Tata Steel or Hindalco: Where will you invest?

Tata Steel and Hindalco, behemoths in the domestic metal industry, have seen their share prices getting battered over the past few months, even faring worse than the benchmark Sensex. The key culprit, according to us, was the leveraged buyout that both these companies indulged in. Hence, any assessment of the future outlook and the investment worthiness of these companies should not only include the analysis of their historical standalone performances but should also include an analysis of their leveraged buyouts. In this article, we have attempted to do the same. Let us first glance through the historical standalone performances of each company.

Profit and Loss A/c: As far as growth in revenues is considered between the period FY03 and FY08, Hindalco registered higher than Tata Steel, while bottomline growth for both the companies stood at nearly same levels.

Profitability Ratios: The operating margins of Tata Steel are best in the steel industry owing to its own captive iron and coal mines. Hindalco is among the lowest cost producer of aluminium in the world. However, its copper business drags the operating margins as it is not 100% reliant on its own copper mines and has to depend on external source for the raw material, which in recent years had become quite costly.

Return ratios: The average return on networth (RONW) between FY03 and FY08 of Tata Steel is twice that of Hindalco. This is an impressive achievement by Tata Steel as its debt equity ratio was nearly the same as Hindalco. Even the average ROIC of Tata Steel is higher than that of Hindalco, thus pointing to the former's better ability at allocating capital as well as the fundamentally strong nature of its business. As far as dividend payout ratio is concerned, here too, the average payout ratio of Tata Steel is higher, nearly double that of Hindalco during the same period.

Now, let us move on to the highly leveraged acquisitions done by both the companies in recent years.

Tata Steel and Hindalco did a leverage buyout of Corus and Novelis respectively. Tata Steel's shareholders made equity contribution to the tune of Rs. 159 bn for Corus while Hindalco's shareholders shelled out Rs. 125 bn for Novelis (assuming the remaining fund raising will have a D/E ratio of 1). Now for the deal to be value neutral, the contribution made by both the company's shareholders will have to be atleast worth the average valuations enjoyed by them in the past five years i.e. 2.5x for Tata Steel and 1.5x for Hindalco. Thus, the value that has to be created for equity holders of Tata Steel is roughly in the region of Rs. 397 bn while for Hindalco's shareholders, it is Rs 188 bn.

As per the last available copy of Corus' consolidated balance sheet, its 2006 book value was around Rs 287.2 bn in rupee terms. Thus, assuming P/BV multiple of 1x (a huge discount to Tata Steel considering Corus's lower margins and returns on capital), we arrive at the intrinsic value of Corus, which we believe to be in the region of Rs 287 bn. Furthermore, Tata Steel's management expects synergies of Rs 20.3 bn (US$ 450 m) per year from the Corus acquisition. Thus, if we value these synergies to perpetuity considering a discount rate of 10%, the total value of synergies is around Rs 203 bn (assuming an exchange rate of Rs.45/US$). Thus, the total value from the Corus deal is sum of the total value of synergies and intrinsic value of Corus i.e. Rs. 490 bn. Since this is slightly higher than the sum of Rs 397 bn that was required for the deal to be value neutral, we believe that if all our assumptions hold true, then the Corus acquisition might turn out to be a value creator for Tata Steel shareholders.

Moving on to Novelis, although no official figures are available, it was being believed that at the time of acquisition, Novelis' book value stood in the region of Rs 17 bn. Here too, we assume a P/BV multiple of 1, thus resulting into intrinsic value of Novelis of Rs 17 bn. However, unlike Tata Steel, there seems to far less scope for synergy exploitation for Hindalco as business models of both the companies appear vastly different. While Hindalco is heavily focused on the upstream segment, Novelis' business model is geared heavily towards the downstream segment. Thus, with no huge tangible synergies in sight, we expect the deal to remain value destructive atleast in the near term.

Conclusion: As far as valuations are concerned, both the companies are currently trading at attractive valuations. However, considering the financial track record and a simple back of the envelope analysis of acquisition made by both the companies, it is not going to be a difficult task to pick one over the other.