The Long Hangover

Debt leads to fragility’ is a key message that Nassim Nicholas Taleb, risk analyst and author, has harped on for a long time. This lesson is being driven home to an increasing number of Indian companies, which had binged on debt to fuel large acquisitions a decade ago. The first wave of Indian companies to have gone global during the 2003-07 bull market is still facing the long hangover of that party.

On 11 April 2016, Tata Steel announced the sale of its long products division in Europe for ‘a nominal consideration’ — reportedly £1. This came less than two weeks after the company announced that it was seeking to “explore all options for portfolio restructuring including the potential divestment of Tata Steel UK, in whole or in parts.” Tata Steel has already suffered a hit of £2 billion (approximately Rs 19,000 crore) in the past five years from its UK business. The proximate cause for the distress is the slowdown in China; as steel demand in China has reduced, Chinese steelmakers are dumping the metal across the world, hitting profitability of Tata’s UK operation.

Effectively, Tata Steel has sold off about one-third of its European capacity for just £1. The debt position of the company remains unchanged, says brokerage house Morgan Stanley in its note on the transaction. This means the company has literally given the asset away. Even so, the development is being seen as positive — brokerage house UBS termed it a “welcome conclusion of Tata Steel’s long-running attempts to dispose of these assets”. Morgan Stanley has an ‘overweight’ rating on the stock while UBS rates the company a ‘Buy’.

A leveraged Buy
The sale marks a full circle from 2007, when Tata Steel had won a bidding war to acquire European steelmaker Corus — with operations in the UK and Netherlands.

The year 2007 was also the centenary year for Tata Steel — it had taken the company 100 years to reach an annual capacity of 5 million tonnes of steel — the Corus acquisition added 21 million tonnes in one stroke. At the time, it had seemed a masterstroke.

The acquisition had come with a hidden risk–increased leverage. Total borrowings of the company, at a consolidated level jumped from Rs 3,377 crore in FY06 to Rs 24,925 crore in FY07 and Rs 53,592 crore in FY08 (see An Unprofitable Deal). Subse-quently, Tata Steel — and the rest of the world — was hit by a black swan — the 2008 global economic crisis. The year 2015 saw another black swan — China’s slowdown and subsequent dumping by Chinese steel makers globally. Both of these events couldn’t have been forecast — and the company management cannot be faulted for not having foreseen them — nobody else did.

However, the high leverage of Tata Steel has made the situation much worse — which is why it is now trying to sell assets in a bad market — instead of holding on till conditions improve. The Corus acquisition allowed Tata Steel to ramp up its capacity by 400 per cent at one stroke at the cost of high debt. A similar move through organic expansion would have taken decades — and wouldn’t have been entirely debt driven — but more sustainable.

The Debt Stampede
Another Indian steelmaker facing headwinds is Essar Steel, which is in talks with banks for restructuring its debt, pegged at Rs 30,000 crore. “We have voluntarily initiated the process to induct a strategic / financial partner, and have appointed SBI Caps and ICICI Securities as advisors for the same,” the company said in a statement.

Giving reasons for the crisis, the company blamed “huge dumping of steel by China at predatory prices, which is an industry issue and the entire steel industry is bearing the brunt of cheap imports”. Essar Group too had gone in for overseas acquisitions — though not at the scale as Tata Steel. In 2007, it acquired Canadian firm Algoma Steel for $1.58 billion. The group later picked up a greenfield steel project in Minnesota, US — where it proposes to build a 7 million tonne/year steel plant. The US plant has been delayed by several years, while the Canadian arm is in financial distress.

It wasn’t just the steelmakers — a number of other Indian companies went in for outsize overseas acquisitions in that period, fuelled by debt. Post-2008 saw these companies trying to sell off the same assets, sometimes for less than the purchase price. Suzlon, Bharti Airtel, Havells and GMR had all acquired large overseas assets during the 2003-07 bull market, sometimes later. Some of these deals ended up being reversed, sometimes at a loss.

