s two biggest steelmakers Mittal Steel (Netherlands) and Arcelor (Luxembourg) will create an industry giant whose output is nearly four times as much as that of the next biggest player (Nippon Steel) and eight times as much as SAIL’s. If it continues like this 35% of steel production confined in the top 10 companies within the next five years. Consolidation among industry players would be driven by strategic fits between companies, rather than financially centered deals. A company can be a good strategic fit for merger if it has, among other things, attractive access to raw materials, production capabilities, proven success in complementary markets, new technologies or patented products and a successful global supply network. In India the three biggest steelmakers, whose combined output is almost 20 million tons, have a market share of 51%. Their domestic competitors are numerous medium sized and smallish companies. One of these, for example, is Ispat with an output of 2 million tons. More mergers can be expected between companies of this size as these firms need to improve their position with regard to the powerful suppliers of raw materials. But till now there is no sign of acquisition or mergers of Indian steel companies within India because most of the major producers are public. As different major global steel producers like Arcelor-Mittal, Posco and others are setting up plants in India, competition in the future will increase. In that case several mid-size domestic companies may go for mergers. But if 57 we see from the current position of the industry we can say that in future Indian steel industry will remain oligopoly or can become a competitive one. Global mergers and acquisitions The ideal way to make headway in production The steel industry has been witness to some mega deals recently through mergers and acquisitions, with Mittal Steel reaching the pinnacle in steel production across the globe, while others have only been too keen to followed suit. The foremost reason for this strategy is to increase commercial production capacity within the stipulated time period with minimum investment. The latest to join the bandwagon is Tata Steel which bought out Rawmet Ferrous Industries, an unlisted Kolkata-based Ferro alloys player, for an undisclosed amount. Rawmet has a Ferro alloy plant near Cuttack consisting of two 16.5 MVA semi closed electric arc furnace having the production capacity of around 50,000 tonnes of high carbon Ferro chrome per annum. The agreement was signed in Bhubaneswar by Tata Steel and representatives of IMR Metallurgical Resources, which holds a 66.46% equity stake in Rawmet. Officials of Rawmet Commodities, which holds 12.48% equity stake, were also present during the occasions. Rawmet Ferrous Industries is planning to set up a Ferro alloy plant along with a waste-based power plant and a coke oven battery at Anantapur village in Cuttack district. The development of the facility will be implemented in four phases. The total cost of the entire project is projected to be Rs 326.50 crore. MITTAL BAGGED ARCELOR: Arcelor SA accepted India-born L N Mittal group's takeover bid with improved quoting by 10% to 25.9 billion Euros ($32.4 billion), thus creating the world's largest steel entity. This acquisition positioned Mittal Steel as the largest steel producer in the world with about 10 per cent of total steel production worldwide. Arcelor had entered into a strategic tie up Severstal which was perceived to be as a last ditch effort to thwart Mittal's bid, which ultimately proved unsuccessful. The final decision preferring Mittal to Russian steel giant Severstal was taken after a marathon meeting of the Board at the company's headquarters. 58 The merger created the world's largest steelmaker, to be called Arcelor-Mittal, with annual production capacity of more than 110 million tons per annum. While the combined company will control 10 percent of the world's steel production, it's not a monopoly by any means, commented experts. Geographically, the companies don't overlap nor do they compete with each other; prior to this deal Mittal didn't have a presence in Europe, where Arcelor was essentially concentrated. About 150 of the plant's nearly 2,500 Workers took voluntary layoffs up to a month. They could be called back if needed. Mittal officials estimate the outage will cost the company 250,000 tons of iron-making, nearly a month's work. The loss should be covered by insurance. Tata and Corus: In addition to Tata Steel's bid for Corus, the largest private sector steel producer in India has made a mark and consolidated it is presence in the foreign land, through acquisition his latest one's being in Indonesia. In case of Corus, only time will tell whether Tata Steel would succeed or not, but in other endeavours the company has already succeeded in acquiring some steel plants. Tata Steel, the country's largest private sector steel company, was in talks with Anglo American of South Africa to acquire its 79 per cent stake in Highveld Steel. While the Highveld acquisition is still going through the evaluation process. According to analysts, if the acquisition of Highveld Steel goes through to completion, Tata Steel's production capacity will go up to 6 million tonne from the current