Indian Steel Sector – Why are PE Funds getting attracted to support Buyouts

Let me first begin with an apology for not blogging as often as I desired to. However, an often repeated nudge from many of my readers has finally brought me back to my passion of writing, after a long hiatus (I wish and hope that I now continue with the momentum).

Indian economy is having an overabundance of structural changes, having an impact on the way businesses operate, bank and non-bank entities function or the way individuals transact. I wish to write on many of these topics. However, the topic that I have decided to write upon today is the Indian Steel sector, as this also I believe is at an inflexion point in many ways. Hence, in spite of the fact that the steel sector is (a) supposedly financially stressed (b) fraught with over capacities globally  (c) susceptible to volatile profitability due to fluctuating input as well as output prices, a little deep dive into it and one finds it pretty interesting to see some massive structural changes that could be potential game changers.

For those who are not following the Indian Banking or metals sector, the background is that there are four steel companies that had over-leveraged their business and have landed up as stressed loans in the books of many Indian Banks. In the last one year or so, multiple regulations have got activated and lenders got an opportunity to refer some of the stress cases to National Company Law Tribunal (NCLT) for resolution. Certain timelines (180-270 days) are prescribed for resolving these cases else many of these businesses could come under the hammer for liquidation. Indian lenders have currently referred four steel companies with a combined steel manufacturing capacity of close to 20 mtpa to NCLT for resolution. These companies are Essar Steel (10), Bhushan Steel (5), Bhushan Steel and Power (3) and Electrosteel Steel (2). If one were to set up this quantum of capacity, it would cost anywhere between USD 12.00 – 18.00 bn, depending upon whether it’s a brownfield or a greenfield project and management’s execution track record and execution capabilities. Interestingly, the cumulative debt of these four companies is almost USD 22 bn (this would be relevant as we do some equity valuation analysis later).

As usual, I am a numbers man and I am going to talk of a lot of numbers. So be ready for some data-heavy read. I personally believe that unless one absorbs the numbers, the assessment is more perception based and less objective. Hence any conviction to invest would always tend to be low without numbers.

Before I get into details, let me share with you a few facts.

1. Do you know that India has trebled its steel capacity in last 15 years? Yes, you read it right. India has increased its steel capacity 3-fold, from 27 million tons per annum (MTPA) in 2000 to 100+ mtpa in 2017.
2. Do you know that almost half (45%) of the steel capacity in India is controlled by only 3 players viz., JSW Steel, Tata Steel and SAIL? In a way, all said and done, India is an Oligopolistic market for the steel sector.
3. Do you know that India requires to add at least about 200 mn tons of steel capacity by 2030? This would mean an investment of approximately Rs 10 trillion or c. USD 200 bn.

As I write more on this below, one would realize the relevance (and the context) of above data points.

FIRST – Very early in my career, I picked up a very important investment trait, and that is nothing but applying the basic principle taught in Economics, that is applying the ‘Principle of Demand and Supply’ to any business. Taking this logic forward, let us assess the demand for steel in India.

Every country goes through a life cycle of ‘infrastructure creation’, ‘Infrastructure maintenance’ and ‘infrastructure rebuilding’ – where the maintenance phase is anywhere between 50 to 75 years, before the need for rebuilding starts. I would classify India in first phase, China getting into the second phase and USA moving towards the third phase.

Consumption of steel, as a proportion to GDP gives a decent sense of whether it is the investments or the consumption that is driving GDP growth.

Take the case of USA. 50 years back, in 1967, USA was consuming 74 mtpa for every trillion of GDP while now in 2017, after 50 years, USA is consuming only 5 mtpa per trillion of GDP. Clearly, for last 50 years, USA was in the ‘infrastructure maintenance’ mode. It is high time that a country like USA would now need to get into the third phase of ‘infrastructure rebuilding’. The fact that one of the big rhetorics of President Donald J Trump is a USD 1 trillion investment in infrastructure kind of indicates that this topic is becoming serious and important for America. This investment may not happen tomorrow. But the fact that they are talking of rebuilding roads, airports, inland waterways, dams, railways, etc are signs of coming years (maybe a decade) of higher steel consumption. Imagine the annual steel consumption in USA to move up marginally from 5 mtpa per trillion GDP to 15 mtpa per trillion GDP, we are talking of steel consumption going up from c.100 mtpa to 300 mtpa. Where does this come from? More of it later.