In March 2016, Bharti Airtel announced sale of its tower subsidiary in Tanzania. In January, it had announced sale of its telecom businesses in two African countries. Bharti had acquired Zain Africa BV in 2010 for an enterprise value of $10.7 billion, funded entirely by debt — it has so far sold stakes in tower arms in nine countries and telecom business in two. Bharti Airtel says that its philosophy is to divest passive infrastructure assets and it remains open to selling such assets for its other Africa operations as well.

In December 2015, electrical appliance maker Havells announced a sale of 80 per cent stake in Sylvania, a company it had acquired in 2007. In a note on the sale, brokerage house IDFC Securities termed it a positive and said, “Sylvania has been a drag over the past few years (losses and lower return ratios). The sale would provide enhanced management bandwidth and surplus cash for the domestic business.”

In January 2015, Suzlon announced sale of European subsidiary Senvion to reduce debt. Senvion was earlier known as REPower and had been acquired by Suzlon in 2007 for €1.4 billion. Part of Suzlon’s problems was due to the high debt it had taken on to fund its European acquisitions. “Consolidated debt jumped from Rs 400 crore in FY05 to Rs 17,800 crore in FY15 due to heavy borrowing to fund the acquisition of REPower,” says brokerage house Centrum in a report on Suzlon. The company had earlier sold off in phases another European acquisition — Hansen Transmissions, a company it had acquired for $565 million in 2006.

In a statement to BW, Suzlon says that the two transactions were “in line with Suzlon’s strategy to focus on the Indian market and additionally to high growth markets like the US and emerging markets like China, Brazil, South Africa, Turkey and Mexico. It helped strengthen our balance sheet and also reduce debt”. Following the Senvion sale, Suzlon’s debt is now a more manageable Rs 7,826 crore.

Twin Risks
There are two common features in the large foreign acquisitions — an increase in complexity and an increase in leverage. Together, they mean much greater risk.

A company with operations across multiple countries is working in a more complex environment and is affected by a larger number of factors. For instance, luxury car makers saw their China sales drop in mid-2015, which some observers blamed on an anti-corruption crackdown in that country. This could affect a company such as Tata Motors, which has a significant presence in China.

Inorganic growth means the complexity of a company’s operating environment goes up dramatically and it becomes vulnerable to a variety of factors — meanwhile, the management’s ability to understand such risks and deal with them may not have gone up overnight.

Secondly, by acquiring large targets, companies such as Tata Steel, Suzlon and Havells have also loaded up on debt. When the cycle turns — as it does eventually — a leveraged company is in a far more vulnerable position compared to its counterparts; and has a much lower ability to ride out a bad market. Old timers may recall the hedge fund Long Term Capital Management. Set up in the 1990s, the fund counted Nobel laureates in economics as its principals. With equity of $5 billion, the fund had built up derivative positions of $1.25 trillion — or a leverage of 250 times. The fund generated good returns for some years. Then in 1998, when markets went awry following Russia’s default on its bonds, the fund’s entire equity melted away in just a few weeks. Growth using leverage is not sustainable.

Indian steelmakers seem to be badly off in the debt department. For instance, the world’s top steelmaker ArcelorMittal — formed in 2006 after India born L. N. Mittal’s Mittal Steel bought out European firm Arcelor — has a net debt of $15.7 billion, or Rs 1.04 lakh crore against borrowings of Rs 81,400 crore for Tata Steel. However, ArcelorMittal is three times larger than Tata Steel in terms of steel production — so the burden is not as bad. In another stark difference in due diligence, Mittal Steel paid 4.5 times the annual revenue for Arcelor as compared to 9 times the revenue paid in the case of Corus by Tata Steel.

ArcelorMittal’s recent experience shows the pain is expected to go away — in time. The company recently declared its 2015 results, a loss of $7.9 billion. The stock price fell sharply in the days following the results, and at one point, the market capitalisation of the entire company was less than one-quarter of the price that Mittal had paid for Arcelor a decade ago. Since then however, the shares have risen sharply. As steel production in China is scaled back and weaker steelmakers go out of the market, the survivors are expected to do better.

A bad market is also a good time to pick up assets cheaply. Unfortunately, Indian steelmakers seem to be stuck on the other side of the bargain — the sellers who are getting rid of the assets at bargain prices. What could have been an opportunity increasingly looks like a lost decade.

The author is an analyst and a writer