level of 5 million tonne. Highveld, the largest vanadium producer in the world, manufactures steel, vanadium products, Ferro-alloys, carbonaceous products and metal containers and closures. Analysts observe a clear trend in Tata Steel's plans to expand capacities. But Highveld was not supposed to be the first global acquisition for Tata Steel. In February 2005, the company completed the acquisition of Singapore's largest steel company, NatSteel Asia, which has a two-million tonne steel capacity with presence across Singapore, Thailand, China, Malaysia, Vietnam, the Philippines and Australia. As per the deal, the enterprise value of NatSteel Asia was pegged at Rs 1,313 crore. Tata Steel has plans to establish steel manufacturing units in Iran and Bangladesh too. With a stated vision to become a 20-25 million tonne company by 2015, the company has also signed a few joint ventures and announced organic expansion plans. 59 SWOT ANALYSIS OF THE STEEL INDUSTRY Strengths 1. Availability of iron ore and coal 2. Low labour wage rates 3. Abundance of quality manpower 4. Mature production base Weaknesses 1. Unscientific mining 2. Low productivity 3. Coking coal import dependence 4. Low R&D investments 5. High cost of debt 6. Inadequate infrastructure Opportunities 1. Unexplored rural market 2. Growing domestic demand 3. Exports 4. Consolidation Threats 1. China becoming net exporter 2. Protectionism in the West 3. Dumping by competitors 60 EXPECTED GROWTH The International Iron and Steel Institute(IISI) has fore casted that the steel demand will go of from 1.12 billion ton to 1.19 billion ton in 2008.And this will further increase in a higher rate up to 2010.In India the growth will be more prominent because of the growth in Real estate, Aviation, Manufacturing, Automobile sectors. Fig-9 61 FACTORS HOLDING BACK THE INDIAN STEEL INDUSTRY The growth of the Indian steel industry and its share of global crude steel production could be even higher if they were not being held back by major deficiencies in fundamental areas. Investment in infrastructure is rising appreciably but remains well below the target levels set by the government due to financing problems. . Energy supply Power shortages hamper production at many locations. Since 2001 the Indian government has been endeavouring to ensure that power is available nationwide by 2012. The deficiencies have prompted many firms with heavier energy demands to opt for producing electricity with their own industrial generators. India will rely squarely on nuclear energy for its future power generation requirements. In September 2005 the 15th and largest nuclear reactor to date went on-line. The nuclear share of the energy mix is likely to rise to roughly 25% by 2050. Overall, India is likely to be the world’s fourth largest energy consumer by 2010 after the US, China and Japan. Problems procuring raw material inputs Since domestic raw material sources are insufficient to supply the Indian steel industry, a considerable amount of raw materials has to be imported. For example, iron ore deposits are finite and there are problems in mining sufficient amounts of it. India’s hard coal deposits are of low quality. For this reason hard coal imports have increased in the last five years by a total of 40% to nearly 30 million tons. Almost half of this is coking coal (the remainder is power station coal). India is the world’s sixth biggest coal importer. The rising output of electric steel is also leading to a sharp increase in demand for steel scrap. Some 3.5 million tons of scrap have already been imported in 2006, compared with just 1 million tons in 2000. In the coming years imports are likely to continue to increase thanks to capacity increases. 62 Inefficient transport system In India, insufficient freight capacity and a transport infrastructure that has long been inadequate are becoming increasingly serious impediments to economic development. Although the country has one of the world’s biggest transport networks – the rail network is twice as extensive as China’s – its poor quality hinders the efficient supply of goods. The story is roughly the same for port facilities and airports. In the coming years a total of USD 150 bn is to be invested in transport infrastructure, which offers huge potential for the steel industry. In the medium to long term this capital expenditure will lay the foundations for seamless freight transport RECENT FINACIAL CRISIS AND INDIAN STEEL INDUSRRY We have witnessed in last few months, the unfolding of financial crises starting from United States and expanding world over. The exact magnitude and extent of the crises is fiercely debated among the financial experts. However, this real impact on economy can easily be observed across many, if not all sectors. The steel industry has not been spared with the impacts of the financial crises. The total market valuation of Arcelor Mittal, Nippon steel and JEE has dropped by approx $165 billion. The price of billet in Dubai market has dropped from its height of $125/ton in June 2008 to a recent low of $350 /ton. One of the steepest drops witnessed in recent history. The wide spread drop in demand for all types of steel required companies to cur production globally. Arcelor Mittal, one of the largest steel producers, alone has recently announced more than 30% reduction in production. It is only human to be frustrated and uncertain of the future. However, over long term, do we really need to be? We explored the steel production data going back to 1900 during last 100 years the worst drop (13.52%) in steel industry accrued between 1979-82. This four year drop in global steel production is horrendous. However, if we look at year over year growth changes in steel industry during a 100 year period from 1900 to 2000 a more optimistic pictures emerges. There is not even one instance when industry saw a consecutive four year of negative year over year growth. The worst case situation is three years of declining year over year growth during 1930-32, 1944-46, and 1980-82. 