Let’s take another example of China, which for the last 17 years (2000-2017) has been in serious ‘infrastructure creation’ mode. The consumption of steel peaked in 2013 at c.110 mtpa per trillion GDP and is now hovering around 55 mtpa per trillion GDP. In the last 4-5 years, the momentum has slowed down and we would gradually see China getting into ‘infrastructure maintenance’ mode. Though China continues to put a brave front by adopting multiple strategies to sustain this high capacity utilisations (through a combination of spending push in home country and aggressive bidding for infra projects in under-developed economies), eventually it has to taper down. However, these shifts are always gradual and not very sudden.

So at one end we would have China getting into ‘maintenance’ mode (and probably start having 100-150 mtpa of excess capacity), at the same time one can fairly expect USA to get into ‘rebuilding’ mode, which should act as a strong counter-balancing force to neutralize these excess capacities in China.

Where is India on steel consumption?

India is consuming less than 35 mtpa per trillion GDP. I think none of us would doubt or disagree with a realistic GDP growth in India of anything below 6.50% per annum. Even at this conservation assumption (I say conservative because as I am writing this, I am surrounded by this news coming in on spends on roads, increasing lending, fiscal stimulus, bank recapitalization, etc, etc), India’s GDP will be close to USD 8 tn by 2035. Maintaining a similar steel consumption ratio of 35 mn per trillion (I am not even assuming an aggressive consumption like what was witnessed by USA and China in their respective ‘infrastructure creation’ phase, as I believe that India has always been a little poor on execution), India will require nothing less than 300 mtpa of steel.

Beyond this math, if one were to look for growth drivers, historically following are the six key consumers of steel viz.,

(1) ‘Construction’ (roads, airports, ports, housing) is the largest consumer of steel (50%),

(2) ‘Transportation’ comprising of automobiles, aircraft, rail coaches (16%),

(3) ‘Machinery and Capital Goods’ (14%),

(4) ‘Metal products and alloys’ (14%),

(5) ‘Domestic Appliances’ (3%) and

(6) ‘Electrical Equipment’ (3%).

So if construction contributes 50% to consumption and is having tremendous government attention and focus (and is being driven by public spending), one doubts if the demand for steel in India will not touch 250-300 mtpa over the next 15 years. Several themes like housing for all (affordable housing), roads for all (rural connectivity), power for all (transmission), mass transport like metros are themes under significant works and drives the confidence and conviction only upwards.

So addition of significant steel capacities is more of a compulsion than a choice.

Second – “Steel Trio” to drive immediate capacity additions

While there seems to be a strong logic of India needing that huge quantum of 300 mtpa of steel, the big question I keep hearing is that steel has historically been (and continues to be) a distress sector and hence who is going to add large capacities. In my every discussion where I talk of the need of adding 200 mtpa capacity over the next 15 years, the expression is one of disbelief – in terms of requirement, capability, et cetera. But when India had a capacity of 10 mtpa in 1980, who thought it would become 27 mtpa by 2000 and who in 2000 thought it will become 100 mtpa in 2016 – hence how many of us are believing that it will become 300 mtpa by 2035. To give you another example, I was a cement sector equity analyst in mid ninetees. We were witnessing growth in cement sector and we used to talk of the capacity increasing from about ~60 mtpa to 100 mtpa by 2000. Can you take a guess of what is the total cement capacity in India? It is 420 mtpa, a whopping increase of 7x in only 20 years – and here we are, talking of 3x increase in a span of next 20 years – doesn’t sound to be an impossible task.

So the bigger question is who is going to set up these capacities?

Today JSW Steel (18 mtpa), Tata Steel (13 mtpa) and Steel Authority of India (14 mtpa) together account for ~ 45% of the total Indian steel capacity. Who are the other major players? Some of the larger ones are Essar Steel (10 mtpa), Jindal Steel & Power (8 mtpa), Bhushan Steel (6 mtpa) and Bhushan Power and Steel (3 mtpa). These 7 integrated steel manufacturers account for about 70% of the total capacities – and then there are multiple, fragmented small players accounting for balance 30% capacity.

