Essar Steel banks on investor to pare debt

1 December 2015

The past two years have seen Essar Steel take several steps to look like a healthier version of itself. After reporting a net loss of Rs 1,054 crore in 2013-14, it turned a profit of Rs 466 crore 2014-15 in spite of the tough conditions faced by the industry as a whole: slowdown in demand and dumping from China, Japan and South Korea.

Some time back, the Union government provided some relief to domestic steel makers by imposing a safeguard duty on flat steel products, the kind that Essar Steel makes, and there is talk of a possible improvement in demand in the coming year.

A bigger concern for the Ruia family-controlled Essar Steel is its debt - Rs 34,928 crore at the end of March 2015 - the interest payout on which threatens its cash flows. While the company does not want to disclose it interest outgo, earlier this month, it gave some indication of how it plans to pare the stockpile of debt: it will induct a strategic investor.

Some analysts are of the view that the weak sentiment in the industry has brought valuations down to a level where strategic investors may be interested in the company. "The current down-cycle in the steel industry is fairly close to the bottom. Strategic investors enter with a 20-25 year perspective in mind and such down-cycles are ripe opportunities for them to come in, given that valuations are at a discount," says SKS Capital & Research Portfolio Manager Giriraj Daga.

The desperation among banks to exit Essar Steel, as they look to reduce their exposure to the stressed metal sector, could reduce the valuation further. Experts peg Essar Steel's current enterprise value at $6-7 billion. "As steel companies are over-leveraged, banks will be willing to take a significant haircut on the book value," says an analyst with a local brokerage.

However, finding a domestic buyer may be a challenge for the Ruias. Given that the local producers are all struggling, they do not have the financial muscle to service Essar Steel's huge debt.

Thus, experts say the stake sale could be a good opportunity for foreign companies, especially those which are looking to strengthen their position in the Indian infrastructure sector - regulatory requirements mandate foreign companies to source at least 40 per cent of the raw material required for infrastructure projects within the country.

"It makes sense only for an overseas investor to walk into Essar Steel as it will give it access to a ready-made plant infrastructure and can lower its imports for such projects. Plus, it will also insulate it from the varying duty patterns," says an executive with A Maheshkumar & Co, who is also a member of the Bombay Iron Merchants' Association (BIMA).

The opportunities in the infrastructure sector presented by proposed projects such as the Mumbai-Delhi corridor, Mumbai metro, eastern freight corridor and Mumbai-Ahmedabad corridor are indeed huge. In all, infrastructure projects worth Rs 10,55,580 core are in the pipeline, with foreign players like Posco, Hyundai, Sumitomo and Nippon vying for a chunk of this.

The synergies between Essar Steel's various plants could also be a big draw for foreign companies. Three of its plants-one each in Hazira in Gujarat, Visakhapatnam in Andhra Pradesh and Paradip in Odisha- are close to ports. This means the company has an advantage when it comes to transporting steel products and raw materials.

While on the west coast, Essar Steel owns a 30-million-tonne deep draft dry bulk port at Hazira, on the east coast, its pellet plant is linked to the Visakhapatnam port through conveyors to enable easy movement of raw material and finished products in and out of the plant. This proximity to a port also facilitates movement of goods between the company's two plants on the east and west coasts.

"The facilities are also relatively young and this is another advantage for an investor as efficiency levels of the plant will be much higher," says Pritesh Jani, analyst with Religare Securities.

Hampering prospects

However, the lack of assured supply of raw material is a big problem. The crackdown on illegal iron ore mining has added to the cost pressure of steel manufacturers in India, making the current downturn even harder to navigate. Once the world's third-biggest iron ore exporter, the country now imports the bulk of its requirement.

The government's plans to auction iron ore mines could ease the process to some extent and put the industry on target to achieve capacity of 300 million tonnes by 2025 (from 10 million tonne now).

"Essar Steel can look to get captive raw material source once iron ore auctions takes place. That will not just further lower its input costs but will also allow it to compete better with peers like Tata Steel which already have cheap iron ore source," says the BIMA trader.

But there are other challenges facing Essar Steel. More than half of its 10-million-tonne steel-making capacity is gas-based. Given the company's highly leveraged balance sheet, procuring gas from abroad won't be feasible either. Industry experts say even if gas is available globally, it will come at a very high price for the new investor. It is unlikely this situation is going to change.

On several occasions, Group CEO Prashant Ruia has admitted that the company does not see any significant increase in domestic gas availability anytime soon. The lack of gas supply has brought down the capacity of the company's Hazira plant to 40 per cent.

These factors, along with the company's poor track record with banks and the investor community, mean Essar Steel's road to revival may be a long one.