63 Extending the past patterns of data to predict future is fraught with peril. It is none the less an important reminder to us that during tumultuous 100 year period the steel industry has been able to successfully weather world wars ,recession and crises of all the genre. Steel is a resilient industry. It is not to say that the current financial crises should not be taken seriously. It should be however, if history holds the chances the impact of current crises extending beyond 2009 are low. The leading steel companies should take these opportunities to improve their operational efficiency and effectiveness to better prepare themselves for impending growth in coming years. Five-Force Analysis of Steel industry Backed by robust volumes as well as realizations, steel Industry has registered a phenomenal growth across the world over the past few years. The situation in the domestic industry was no exception. In fact, it enjoyed a double digit growth rate backed by a robust growing economy. However, the current liquidity crisis seems to have created medium term hiccups. In this article, we have analyzed the domestic steel sector through Michael Porter’s five force model so as to understand the competitiveness of the sector. Barriers to entry: We believe that the barriers to entry are medium. Following are the factors that vindicate our view. Capital Requirement: Steel industry is a capital intensive business. It is estimated that to set up 1 mtpa capacity of integrated steel plant, it requires between Rs 25 bn to Rs 30 bn depending upon the location of the plant and technology used. Economies of scale: As far as the sector forces go, scale of operation does matter. Benefits of economies of scale are derived in the form of lower costs, R& D expenses and better bargaining power while sourcing raw materials. It may be noted that those steel companies, which are integrated, have their own mines for key raw materials such as iron ore and coal and this protects them for the potential threat for new entrants to a significant extent. 64 Government Policy: The government has a favorable policy for steel manufacturers. However, there are certain discrepancies involved in allocation of iron ore mines and land acquisitions. Furthermore, the regulatory clearances and other issues are some of the major problems for the new entrants. Product differentiation: Steel has very low barriers in terms of product differentiation as it doesn’t fall into the luxury or specialty goods and thus does not have any substantial price difference. However, certain companies like Tata Steel still enjoy a premium for their products because of its quality and its brand value created more than 100 years back. Bargaining power of buyers: Unlike the FMCG or retail sectors, the buyers have a low bargaining power. However, the government may curb or put a ceiling on prices if it feels the need to do so. The steel companies either sell the steel directly to the user industries or through their own distribution networks. Some companies also do exports. Bargaining power of suppliers The bargaining power of suppliers is low for the fully integrated steel plants as they have their own mines of key raw material like iron ore coal for example Tata Steel. However, those who are non-integrated or semi integrated has to depend on suppliers. An example could be SAIL, which imports coking coal. Competition It is medium in the domestic steel industry as demand still exceeds the supply. India is a net importer of steel. However, a threat from dumping of cheaper products does exist. Threat of substitutes It is medium to low. Although usage of aluminum has been rising continuously in the automobile and consumer durables sectors, it still does not pose any significant threat to steel as the latter cannot be replaced completely and the cost differential is also very high. After understanding all the above view points and the current global scenario, we believe that the domestic steel industry will likely to maintain its momentum in the long term. However, the growth may get affected in short run. Investors need to 65 focus on companies that are integrated, have economies of scale and sell premium quality products Articles from Newspaper on steel industry India aiming to double steel production by 2011-12 Sunday, 14 December 2008 India is aiming to more than double its steel production to 124 million tonnes by 2011-12 and further raise it to 280 million tonnes by 2020, Steel Minister Ram Vilas Paswan