The top three players have each announced their organic growth plans:

(1) JSW Steel – This company is generating adequate cash and is also comfortably leveraged and has announced some brownfield expansions at Dolvi of about 5-8 mtpa;

(2) Tata Steel – seems to be getting its overseas problems under control, which in turn will start releasing management bandwidth for India operations and is working effectively on its Kalinganagar’s 8-10 mtpa capacity expansion plans and

(3) SAIL – which in spite of having significantly poor operational parameters will continue to grow its capacity, purely on account of social compulsions driven by government pressure. They have too been talking of a minimum of 8-10 mtpa capacity addition.

So the top three integrated steel players, who would be adding anywhere between 20-25 mtpa of incremental steel capacities by 2020, have their hands full, at this point of time.

Third – Grabbing existing capacities – but at the right price. Hence right financial structure and appropriate valuation is the key.

Considering that the Top 3 Indian players are increasing their capacities by about 50% and will increase their market share from 45% to close to 60%, why should someone spend their bandwidth on acquiring any other steel capacity. I believe, there are primarily three reasons viz.,

1. Buying a ready made, high quality asset is always preferable to setting up a new plant, as the later is a long drawn process of acquiring land, clearances, uncertainties and so on;
2. Secondly, why should a large Indian player give away this opportunity for a non-significant Indian or a strategic international metal player to get a toe-hold in the Indian markets;
3. And finally, as long as the price is comparable to setting up a new plant, why should one not just go and acquire the same. However,what premium one is willing to pay would depend on what benefits the acquirer is getting in terms of access to iron ore or coal mines, geographical diversification, ability to sweat its other infrastructure like a port or power plant(s), besides the two variables mentioned above.

So how would any steel industrialist or a private equity fund house evaluate the existing opportunities? The key decision driver is the ‘Right Price’ and ‘Right Structure’ as this would decide the returns that any incoming investor will make on its equity investment. While this is subject to a very detailed due-diligence and also on the ability of the acquirer to enhance operational efficiencies, land and other infrastructure availability for brownfield expansion and so on, I have attempted to do a math from an investor’s perspective.  Let me try to play out the situation with an example.

Let’s take a steel company with a 5.6 mtpa capacity, operating at about 70-75% capacity utilization, selling steel at an average realization of around USD 550/ton and having an operating margin of say around 20% (USD 110/ton) in this current environment (being a commodity business, margins do fluctuate and the same gets reflected in the valuation multiples). Expecting a 12-14% Return on Capital on a sustained basis, one should be looking at a fair enterprise value of around USD 800-900 per ton or a total Enterprise Value of around USD 4.50 – 5.00 bn for this asset. However, as mentioned above, the premium that one would be willing to pay would depend on multiple factors and I am not factoring the same as of now.

Let’s say, this company has a total debt of about USD 7.50 bn. So the first big task is to align the value of debt in the books of lenders and the fair value in the minds of investors. In this case, this gap appears to be about USD 2.50 – 3.00 billion or roughly 35-40%. The balance debt needs then needs to be ‘Structured’ into different ‘Layers of instruments’. Some of these could be simple debt, others could be plain vanilla equity and there could be a class or classes of instruments that could provide some upside to both existing lenders as well as incoming investors.

I have tried to create some of these instruments for the case that we are discussing.

The split could be as under:

Total Debt	USD 7.50 bn. This would be re-structured in four parts, as under.
Part One (33%) – Haircut / Loss	USD 2.50 bn To be considered a loss by the existing lenders.  This is the first (and foremost) point of discussion and which will decide whether the deal will get consummated or not. This is primarily because we are assuming that the fair and viable enterprise value is around USD 5.00 bn.
Part Two (33%) – Senior Debt	USD 2.50 bn To continue as senior debt with market driven pricing and serviceable tenors
Part Three (17%) – Equity infusion to repay debt.	USD 1.25 bn Equity to be brought in by the incoming investors at current book value (which currently would be close to zero or in some cases even negative). This would in a way give almost 100% shareholding to incoming investors. The proceeds to be used to repay existing lenders.
Part 4 (17%) – Convertible instrument.	USD 1.25 bn This is the trickiest piece because as an incoming investor, I would want to maximize my return and hence not give in any upside to anyone else (hence subscribe to this amount and repay to lenders even this USD 1.25 bn) WHILE AT THE SAME TIME, some of the lenders may be looking to compensate the losses that they take on the debt hair cut by having some share in the upside (hence would want to subscribe to this instrument).   This instrument will help achieve two objectives viz., 1. From company’s point of view, if structured well, will reduce interest cost and 2. From investors / lenders perspective, will provide a window for an upside. Let’s assume that the lenders agree to subscribe to these instruments, then a certain ratio of upside sharing will be the next important variable for discussion.

