The acquisition of a steel plate mill and a steel pipe mill in the US from Jindal SAW Ltd by JSW Steel Ltd has left the market unimpressed, with the stock falling around 5.5% over the last couple of days, despite a small jump on Wednesday. The company’s rationale for the acquisition is simple: JSW Steel’s current capacity is 3.8 million tonnes (mt), of which 2.8mt are being used for value-added products. The balance 1mt of steel slabs are currently being sold in the open market. JSW Steel says it will ship these slabs from India to be used in the US plants, leading to lower costs and higher margins for the US operations. There will also be gains from supplying the right size of slabs, instead of having to fit them in the US, which not only entails higher costs but also results in higher amount of scrap, reducing yields. The plants are currently running far below capacity—the JSW management attributes it to a lack of management focus—which has prevented their upgradation and modernization. JSW’s strategy is to improve capacity utilization, add capacity and improve margins.
The concern is whether JSW has paid too much for the plants. The management says the plants have an enterprise value of $900 million (Rs3,690 crore), of which JSW is acquiring 90%, which makes the payout $810 million. Of this, $150 million will be pumped in as equity and $230 million as debt guaranteed by JSW; the balance $430 million is non-recourse debt on the US entity’s balance sheet.
An additional $61 million will be required to upgrade the US units. JSW management says it has paid “6.25 times proforma Ebitda (earnings before interest, taxes, depreciation and amortization) of $144 million.”
But analysts point out that this is merely a proforma number, after taking into account all kinds of adjustments, including the gains to be made on shipping the steel slabs from India. The actual Ebitda of these units is estimated at $75 million, which makes the acquisition cost very high indeed.
Furthermore, JSW Steel has a massive expansion programme in place in India which will take its total capacity to 10mt per annum and the estimate is that the debt-equity ratio for the consolidated entity will now be around 1:1.4 or so, although the management says the ratio for the standalone company will still be 1:1. The average cost of the debt is estimated by the management to be 2.5% over Libor (London interbank offered rate), a benchmark rate.
The current credit environment in the US is another concern—not only for funding requirements, but also whether the credit crunch will lead to a slowdown in the economy. Analysts also point to plenty of new capacity coming up in steel plates over the next couple of years, which might lead to pressure on prices.
These factors have overshadowed the positive factors such as the proposed setting up of a plant that will convert low-grade iron ore into high-grade ore, or the Rs106 crore of carbon credits that will be booked in the current quarter, or the settlement of a Rs50 crore arbitration dispute.
The Bombay Stock Exchange’s (BSE) IT index is among the bourse’s worst performing sectoral indices in the correction that started on 24 July. The index has fallen 12.4%, compared with a fall of less than 10% in the Sensex. What’s strange about this is that the underperformance was despite a 2% depreciation in the rupee, which would improve profit margins of software companies by 80-100 basis points.
What gives? The markets are now worried about the impact of the credit crunch in the US markets on software companies that thrive on outsourcing work from US clients. Analysts say the worry is about a squeeze on IT budgets by clients in the financial sector, which is the worst hit in the US crisis. The top four players in the industry have an exposure of between 24% and 43% to the banking, financial services and insurance (BFSI) space.
It’s interesting to note that Satyam Computers Services Ltd’ shares are the worst hit among the top four players, with a drop of nearly 20%. Satyam, incidentally, has amongst the lowest exposure to the BFSI segment, at 24%, based on its latest results. Shares of Tata Consultancy Services Ltd—which has a much higher 43% exposure to the sector—have fallen at a lower rate of 12.5%. The higher fall in Satyam’s shares has probably got to do with the relatively high level of FII (foreign institutional investor) ownership in the company, besides the fact that its shares had outperformed in the preceding months.
For the sector as a whole, the concern is clearly about the situation in the US. It may be months before a clear picture emerges about the extent of the problem and its impact on Indian outsourcing firms, but the markets seem to be taking the call that it is better to be safe than sorry. But, there are some sections in the market that see value in IT stocks at current levels, especially since the rupee has depreciated. As Goldman Sachs’ Economics team points out in a recent report, “Services exports are traditionally more demand-inelastic and may be less affected. Indeed, the need to save costs in the US may lead to more service outsourcing.”
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