India’s largest private sector steel firm Tata Steel Ltd’s valuation has risen by about 45% since news of its Corus Group Plc. acquisition first hit the markets in October 2006. Apart from the US market, steel prices have been strong since the acquisition. And the fact that Corus has a high operating leverage has led to expectations that profit growth would be super normal. Corus’ results for the June quarter supported this theory. The operating profit of overseas subsidiaries (including a marginal contribution by NatSteel Asia Pte Ltd and Millennium Steel Public Co. Ltd) stood at Rs3,200 crore, much higher than the combined profit of Rs2,265 crore reported by overseas subsidiaries in the March quarter.
But consolidated results for the September quarter, which were released only in late January, show that the high leverage can even work against the company. Operating profit of the overseas subsidiaries fell 15% compared with the June quarter as higher raw material costs and other operating expenses eroded margins.
Apart from high operating leverage, Corus also has a high financial leverage. So, after accounting for higher interest cost, profit before tax and exceptionals fell by as much as 60% compared with the June quarter. As a result, although the stand-alone business did well to report a 10% sequential increase in pre-tax profit, consolidated profit fell by 25% because of the sharp drop in Corus’ profit.
Now, although Tata Steel reported decent numbers on a stand-alone business for the December quarter, with operating profit growing by 15% year-on-year, what’s more important is how Corus has fared. This may take a while, but investors must note that the operating and financial leverage they are betting on can also work against the company.
This is not to say that the Corus acquisition is certain to work against the company. The company has already achieved 30% of the integration benefits of $450 million (Rs1,773 crore). The company’s non-recourse loans are linked to the London interbank offered rate (Libor), which has fallen sharply in the past three months. Besides, Corus’ technological expertise has enabled Tata Steel to an entire gamut of steel products to customers. But on the other hand, prices of iron ore have risen sharply and coking coal is in short supply as well. Tata Steel’s Indian operations, of course, have the benefit of captive mines, which hedges against raw material price increase.
But Corus would have to raise prices again, profitability will be under strain. That may not be as easy given the prospects of a slowdown in the US. Indeed, the company told analysts in a recent interaction that some European markets already witnessed a slowdown in demand in the December quarter owing to high stock levels. Perhaps, there’s a case for tempering return expectations.
The January crash has depressed valuations in stock markets across the world, seen from the Standard and Poor’s (S&P)/Citigroup Inc. price-earnings multiples. The one-year forward multiple for the World index was 13.7 and for the Emerging Markets (EM) index 13.87 on 31 January, compared with 15 and 15.6, respectively, for the World and EM indices as on 31 December. Clearly, emerging markets fell harder in January and their premium over the World index has declined. For the Indian market, the one-year forward PE multiple has fallen from 25.62 at the end of December to 21.57 at January end. According to the S&P/Citigroup indices, we remain the most expensive market in Asia—their China index has a one-year forward PE of 18.44.
Foreign institutional investors (FIIs) may be selling equities, but that has neither stopped foreign fund inflows to the country, nor has it stopped the Reserve Bank of India (RBI) from continuing to buy dollars to prop it up against the rupee. RBI data show that for the week to 18 January, foreign exchange reserves rose by $3.1 billion. The previous week had seen an addition of $5.5 billion. A. Prasanna, economist with ICICI Securities Ltd, says he believes that, net of the valuation effect, there have been net inflows of $12-13 billion in the last three weeks.
The impact of the inflows is also seen from the net foreign exchange assets of RBI, which increased by 41.9% year-on-year as on 18 January. A few weeks ago, on 21 December, the year-on-year growth rate of RBI’s net foreign exchange assets was 37.5%.
Does that mean there are other sources of funds apart from FII flows to the equity markets? Bankers say the reason is probably the high-value initial public offerings that hit the market and have been heavily subscribed by FIIs. Yet another reason, they say, could be that RBI had bought dollars earlier in the forward market and the impact of those transactions is being felt now. It’s also possible that the growing interest rate differential may also be having an impact, although bankers say the impact of that is likely to take some time, as companies opt for cheaper foreign funding.
Whatever be the reason, it’s ensuring that money supply growth continues to increase and liquidity continues to be abundant. Year-on-year money supply (M3) growth has been rising in recent weeks, with the rate of growth going up from 21.4% on 7 December to 23.8% on 18 January.
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