told Rajya Sabha today. Replying to supplementary during Question Hour, Paswan said India ranked eighth in world steel production when UPA Government took office in 2004 and has today climbed to 5th spot with 54 million tonnes of annual steel production. "Our National Steel Policy had targeted 124 million tonnes of steel production by 2020. But we have now brought the target forward to 2011-12 and for 2020 we are aiming to raise production capacity to 280 million tonnes," he said. Steel Ministry, he said, was of the view that high quality iron ore, the reserves of which in the country are very limited, should not be exported or their export discouraged through high export duties. The exports cannot be fully stopped as iron ore mines employ some 500,000 people and their employment cannot be risked, he said adding export duty on iron ores has already been levied. The global economic slowdown has seen growth in steel consumption in the country fall to 1.75 per cent from a high of 13 per cent. Also, prices of steel products have fallen since June. Paswan said his Ministry has been holding consultations with the industry and recently the Government rolled back export duty on all categories of steel items, except melting sap, to help producers tide over fall in consumption levels in the country. STEEL IMPORT STRENGTHEN 70% IN NOV (Source-economic times 13th December) India’s steel imports jumped more than 70% to 1.4 mn tonnes last month against 8 lakh tonne in the same month a year ago. The sharp rise in imports was due to low-priced shipments coming from China, Thailand and Ukraine into India at $450-500 per tonne, 66 25% cheaper than the international price, then ruling at $600-700 per tonne. The steel ministry’s Joint Planning Committee that collects data on iron and steel on a monthly basis shows that steel imports dipped 10.7% to 5.25 million tonnes in April-October against 5.88 million tonnes in the corresponding period a year ago. Availability of low-priced imports from some countries resulted in huge imports in November. This happened when domestic steel makers were cutting production due to lower demand. Last month, the government imposed 5% import duty on steel products to protect domestic industry against cheap imports. But steel producers feel the move is insufficient to bring down imports as china as withdrawn export tax on some steel products to get rid of surplus stock. The government has also initiated investigation into dumping from China but steel firms feel it’s a lengthy process and will take at least 8-9 months to complete. 67 68 CHAPTER 5: CONCLUSION AND RECOMMENDATIONS 69 Conclusion The liberalization of industrial policy and other initiatives taken by the Government have given a definite impetus for entry, participation and growth of the private sector in the steel industry. While the existing units are being modernized/expanded, a large number of new/Greenfield steel plants have also come up in different parts of the country based on modern, cost effective, state-of-the-art technologies. Indian steel players, now, concentrate on the global market as they know the trend of world market of steel. The recent movement of Tata steel is also a big evidence for the development of Indian steel industry. The acquisition of Corus Steel immediately increases the production of capacity of Tata steel by 12 mt. One size doesn't fit all. Many companies find that the best way to get ahead is to expand ownership boundaries through mergers and acquisitions. For others, separating the public ownership of a subsidiary or business segment offers more advantages. At least in theory, mergers create synergies and economies of scale, expanding operations and cutting costs. Investors can take comfort in the idea that a merger will deliver enhanced market power. By contrast, de-merged companies often enjoy improved operating performance thanks to redesigned management incentives. Additional capital can fund growth organically or through acquisition. Meanwhile, investors benefit from the improved information flow from de-merged companies. M&A comes in all shapes and sizes, and investors need to consider the complex issues involved in M&A. The most beneficial form of equity structure involves a complete analysis of the costs and benefits associated with the deals. What we learned in this: A merger can happen when two companies decide to combine into one entity or when one company buys another. An acquisition always involves the purchase of one company by another. The functions of synergy allow for the enhanced cost efficiency of a new entity made from two smaller ones - synergy is the logic behind mergers and acquisitions. Acquiring companies use various methods to value their targets. Some of these methods are based on comparative ratios - such as the P/E and P/S ratios - replacement cost or discounted cash flow analysis. 