Consolidation & Innovation Will Create a Structurally Sound Indian Steel Industry

The global steel industry has long suffered from the structural ailment of fragmentation. In the past two decades, consolidation efforts were offset by global capacity growth, leaving the steel industry relatively fragmented with top five producers accounting for less than 20% of the global production. This has resulted in structurally unsound industry dynamics where capacity utilizations remain depressed for extended periods and average global EBITDA margins remain in the teens, while boom-bust cycles dominate the industry fortunes.

However, while global markets may be fragmented, high growth regional markets like India have the opportunity to consolidate, increase concentration and scale and become structurally sound over time. The landmark policy mechanism which is enabling the industry consolidation is the Insolvency and Bankruptcy Code (IBC).

Historically, majority of India's steel industry has been composed of the less capitally intense secondary steel sector whose smaller scale induction furnace and coal based sponge iron units did not necessarily have the scale or the operational efficiencies to support a sustainable business in the long run.  At the same time, many of the larger integrated steel plants were built on unsustainable leverage through bank debts. The deep industry downturn of 2014, accelerated the exposure of these fundamental weaknesses and the bankruptcy based restructuring of these distressed assets is driving the structural transformation of the industry.  The resulting M&As and buyouts is creating more concentrated and productive capacity, while weaning out uncompetitive steel plants.

Till date, IBC based restructuring has resulted in mergers and acquisitions of 20 mtpa of distressed capacity which had more than $20 billion in distressed debt. Larger capacities like BSL, BPSL, Essar, Electrosteel and Monnet have either been acquired or are close to being resolved through the IBC, and more than 100 smaller scale induction furnace based units have either been absorbed or have exited in the last two years. As a result, the industry concentration ratio has moved up a healthy 5% points to 48% post these mergers and will likely move much beyond 50% as the larger opportunities for consolidation in the smaller scale secondary steel sector materialize over the next few years.

A particular case in point is the successful acquisition of Bhushan Steel (BSL) by Tata Steel where the marketing, product mix, operational and procurement synergies could be significant.  BSL complements Tata Steel's flat steel product mix and improves its market power and scale in the auto-grade steel markets. Further, debottlenecking and operational improvement will likely significantly improve output, productivity and cash-flows and take BSL from its current operating capacity at 3.5 million tons per annum to the 5.6 million tons of rated capacity. Broader gains can be realized by exploiting interplant synergies and capacity matching, between Tata's Kalinganagar and BSL's Angul plant while simultaneously expanding market presence in the state of Odisha. All this will likely result in a healthy EBITDA peg of at least of about Rs 10,000/ton for BSL. There have been opinions that Tata's acquisition of BSL at over Rs. 35,000 crores may have been value destructive.  If one takes the synergies and the replacement value of the BSL asset, including the optionality of expansions and the time value of foregone cash-flows -  given that it takes over 4 years to build a greenfield plant - BSL's value is probably well north of Rs. 45,000 crore.

As world class steel makers with expertise in turning around distressed assets world-wide look for such value accretive deals, bankruptcy restructurings will draw these multinational steel makers into acquiring stressed assets in India and turning them around into high-performing assets. It is however important that the acquisitions have the right fit, otherwise ambitious and well-meaning mergers may turn into industrial nightmares. Past experiences appear to indicate that steel mergers have a higher likelihood of success when there are technology and operation synergies and when the markets are regional.

While consolidation can improve market concentration, productivity and margins, it may postpone new investments in large-scale capacity expansions in the medium term as investments in the acquired capacities are fully integrated. At the same time, as the bankruptcy resolutions clean the bank balance sheets, credit markets and debt markets will deepen and this will open up avenues for investments in more intelligent, balanced and productive capacity growth for the longer term.

Apart from consolidation driving higher EBITDAs, some steel companies in India have also been looking at product differentiation and value-added steels as a means to create competitive advantage and sustainable margins. SAIL's proposed joint venture with Arcelor Mittal is an attempt to create a value-added product complement through auto-grade steels, presumably to create such an advantage while elevating its margins. Apart from the fact that SAIL's major opportunity for profitability improvement lies in improving productivity of its existing operations, we need to recognize an inconvenient truth that value addition does not necessarily improve EBITDAs of steel firms. In fact, analysis of data from diverse steel plants worldwide by BCG, a consulting firm, has quantified this intuition and concluded that there is no clear correlation between EBITDA margins and value addition.

Consolidation is however an important step that sets the stage by removing the structural impediments that will increase concentration, market power, productivity and industry margins. Consolidation aids a pure operational efficiency play on common available technologies, which eventually results in a more oligopolistic and reasonably profitable market with a steeper industry cost curve. That said, it is most likely that future competitive advantage for steel enterprises with sustained higher margins above the industry average will come through innovation in process, product and business models. Eventually, steel companies which embrace digital transformation, design intelligent plants, build flexible and resilient capacities, innovate on raw materials and the supply chain and introduce new steel technologies, will push the disruption envelope and create the high margin stars of the future.