Tata Steel-Thyssenkrupp deal: Can two problems equal a solution?
The answer to that will be known only some years down the line, when this joint venture (JV) walks the talk. An equal JV is difficult to pull off, especially if the management is also shared equally. The motivation on both sides to lighten the load of the steel business, on their books and valuations, has to remain strong, to settle any differences of opinion. This, more than any financial engineering, is what can determine the success of this joint European steel project.
Tata Steel Ltd and Thyssenkrupp AG will both take a 50% stake in Thyssenkrupp Tata Steel BV, contributing assets of their respective flat steel businesses, while Thyssenkrupp will also contribute its steel mill services business.
Tata Steel gets an equal share, despite Thyssenkrupp’s steel business earning more in terms of revenues and Ebitda (earnings before interest, tax, depreciation and amortization), and also earning a higher margin (see graphic).
This could be explained by the liabilities that each will transfer to the business and the market value or potential of the respective steel assets. For instance, Tata Steel will transfer €2.5 billion of its senior debt whereas Thyssenkrupp has said it will transfer €4 billion of liabilities, including €3.6 billion of pension liabilities. The difference in transfer of liabilities could possibly explain why the equity value is equal, despite the headline numbers giving Thyssenkrupp the edge.
What do both companies get in return? The steel assets and identified liabilities will move from their books to the JV. The companies have said they will consolidate the JV’s financials under the equity method, which means only the profit or loss of the JV will be included in their consolidated financials. This will lead to a leaner balance sheet for both companies, as there will be no line-by-line consolidation, of revenues and expenses, or assets and liabilities.
How will Tata Steel’s performance change? Its net profit will improve as it will get 50% share of profits from a more profitable European steel business. Its interest cost will decline to the extent it transfers debt. Its India business, which is more profitable, will have a bigger influence on its Ebitda, once the JV is formed. In the June quarter, its Ebitda/tonne at Rs10,623 was double what Europe earned.
On the debt front, if Tata Steel transfers €2.5 billion of debt, it will still retain significant debt which it said is slightly higher than the debt being transferred. The annual report of Tata Steel Europe mentions that gross debt as of 31 March was €6.9 billion (based on the current £ to € exchange rate) and 61% of this are borrowings from the Tata Steel group. While €2.5 billion will be transferred, the rest will be restructured, the management said in a press meet.
While no further details were given, this could imply a write-down in Tata Steel’s books. If that does happen, it would be a significant one-time hit on profits. More details will be known when the JV structure and the value at which the assets are being transferred are finalized.
Once the deal is done, slated to be in place by end-2018, focus will shift to the JV’s performance. The firms have said they expect to see cost savings of €400-600 million as a result of integration and cost- cutting. This may happen over a period of few years.
The bigger project will start post-2020, when the companies intend to assess the JV’s upstream production, liquid steel and hot rolling mills, to see how they can optimize that part of the business, according to Thyssenkrupp. Then, the business can focus more on the value-added parts where the margins are higher. The year 2020 is relevant, because Brexit will be done by then with its impact on the business becoming clear, and on the regulatory front developments on emission trading and punitive trade tariffs will also become known.
The immediate benefits for both companies is clear, both have faced tough times in their steel business due to volatility in prices and competition from cheap imports. They don’t believe their European business can do better by itself. The JV solves their problem by half, one could say. But both are unlikely to be wedded together indefinitely.
There is one critical difference between the two. Tata Steel is a focused steel company and remains so, even after this transaction. Thyssenkrupp has a more profitable capital goods business it would like to focus on, and producing steel is not its main thrust. Recently, the company sold its steel business in Brazil.
At some point, if Tata Steel gets an opportunity to do so, it may favour a higher stake in the JV and Thyssenkrupp may not be averse to it. A listing of the JV could be another option, where it unlocks value for both companies and also make raising capital easier.
The muted reaction in Tata Steel’s share price—it gained by 1.6% on Wednesday—indicates that investors appear to have priced in this event. Since 8 May, the shares are already up by about 60%, partly also due to higher steel prices. How the two firms work to make the European steel business more profitable, and the eventual endgame for the JV, are aspects investors will watch out for in the years ahead.