Some prominent firms say that the acquisition is expensive and that reviving the small-capacity steel maker will put a heavy financial burden on JSW

JSW Steel is to acquire 39% of Ispat for Rs21.4 billion and make an offer to buy another 20% from the public by March 2011. JSW is also to refinance Ispat's debt by September 2011. Ispat runs a 3.3 million tonnes per annum plant (mtpa) near Alibaug (on the coast) which is incurring losses due to lack of raw material integration and high power costs. Brokers assume the enterprise value of the deal between $750 and $950 per tonne, which is lower than its replacement value of $1,000 per tonne. JSW will get management control, but with a 26% stake the Mittals still hold veto rights.

CLSA believe the best part about the deal is that JSW has valued Ispat at an EV per tonne of $756 against a replacement value of $1,000 per tonne. However, it is concerned that the deal values Ispat at nine times FY10 EV/EBITDA and that's expensive. The rationale for the deal, CLSA says, is the long delays in setting up steel plants in India, so buying one makes a lot of sense.

But JSW will have huge challenges ahead: It has to improve Ispat's EBITDA per tonne to $100 by Q4 from the negative levels in Q2 and refinance Ispat's debt at lower costs by mid-FY12. "Longer-term, JSW is targeting to improve margins to $175 post-completion of multiple projects and hopes to improve raw material integration in 2-3 years, but we believe that it is too early to factor in either. Overall, we don't see the acquisition either adding to or taking away much from JSW's earnings and valuations in the near-term."

"Why Ispat was not able to procure inputs at cheaper rates on its own remains a mystery," CLSA says, but it feels that the company will see a rise in profits in the coming quarters.

At the core of JSW's game-plan is cost reduction. "JSW plans to cut Ispat's costs by about $50 per tone, by sourcing lower-cost power from JSW Energy, lower-cost coke from Jindal Stainless and surplus pellets from its own Vijaynagar plant, boosting EBITDA per tonne to $100 by Q4FY10 from negative levels in Q2," says CLSA. The brokerage also likes the fact that JSW is buying fresh shares, as this will mean that the "cash will stay within the consolidated entity and go towards reducing debt."


The task is not as easy as it appears on paper. Ispat has reported losses in four of the last five years and in FY10 EBITDA per tonne was just $109. The biggest problem, CLSA points out, is that the whole margin improvement project will take at least a couple of years, until which time Ispat (and by association JSW) remain vulnerable. "There is a risk that JSW might have to support Ispat's capex plans and debt-servicing requirements if steel prices dip and stay lower for longer. The deal also increases JSW's FY11 consolidated net debt-to-equity to 1.21x from 1.01x, reversing the trend of declining gearing of the last two years."

CLSA is not very convinced about JSW's track record in acquisitions either. However, the fact that EPS dilution will be just 3-5% even if one were to assume a lower EBITDA per tonne of $110 over FY12-13 (instead of it improving to $125-130 per tonne to make the acquisiton EPS neutral) is slightly comforting.



In the medium term, Ispat needs a capex of around Rs32 billion-this includes Rs5 billion for a 110MW power plant, Rs6 billion for a 3mtpa pellet plant, Rs5 billion for a 1mtpa coke oven plant, and the big daddy, capacity expansion from 3.3mtpa to 4mtpa for which it needs Rs14 billion.
Credit Suisse mentions an issue that not many other brokers are talking about. "Turning around Ispat is likely to be tricky with existing promoters still holding veto power." It has a divergent view about EV per tonne being below replacement costs too. "EV per tonne is $940, but with further (about) $430 million needed to raise profit to normal levels EV per tonne reaches (about) $1,080."

Credit Suisse believes that with Rs23 billion of cash from the JFE deal still on JSW's balance sheet, funding should not be a problem, but leverage will once again become an issue, since cash contribution from Ispat is a while away.

To get 6x EV per EBITDA, EBITDA per tonne must reach $155, which is targeted after 2-3 years, Credit Suisse points out. "This includes coking coal and iron ore supplies from its own mines (coal from Colombia and ore from Maharashtra)."

Here are Credit Suisse's key takeaways from the analyst meet yesterday.

• Deal closure expected before the end of this financial year. Open offer to start on 11 February 2011 and end on 2 March 2011.
   
•  Informal agreements are in from 70% of the lenders.

• Even though JSW categorically denied the need for Ispat to raise more equity, the latter needs $550-600 million in new capex over the next two years. Of this, about $170 million is expected to come from JSW's infusion, implying that Ispat must generate a further $430 million in cash, in addition to refinancing most of its rupee debt by September 2011.

•  Even if Ispat becomes EBITDA positive by March 2011, it is unlikely to become materially EPS positive before FY13. The impact on JSW's EPS is thus likely to be a negative 8-10%.

• Ispat promoters continue to hold the veto power and this could complicate the turnaround, as some decisions may be tough to take.

HSBC Securities and Capital Markets does not think much of the deal either. "Our analysis suggests all synergies, if realised, would help Ispat save Rs1,700 per tonne on costs on an annualised basis. Assuming JSW manages to increase EBITDA per tonne to $170 eventually (2005-10 average being $100 per tonne) the upside to JSW's market cap would be just 6%."


HSBC believes that JSW can help save power costs for Ispat through power purchases from JSW Energy. However, since JSW Energy is a listed company, the transaction will have to happen on an arm's length basis. Even so, it can be far better than the Rs5 per unit electricity cost that Ispat is working with right now. A saving of just Rs0.50 per unit can result in savings of Rs1.2 billion or Rs300 per tonne for Ispat on an annual basis, the brokerage points out.

JSW plans to supply 350 kilo-tonnes per annum (ktpa) of coke to Ispat and rent out Jindal Stainless' excess capacity-Ispat needs 700ktpa of coke at $377 per tonne. HSBC calculates that savings of $50 per tonne on coke costs can result in a savings of Rs1.6 billion (or Rs400 per tonne) for Ispat on an annual basis. According to its other calculations, savings of $25 per tonne on pellets can result in a savings of Rs1.6 billion (or Rs400 per tonne) on an annual basis. "Ispat can also avail Rs1,300 per tonne VAT benefit selling in Maharashtra and Rs1 billion on freight costs."

(This article is based on secondary research. The report is for information only. None of the stock information, data and company information presented herein constitutes a recommendation or solicitation of any offer to buy or sell any securities. Investors must do their own research and due diligence before acting on any security. Some of the opinions expressed in this article are the author's own and may not necessarily represent those of Moneylife.)