Monday, February 26, 2007

India Global and the Leveraged Buyout

Puzzlement has been the most prominent among the public reactions to the mega-deals that have seen Indian companies aggressively pursue global players and buy them up. Money that once seemed beyond the ambitions of the country – money that could cover India’s entire defence budget and substantially bridge the fiscal deficit, that most intractable problem of the economy, -- suddenly seemed within easy reach of India’s corporate houses. And a country that once seemed the poor relative in a world where investor interest was the ultimate benediction, seemed to have turned the tables. From desperately seeking foreign investment, India had transformed itself into the source for much foreign investment.

Business pundits and the media though, suffered none of the confusion of the general public, certifying the recent deals as an unequivocal signal that India had arrived on the world stage. Yet for all the euphoria in evidence in these quarters, the response of the stockmarkets was if anything, curiously contrary. Shares in Tata Steel fell sharply the day it announced that it had tied up a mammoth $ 12 billion deal to take over the Anglo-Dutch steel conglomerate, Corus. And the Birla-owned Hindalco was buffeted by similar shareholder scepticism immediately after its announcement that it would take over the Canadian aluminium major Novelis, in a deal costing $ 6 billion.

If the stockmarket were to be considered a reliable barometer of business prudence, then the verdict on corporate India’s two most recent mega-deals has been fairly unequivocal. They have come at too high a price. The Tata and Birla acquisitions in this respect, closely mirror last year’s takeover of the European steel manufacturer Arcelor by the Lakshmi Mittal group. After much competitive haggling which compelled Mittal to successively hike up his bid, he finally had to settle for a merger plan that confined his shareholding to a distinct minority.

By acquiring Corus, Tata Steel has emerged as the world’s fifth largest steel manufacturer in terms of capacity. On annual sales revenue computations, it would be catapulted to the mid-200s in rankings in the Fortune 500 global list. This would put it well ahead of Reliance Industries and Indianoil in the global list of Indian corporations.

Yet with all this, the adverse reaction of the stockmarket needs to be considered, because Tata’s acquisition has, after a host of modestly sized deals, brought the practice of massively leveraged buyouts to the Indian corporate landscape. Modes of financing the $ 12 billion (or Rs 53,000 crore) deal still remain secret.

The initial offer made by Tata was for a takeover valued at $ 8.8 billion. At this level, the plan was to invest $ 3.5 billion as equity from Tata and raise the rest through debt. The calculation, simply, was that the increased debt of $ 5.3 billion (or roughly Rs 23,000 crore) could be serviced through the cash flows that the Corus acquisition would bring.

Intense competition from a Brazilian steel company forced the Tatas to increase their offer in stages. Financing a deal finally concluded at an immensely higher cost, could now require certain extraordinary recourses. Apart from the money that the Tatas can summon from the coffers of their cash-rich companies, a sell-off in the business group’s principal revenue source, the Tata Consultancy Services (TCS), now seems inevitable. And even when this option has been pushed to the limits of its feasibility, Tata Steel would need to raise fresh capital through a public issue of shares.

With all that, the debt that the company would need to take onto its balance sheet is immense – estimates range from Rs 11,000 crore to Rs 15,000 crore. Tata Steel seems to have gambled enormously on the future, on the strength of about five years of sustained growth in sales, when internal accruals were sufficient to finance expansion. The company’s debt, roughly matched with equity in 2003-4, rapidly fell in the years afterwards. With the Corus acquisition, debt is likely to spiral to a level several times higher than equity, even as the shareholding pattern becomes more widely based.

Most details of the Tata Steel deal remain obscure at the moment and shareholder sentiment tends to view the company’s international foray as ambition carried to excess. Market analysts concur with the short-term forecast but counsel that the long-term investor should keep faith. The acquisition of steel capacity in Europe, it is argued, will significantly augment Tata’s long-term commercial synergies. The company will gain access to a lucrative market while optimally leveraging access to low-cost raw material and labour. It could supply highly competitive crude steel, utilising capacity in Europe to generate value addition that would significantly improve overall profitability.

All this would be reassuring if Tata Steel had the functioning capacity to optimally utilise Corus facilities. That is quite far from being the case, since Tata’s greenfield projects in Chattisgarh and Orissa will not be going onstream till well after 2012.

With the manifold rise in its level of debt, can Tata Steel negotiate this zone of uncertainty? The many uncertainties in the global environment make this a question more conveniently evaded than addressed. Real estate, automobiles and a limited number of other boom sectors have been a major engine of growth for the global economy over the last half-decade. But these sectors, which picked up the slack from the collapse of the “dot-com” bubble, are themselves approaching a major shakedown. If there is a generalised downturn in the global economy, Tata Steel’s fortunes – which have effectively been gambled on an ambitious acquisition in Europe – could well plummet.

Similar concerns surround the Hindalco takeover of Novelis – effectively a case of David not defeating, but buying over Goliath – since the company that has been bought up had on last reckoning, sales revenues ten times larger than its buyer. As with the Tata takeover of Corus, Birla’s acquisition of Novelis was followed by serious questions of how the corporate debt that had been bought up would be dealt with.

Few market analysts on Dalal Street expected the Novelis deal. On studying its details, still fewer could understand its rationale. Hindalco has, aside from the borrowing it has engaged in for the purchase of Novelis, also inherited a significant burden of debt that Novelis has in its own recklessness acquired. And this has been happening at a time when the global market in aluminium was not quite buoyant, indeed, showing positive signs of meltdown.

The clinching argument in these circumstances would be that international banks are unlikely to bet unwisely. If they have advanced serious money to the Tata and Birla groups, the underlying business propositions must be sound.

At the risk of seeming inconsiderate, it should be borne in mind that these very banks also lent with gay abandon to all of Latin America in the 1970s, thus creating the conditions for the debt bomb explosion of the 1980s. So too, did these banks lend with few reservations to the U.S. corporate sector through the 1980s. Seduced by the boom in share prices, they paid little attention to the economic fundamentals, thus setting the stage for the asset value meltdown of the 1990s, which pushed the U.S. economy into a recession that only the “dot-com” bubble retrieved it from.

If the Tata and Birla global conquests are a prelude to similar enactments in future, that is sufficient reason why Indians should be wary of media-induced euphoria and debt-financed illusions of a “global Indian takeover”.

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