Essar Steel sale: What’s on offer?

Essar Steel’s debt in FY17 rose by 18.9% over the start of the fiscal year.

As the curtains are set to come down on Essar Steel’s restructuring, the closing scene looks barren with only two actors—ArcelorMittal and Numetal Mauritius—left on stage. Even as you read this, lenders must be assessing the two bids.

Here’s what’s on offer for the winning bidder for Essar Steel, gleaned from its fiscal year 2017 (FY17) annual report. The resolution of steel non-performing assets (NPAs) got a fillip after a series of government policy initiatives to support the domestic steel industry was followed by a sustained increase in steel prices. Together they have made steel a more viable business. This is seen in the company’s performance in FY17 as well.

Essar Steel’s stand-alone financials show that its net cash from operations came in at Rs3,018 crore, up nearly sixfold from Rs526 crore a year ago. With capex at a low Rs167 crore (Rs173 crore a year ago), free cash flow saw a substantial increase too.

This improvement in its cash flows was on the back of a better showing on the output and sales growth front. Essar Steel sold 5.3 million tonnes (mt) of steel in FY17, up 44% over a year ago. It produced 5.47 mt of crude steel, giving it a 5.6% share of the country’s output, as per Joint Plant Committee data. The company’s annual report mentions that output rose on the back of an affordable gas-based iron-making process.

This improvement in volumes contributed to a 46% increase in net sales to Rs19,907 crore. While Essar Steel earned an operating profit margin of 13%, depreciation, and a massive interest liability—Rs5,608 crore—and some exceptional items led to a loss of Rs5,198 crore. At the consolidated level, the loss was higher at Rs5,620 crore.

While the auditors have not qualified the accounts, they have drawn attention to a few points. One of them pertains to current liabilities exceeding current assets by Rs33,304 crore. In the notes, the company mentions that current liabilities include maturity of long-term debt and long-term export performance bank guarantees that have turned into a fund-based liability. Its statement of indebtedness shows a principal outstanding of Rs50,786 crore as of 31 March 2017, of which Rs5,016 crore is interest outstanding. Essar’s cash flows are not enough to repay its outstanding debt.

That then is a short financial snapshot of the company, which shows a balance sheet that is clearly under duress but with a steel business that was profitable in FY17 and is likely to have sustained its performance, and perhaps improved it too, in FY18. Most steel makers have reported an improvement in profitability in FY18. The problem is that the earnings are not enough to service its debt, which is why the company finds itself in the corporate insolvency resolution process.

A prospective bidder would have evaluated, among others, factors such as the extent to which the business’s cash flows can improve, the purchase price, the loan haircut required from lenders, ability to improve sales and profitability, fresh investments required for such improvement, and likely cash flows from the business over a long period (important because of the cyclicality of the steel business).

For instance, ArcelorMittal, one of the bidders, said the company has a crude steel capacity of 9.6 mt but the maximum achievable capacity at present is 6.1mt due to a bottleneck in the steel making and casting process. If those bottlenecks could be addressed, the value of the asset could change in future. For ArcelorMittal, getting the asset would give it a significant foothold in the domestic steel market.

Why Essar Steel did not attract more interest is a question that must trouble fans of the insolvency process. The long-term story for steel in India is intact. There are few large firms in India, and they have been consolidating their hold over a fragmented market. Essar Steel’s balance sheet is creaking under the weight of debt but the restructuring would have lightened it. Did bidders get put off by the controversy around not getting access to a slurry pipeline that is critical for the steel operations? But that did not deter ArcelorMittal, so why should it deter others?

One thing is clear. The insolvency process was supposed to help unlock value in stressed assets, especially those that had not been managed well. There was talk that bidders would fall over each other to buy a piece of India’s industrial action at attractive prices. Matching talk with hard cash is no easy task.

Restructuring is only the first step. The new owners have to succeed where others failed, generate adequate return on capital for their own shareholders, and ensure cash flows are adequate to service the restructured debt. Else, they will find themselves in the insolvency queue.