70 An M&A deal can be executed by means of a cash transaction, stock-for-stock transaction or a combination of both. A transaction struck with stock is not taxable. Break up or de-merger strategies can provide companies with opportunities to raise additional equity funds unlock hidden shareholder value and sharpen management focus. De-mergers can occur by means of divestitures, carve-outs spin-offs or tracking stocks. Mergers can fail for many reasons including a lack of management foresight, the inability to overcome practical challenges and loss of revenue momentum from a neglect of day-to-day operations. Finally, our dissertation suggests- The economic indicators are all favorable for Growth, temporally slump is ephemeral. Indian steel industry exudes optimism Investment in infrastructure is crucial to step up demand for steel. Supply may have to be rationalized in line with the demand (Dom + exports) Integrated Mills would hold the key in future growth of Indian Steel supplies. New technologies to use indigenous natural resources would have to be developed 71 SUGGESTIONS AND RECOMMENDATIONS In a giant leap, Tata Steel's acquisition of the Anglo-Dutch steel major Corus has vaulted the former to the fifth position from 56th in global steel production capacity. With the exception of Arcelor Mittal, which has combined production capacities of 110 million tonnes, Tata Corus, with a capacity of 23.5 million tonnes, will be only 5-7 million tonnes shy of the next three players — Nippon Steel, Posco and JFE Steel. At the same time, it will also have players such as Bao steel, US Steel, Nucor and Thyssen Krupp breathing down its neck in the global sweepstakes. Spelling out the rationale for the deal, Mr. Ratan Tata, Chairman, Tata Sons, has claimed, "... it will take several years for us (Tatas) to build a 19-million-tonne enterprise from scratch, leave alone establishing it in Europe with a brand name." In that sense, it is obviously an important strategic move for Tata Steel with long-term global implications in a consolidating sector. This hotly-contested mega deal has, however, come at a stiff price of $12.1 billion in equity value and with a debt component of around $1.5 billion Corus as an enterprise is worth $13.6 billion. That takes the winning final bid for the shares of Corus 34 per cent higher than the initial offer the Tatas made on October 20. The Tata Steel stock has shed over 10 per cent since the acquisition and has also been a sharp under-performer relative to the broad market and its sectoral peers over the past six months. With the debate on "overvaluation' and "winner's curse" hanging over this deal, here is a look at the implications from a short- and long-term investment perspective: Short-Term Implications Investors with a one-to-two year perspective may find the Tata Steel stock unattractive at current price levels. While the potential downside to the stock may be limited, it may consolidate in a narrow range, as there appears to be no short-term triggers to drive up the stock. The formalities for completing the acquisition may take three to four months, before the integration committees get down to work on the deal. In our view, three elements are stacked against this deal in the short run: 72 Equity dilution: The financing of the acquisition is unlikely to pose a challenge for the Tata group, but the financial risks associated with high-cost debt may be quite high. Though the financing pattern is yet to be spelt out fully, initial indications are that the $4.1 billion of the total consideration will flow from Tata Steel/Tata Sons by way of debt and equity contribution by these two and the balance $8 billion, will be raised by a special investment vehicle created in the UK for this purpose. Preliminary indications from the senior management of Tata Steel suggest that the debt-equity ratio will be maintained in the same proportion of 78:22, in which the first offer was made last October. The Corus steel factory in Ijmuiden, the Netherlands. Based on this, a 20-25 per cent equity dilution may be on the cards for Tata Steel. The equity component could be raised in the form of preferential offer by Tata Steel to Tata Sons, or through GDRs (global depository receipts) in the overseas market or a rights offer to shareholders. This dilution is likely to contribute to lower per share earnings, whose impact will be spread over the next year or so. As Tata Steel also remains committed to its six-million- tonne greenfield ventures in Orissa, its debt levels may rise sharply in the medium term. Margin picture: Short-term triggers that may help improve the operating profit margin of the combined entity seem to be missing. In the third quarter ended September 2006, Corus had clocked an operating margin of 9.2 per cent compared with 32 per cent by Tata Steel for the third quarter ended December 2006. In effect, Tata Steel is buying an operation with substantially lower margins. This is in sharp contrast to Mittal's acquisition of Arcelor, where the latter's operating margins were higher than the former's and the combined entity was set to enjoy a better margin. Despite that, on the basis of conventional metrics such as EV/EBITDA and EV/tonne, Arcelor Mittal's valuation has turned to be lower than Tata Corus. On top of that, Tata is making an all-cash offer for Corus vis-à-vis the cash-cum-stock swap offer made by Mittal for Arcelor. 