Now assuming that the above structure is agreed upon, how would the Return on Equity look like? With a USD 550/ton revenue, USD 110/ton EBIDTA, USD 450/ton debt, USD 40/ton interest, USD 900/ton EV, USD 750/ton capex, USD 38/ton depreciation, USD 32/ton PBT, USD 24/ton PAT, USD 225/ton Equity – the post-tax ROE is approximately 11%, in line with the returns earned by some of the best performing integrated steel players.

In addition to this, there is a potential upside. Now let’s assume, that the equity starts trading at a PE multiple of 15x. Which means, the market cap would be USD 360/ton or close to USD 2.00 bn for 5.6 mtpa capacity. Current equity infusion would be USD 1.25 bn. So there is a potential upside of almost 60%, in say 2 years. Or about 25% CAGR. Now a sharing of this between incoming investor and existing lenders is an upside for the former and loss reduction for the lenders.

Fourth – Private Equity Funds keen to play an important role in providing equity to strategic investors

Based on the above case study, if one were to extrapolate the numbers for 20 mtpa capacity that is currently on the blocks, the system would need around USD 4.00 bn of plain-vanilla equity and another USD 4.00 bn of structured debt. A total of USD 8.00 bn is a lot of money and the Indian financial markets are still quite shallow to support acquisitions of this scale. India has not too often witnessed Leverage Buyouts of this quantum. Large Global Fund Houses with an Indian strategy to invest in Special Situations, through instruments that provide Structured Equity and have large underwriting ability are best positioned. Hence all the major ones are seeing this as an opportunity to deploy their capital in a meaningful way. The question is how do these Fund Houses go about? Do they bid for these assets independently? Do they partner with any Indian or Global Strategic Steel Player?

As we discussed above, interest for buying these steel assets are from (a) Indian steel leaders (like JSW Steel and Tata Steel), (b) international metal players (like Arcelor Mittal and Nippon Steel) and (c) several private equity funds (like KKR, AION, SSG, Bain, Edelweiss ARC being some of the prominent ones).

Since operating leverage would be a significant driver for equity value creation, it would make immense sense for these PE funds to partner with strategic players (except for someone like Edelweiss ARC who have lately built in-house expertise to operate Indian businesses).

JSW steel and Essar Steel are the two companies that have the maximum opportunity to integrate the acquired business with their ports and power businesses and hence most of the PE Fund houses would aspire to tie up with one of these two steel manufacturers. As far as Tata Steel is concerned, one is not sure how open they would be to an external equity infusion for these acquisitions. In fact, its seriousness for inorganic growth has not been too visible, though they have that uncanny knack of surprising the markets.

Exit has been one of the biggest challenges for most of the alternate investors who have been investing in India. Interestingly, three of the four companies that have been referred to NCLT are listed – Bhushal Steel, Essar Steel and Electrosteel. Besides this, the key companies who are the likely bidders, be it JSW Steel, Tata Steel and SAIL are also listed companies. Thus, it makes far easier for PE Funds to exit their investments, going forward. Further, the multiple instruments through which these funds can structure their investments would provide them different ways to exit through servicing of some debt from operating cashflows of acquired businesses, some fall backs on acquiring investors, incoming investors’ interest to increase their stake and hence certain future stake sales to promoters besides exits through equity capital market. All these assets are of high quality, operating in high demand growth markets, reasonable demand-supply equilibrium and generating operating cash flows. These businesses had less of ‘Profit and Loss’ statement issues and more of ‘Balance Sheet’ problems. Any ‘Balance Sheet’ resolution will provide tremendous financial benefits.

To conclude, the next 5-6 months are full of action. If a resolution won’t happen now, it is unlikely that it would ever happen thereafter. The challenges are several, stake holders are too many, regulations are evolving, negotiations will be lengthy, structuring would be complex and decisions would be painful. But this process and pain is necessary (as well as inevitable) for a better and stress free tomorrow – less stress financially as well as mentally.