Ind-Ra: Acquisition of Stressed Steel Assets Brings Focus on Off-Balance Sheet Liabilities

Considering the ongoing brownfield expansion, operator investors, if successful in bidding for stressed assets, may further increase their off-balance sheet risks says India Ratings and Research (Ind-Ra). An off-balance sheet risk arises from obligated future payments to financial partners, unexpected financial support to be extended to target companies in the near term, lender's requirement for debt undertakings such as letter of comfort, and other merger related challenges. This, coupled with existing brown field expansion related non-funded liabilities (capex letter of credit) and capital commitments could add significantly to the overall off-balance sheet liabilities.

The agency believes the steel sector is likely to consolidate in FY19 with the acquisition of large stressed assets by domestic majors. The top three players including Steel Authority of India Ltd ('IND AA-'/Negative), JSW Steel Ltd ('IND AA-'/Negative) and Tata Steel Ltd ('IND AA'/Rating Watch Evolving) could constitute 60%-65% of India's steel production. Consolidation will benefit large steel players with economies of scale and better bargaining power on sourcing, which would improve the product profile. Further, acquisitions provide immediate availability of capacity and improve the market share in a demand-growth scenario as large players are already operating at high levels (80%-90%). JSW Steel and Tata Steel have demonstrated track record in inbound mergers and acquisitions than outbound growth ventures. JSW Steel acquired Ispat Industries Ltd in 2011 and Welspun Maxwell in 2014, converting into a major shareholder, and consolidated the financials following the turnaround of assets. Similarly, Tata Steel completed major expansions through structures, which were consolidated at a later stage.

No Immediate Impact on Balance Sheet: Ind-Ra expects acquisitions to not be significantly leveraged, as the final bid will be based on sustainable debt framework for the acquired asset. Further, the sector is on an uptick with improved demand growth prospects in the end-user segment, which will support margin improvement and robust cash flows. An upfront cash infusion in some of the operational stressed assets may be relatively modest than balance sheets of large players. The acquirers' are likely to ring fence themselves from the target company to avoid consolidation of financial accounts, until the latter's turnaround. Timely equity raise will mitigate high balance sheet risks. The agency has revised its FY19 Outlook for the steel sector to stable from negative.

Moderate Upfront Cash Investments: The kick-start investment required in some of these stressed assets may not be significant as compared with the asset block. The zero-year outflow for investors may not materially impact balance sheets of investors and large operators. The operator investor is premised to obtain clean credit for raw material inputs or extend credit period to create room for liquidity during the ramp-up period. The banks may insist for undertakings such as letter of comfort from the operators. Given the market standing of the operators, clean credit for inputs could be likely and have optionality to supply their own finished inputs for downstream production. For instance, hot-rolled coil could be used to produce cold-rolled coil or even leverage the operator's existing sourcing relations to supply raw material inputs such as iron ore and coking coal. Upfront cash infusion may not be material compared with the investor's existing balance sheets. A large portion of the upfront cash may come in as equity to keep sustainable debt low; this would also be required to obtain equity holding.

Merger Motives: Three of the major National Company Law Tribunal referred steel companies namely Monet Ispat Limited, Bhushan Steel Limited and Bhushan Steel and Power Limited have a prominent presence in the eastern region, while Essar Steel Ltd has major capacities in West. Tata Steel has a presence in Jharkhand and Odisha while JSW Steel is focused on West and South India. Since eastern states have higher coal and iron ore reserves, the steel plant benefits from logistic and steady raw material supply. For Tata Steel, the acquisition could strengthen its presence in the eastern market, while for JSW Steel the acquisition could enable access to a new consumer market and or raw material inputs. For overseas buyers, a large-sized capacity such as Bhushan Steel or Essar Steel could be of interest to get an immediate entry into a high growth steel market.

Structuring Strategy - Key Element: The agency believes the effectiveness of the structure (vehicles holding the acquired asset) in ring-fencing the investor's financial profile is to be decided on a case-to-case basis. The strategy involving bidding by a combination of an operator and financial investor may mitigate the risks as compared with a single-party acquirer. The deals are likely to be configured in a way to ring fence the operator investor's balance sheets, with the control element being with the financial investor. This is by way of holding non-controlling stakes and proportionate representation on board not qualifying for IND-AS requirements for full consolidation. The new investors are also likely to change majority of the existing leadership team. However, Ind-Ra will independently assess the linkages under its Parent & Subsidiary Linkage Criteria to determine the treatment of the acquired entity, and whether it warrants consolidation.

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