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Tata Steel and the Corus buyout structure: Not Worth It

Tata Steel (Tisco) revealed how it will fund the Corus Acquisition ($12.9 billion, or 52,000 crores). Out of this, Tata Steel will provide $4.1 billion (Rs. 17,750 cr).
1) Promoters (Tata Sons) have, on April 18, converted preferential allocation of 2.85 crore warrants to ordinary shares at Rs 484.2 a share. That’s a net amount of Rs. 1380 cr.
2) Rights issue at 1:5 (five for every one share held) at Rs. 300 per share. This is a 40% discount to current prices of Rs. 500 per share. They’ll raise 3,660 cr. this way, giving out 12.2 crore shares.
3) Preference shares of 1:7 (1 shares for every 7 you own) for Rs. 4350 cr. at 2% interest, convertible at a rate between Rs. 500 and 600 after two years. Let’s assume the price to be Rs. 550. That’s an additional 7.91 cr. shares.
4) A foreign issue of equity for about $500 million (Rs. 2100 cr.) Let’s also assume a price of Rs. 550, and this yields us another 3.82 crore shares issued for this.
5) A “quasi-equity” issue (meaning: We are going to dilute, we just wont tell you how much right now) by Tata Singapore, for $1.25 billion. Let’s assume Rs. 550 per share for this, gives us an equity dilution of 9.77 cr. shares.
Internal Accruals:
1) Own cash of Rs. 3000 cr. ($700 million)
1) External Commercial Borrowing of $500 million (Rs. 2170 cr)
2) UK Debt, already taken and with no recourse to Tata Steel: $6.14 billion, about Rs. 26,400 cr.
3) Tata Singapore has taken on debt of $1.41 billion (Rs. 6063 cr)
Now Tata says the cost of servicing this debt is 4.3%. Let’s apply that to all the debt they’ve taken, which totals 34,635 cr. The cost of servicing this debt is 1489 cr.
Let’s now see how much Tata Steel earns today, and how much it stands to earn. The last four Quarter earnings are Rs. 3901 cr. This translates to a current EPS of Rs. 67.21 per share, at a current share capital of 58.05 cr. shares. (This is a P/E of 7.5)
Corus, from their last results, has shown a 269 million pound profit for the first three quarters of 2006 (fourth quarter results are not available). But if we annualised it and used a pound rate of Rs. 84, we get a Net Profit of Rs. 3013 crores for Corus. (Note: this is LESSER than Tata’s annual profits)
Now let’s add this up and deduct the cost of servicing the extra debt, and we get a consolidated net profit of Rs. 5426 cr. for the merged entity. With all this equity changes, the total equity will increase to 94.6 cr. shares. For the additional share dilution, the real EPS will then become Rs. 58 per share.
At the current share price, the P/E will then be Rs. 8.81, a 17% premium to today’s price. For a commodity business this is quite high, and other steel businesses are available for lower than that – a P/E of 6 to 7 is probably more sustainable. I would think that the price of this share should be between Rs. 430 and Rs. 440 for it to be a good buy.
Unfortunately, this is not how the company will show it. In Indian law you are allowed to “ignore” future dilutions, even if the money has come in today. Meaning, they will not show the increased capital (through the preference shares or the rights issue) until after the conversion to shares; but that is terribly unfair, because the money is already paid! So they will show you lesser number of shares than the above, and therefore a higher EPS.
This is unfortunate because it’s legal. But you should read between the lines and find the true EPS rather than going by what the company reports.
There are other factors that will affect the merger. Consolidation can take two years when companies of this size merge, and the positive effects of that consolidation will be visible three years away – in 2010. Till then the profits will be subdued, though the reported EPS will be higher.
Further, to control inflation, the Indian government wants steel companies to keep prices lower. That is not a good sign.
But the positive is that in the long term, Tata’s lower costs will help the merged company make much higher profits. That is a long time away – 2010 I would expect – and steel, being a cyclical, may have a downturn in the meantime. Any steel price depression will severely affect the real EPS.
My recommendation is: Don’t buy at this price. If you already own shares sell them – a better price would be far below this, around Rs. 430 to Rs. 440 per share. And I think this share will reach there in the next three quarters – that is, by October 2007. That will be a better time to evaluate purchasing this stock.
My analysis:

1) From Business Standard:

At the current price of Rs 510 a share, the effective cost per share—if one subscribes to the rights issue at Rs 300 a share—is Rs 475. At Rs 475, the stock trades at a multiple of 6 times estimated FY08 earnings and around 5.5 times FY09 earnings. That is not cheap for a commodity play over a two-year horizon.

2) Some of the above is unfair. Tata Sons, in 2006, paid Rs. 51.6 per share for 2.85 cr. warrants, convertible they said at Rs. 516 per share “or as per SEBI standards”. They also paid Rs. 516 for about 2.7 cr. shares. Now when the price is around 500, they converted the warrants at Rs. 474.2 per share! At a time when Tata Steel really needs the money, Tata Sons is paying so much lower than market price. But you could say that they did pay Rs. 516 per share in August last year, so it’s only right that they get a lower price now. Anyways that’s a lost story.
3) The Rights issue is at 1 more share for every five shares you own. So if you buy five shares today at Rs. 500, you could buy 1 more share at Rs. 300, giving you a total of 6 shares, for Rs. 2800. This is equivalent to Rs. 467 per share, to which the share will come down, obviously.
That means a) buying now or owning shares now and not subscribing to the rights issues is downright dumb – but many investors who have no time to handle a rights issue, will do exactly that, and in the process lose 5% of their share value. Rule No. 1: If you own Tata Steel shares, and have no time to handle the “rights issue” paperwork, or can’t pay Rs. 300 for every five shares you own, SELL all your shares immediately.

4) I have a short position in this stock. I want to put my money where my mouth is, so I’ve bought a put option on this stock to see if I can actually make profits from my analysis.

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