73 Corus has been working on the "Restoring Success" programme aimed at closing the competitive gap that existed between Corus and the European steel peers. The gap in 2003 was about 6 per cent in the operating profit level when measured against the average of European competitors. And this programme is expected to deliver the full benefits of 680 million pounds in line with plan. With this programme running out in 2006 and being replaced by `The Corus Way', the scope for Tata Steel to bring about short-term improvements in margins may be limited. Even the potential synergies of the $300-350 million a year expected to accrue to the bottomline of the combined entity from the third year onwards, may be at lower levels in the first two years. As outlined by Mr. B. Muthuraman, Managing Director of Tata Steel, synergies are expected in the procurement of material, in the marketplace, in shared services and better operations in India by adopting Corus's best practices in some areas. The steel cycle While the industry expects steel prices to remain firm in the next two-three years, the impact of Chinese exports has not been factored into prices and the steel cycle. There are clear indications that steel imports into the EU and the US have been rising significantly. At 10-12 million tonnes in the third quarter of 2006, they are twice the level in the same period last year and China has been a key contributor. This has led to considerable uncertainty on the pricing front. Though regaining pricing power is one of the objectives of the Tata-Corus deal, prices may not necessarily remain stable in this fragmented industry. The top five players, even after this round of consolidation, will control only about 25 per cent of global capacities. Hence, the steel cycle may stabilise only if the latest deal triggers a further round of consolidation among the top ten producers. Long-Run Picture Whenever a strategic move of this scale is made (where a company takes over a global major with nearly four times its capacity and revenues), it is clearly a long-term call on the structural dynamics of the sector. And investors will have to weigh their investment options only over the long run. 74 Over a long time-frame, the management of the combined entity has far greater room to maneuver, and on several fronts. If you are a long-term investor in Tata Steel, the key developments that bear a close watch are: Progress on low-cost slabs Research shows that steel-makers in India and Latin America, endowed with rich iron ore resources, enjoy a 20 per cent cost advantage in slab production over their European peers. Hence, any meaningful gains from this deal will emerge only by 2009-10, when Tata Steel can start exporting low-cost slabs to Corus. This is unlikely to be a short-term outcome as neither Tata Steel's six-million-tonne greenfield plant in Orissa nor the expansion in Jamshedpur is likely to create the kind of capacity that can lead to surplus slab-making/semi-finished steel capacity on a standalone basis. Second, there may be further constraints to exports as Tata Steel will also be servicing the requirements of NatSteel, Singapore, and Millennium Steel, Thailand, its two recent acquisitions in Asia. However, this dynamic may change if the Tatas can make some acquisitions in low-cost regions such as Latin America, opening up a secure source of slab-making that can be exported to Corus's plants in the UK. Or if the iron ore policy in India undergoes a change over the next couple of years, Tata Steel may be able to explore alternatives in the coming years. Restructuring at Corus: The raison d'etre for this deal for Tata Steel is access to the European market and significantly higher value-added presence. In the long run, there is considerable scope to restructure Corus' high-cost plants at Port Talbot, Scunthorpe and the slab-making unit at Teesside. The job cuts that Tata Steel is ruling out at present may become inevitable in the long run. Though it may be premature at this stage, over time, Tata Steel may consider the possibility of divesting or spinning off the engineering steels division at Rotherham with a production capacity of 1 million tonnes. The ability of the Tatas to improve the combined operating profit margins to 25 per cent (from around 14 per cent in 2005) over the next four to five years will hinge on these two aspects. 75 In our view, two factors may soften the risks of dramatic restructuring at the high-cost plants in UK. If global consolidation gathers momentum with, say, the merger of Thyssenkrupp with Nucor, or Severstal with Gerdau or any of the top five players, the likelihood of pricing stability may ease the performance pressures on Tata-Corus. Two, if the Tatas contemplate global listing (say, in London) on the lines of Vedanta Resources (the holding company of Sterlite Industries), it may help the group command a much higher price-earnings multiple and give it greater flexibility in managing its finances. 76 Reference ANALYSIS FROM CRISIL. ECONOMIC TIMES,EXIM NEWSLETTER WWW.WORLDSTEEL.ORG WWW.CRISIL.COM WWW.INDIANINDUSTRY.COM HTTP://STEEL.NIC.IN/ HTTP://EN.WIKIPEDIA.ORG/WIKI/STEEL Newspapers like Hindu, Economic Times, Business standard etc. Search engine like Google.com, Yahoo.com etc. 77 CHECKLIST 1. Is the report properly hard bound/Spiral bound. Yes / No 2. Is the Cover page in proper format as given in Annexure A? Yes / No 3. Is the Title page (Inner cover page) in proper format? 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