"We didn't cook this deal up, it wasn't microwaved. This was like an Indian curry where you've got to marinate the ingredients for a long time." So said Jim Leng, chairman of the �9.2 billion Anglo-Dutch steelmaker Corus after approving a takeover bid from Tata Steel [Get Quote], valuing its equity at $8.2 billion and enterprise value at around $10 billion.

Leng was obviously referring to the protracted negotiations that Corus had had, over eleven months, with the Tatas. With a bit of luck, the deal should go through, catapulting Tata Steel from number 56 to number six in the global steel sales hierarchy, of $24.4 billion.

But, for the $5-billion Tata Steel it might just be like marinating another Indian curry. Only, this curry could take longer than eleven months to cook.

Not a steal

To begin with the acquisition has not come cheap. On an EV/EBITDA (enterprise value/earnings before interest, depreciation and tax) basis for CY2006 estimated earnings, the multiple is 6.2 times. That's more or less similar to the Mittal-Arcelor deal.

But, the big difference is that the deal is being paid for entirely in cash, while the Arcelor deal involved a share-swap along with cash. So, it is more expensive since it will mean a cash outflow from Tata Steel of �1.84 billion (Rs 15,000 crore -- Rs 150 billion -- or $3.3 billion).

On an EV/tonne basis, Mittal paid $586 a tonne for Arcelor, while Tata Steel will get Corus at $537 a tonne. But that's because Arcelor is more profitable than Corus.

A glance at the share prices of steel stocks (See Global Metal Stocks Performance) shows that they have moved up sharply and had Tata Steel been a little more nimble, it could perhaps have got itself a better price.

The implied EV/tonne valuation of $537 for Corus is higher than that of $374 paid for NatSteel and $333 for Millennium Steel, which Tata Steel acquired in 2004 and 2005, respectively.

Apart from the timing, Tata Steel would definitely have had to pay a premium for Corus because of the much larger operations of Corus -- second largest rolling capacity in Europe of 18 million tonne -- and access to better technology.

Tata Steel's cash flows at the end of March 2006 were Rs 4,281 crore (Rs 42.81 billion) and it should generate around Rs 5,700 crore (Rs 57 billion) in FY07 and Rs 6,000 crore (Rs 60 billion) in FY08.

However, it may need to dilute its equity to keep the leverage -- its debt-equity is at 0.26 -- under check given that it has $4-6 billion worth of projects in the pipeline.

Corus vulnerable to falling steel prices. . . The borrowings in Tata Steel UK, of �3.3 billion ($6.3 billion), will be repaid through the cash flows of Corus. According to analysts' projections, the topline growth could slide to �9.53 billion in 2007 and further to �9.37 billion in 2008. Corus is expected to turn in an earnings before interest and tax (EBIT) of around �520 million in CY06 on net sales of around �9.6 billion.

In fact, analysts believe the EBIT will go up only marginally in CY07 to between �550-570 million and could even dip to �500 million in CY08.

Thus, if steel prices slip even marginally, they could stretch Corus' finances with an adverse impact on its topline and consequently its ability to repay the debt -- annual interest outflow estimated at around �300-350 million on the new debt -- because there's little room for cutting costs.

. . . but access to slabs can change things

Should Corus have access to low-cost slabs, the deal begins to look better. Corus is Europe's second largest steelmaker with crude steel capacity of 18.2 million tonne in the Netherlands and the UK.

But it is far less efficient than Tata Steel which, thanks in part, to its access to iron ore and coal mines, is one of the world's lowest cost producers with operating profits of $1.5 billion from 5.3 million tonne. Corus has an EBITDA/tonne of $97 compared with Tata Steel's $300.

As some of Corus' plants suffer from high slab cost production (estimated at around $330-340 per tonne), the company needs to be supplied with slabs, at a competitive price. Tata Steel, whose slab cost is close to $180-190 per tonne, could be aiming to ship out slabs to Corus, and in the process saving around $100 per tonne, after incurring freight costs.

However, Tata Steel MD, B Muthuraman, is not saying that slabs will be exported to Corus. While he agrees that the supply of slabs to Corus is core to the strategy, he is unwilling to disclose where the slabs are going to come from. "We have several options," is all the CEO will say, adding that, "the slabs will be sent at the appropriate time from India or elsewhere."

Since there is still time to go -- three to four years -- before Tata Steel's slab capacity is commissioned, the answer could lie in an acquisition of a company that makes slabs cheap located either in Russia or in Latin America, since that's where the low-cost slab makers are to be found (See Slab cost).

In fact, the Corus management is believed to have indicated to investors some time back, that it was pursuing a "value-enhancing business-combination with a low cost producer and exporter of steel from the BRIC region." If the arrangement works out, Corus' operations would become far more efficient.

A ready rationale for the acquisition

Even if the acquisition of a slab manufacturer means a bigger cash outflow or a higher degree of leveraging, it would be worth it. That's because there are several benefits. These include:

• Scale -- Tata Steel and Corus will be the fifth largest global steel producer with a combined output of 23.5 million tonne.
• A high-quality low-cost growth platform in Asia.
• A better geographical mix.
• High value-added product mix and strong market positions in automotive, construction and packaging.
• Increased procurement knowledge and hence bargaining power with vendors.
• Better R&D -- a total of 1050 people.

As Muthuraman points out, "We are trying to change the way we operate by putting the correct parts of the value chain in the right places. We will not move iron ore but we will move other products."

The strategy clearly is to produce cost competitive intermediate steel close to raw material sources and finish the high-end products in developed markets. And the acquisition of Corus fits in perfectly with this. Muthuraman claims synergies will be seen from day one.

Says he, "We believe there are cost reduction opportunities in terms of logistics and re-distribution of inputs and output." But analysts believe cost synergies, estimated at around $500 million a year, may not come through before 2010.

True, as a result of the deal, Corus could get access to low-cost, high-grade iron ore. The Tata Steel management has already said it is looking at companies in countries where iron ore, coal and gas are inexpensive and Corus will give it access to high grade processing operations.

Explains Muthuraman, "We can make newer grades of auto and packaging steel and Corus makes high quality tinplate, which will give us an edge."

Tata Steel's capex not to suffer

The management has stated that its expansion plans -- 5 million tonnes at its Jamshedpur facilities by 2010 and also plants in Kalinganagar (Orissa), Chhattisgarh and Jharkhand taking the capacity to 20 million tonnes  -- will not suffer.

It acquired around 3.7 million tonne a year finishing capacity in South East Asia through NatSteel Asia and Millennium Steel and now has a presence in several countries in South East Asia including Singapore, Thailand, Vietnam, Philippines, China and Australia.

Its sales mix today comprises approximately two thirds flat products -- hot rolled, cold rolled and coated -- and one third long products -- value -- added finished products such as wires, wire rods and merchant bars.

Stock unlikely to be on a roll

According to Muthuraman, steel prices should remain stable at current levels of $330-340 per tonne and in the long run should stabilise at around $450 per tonne.

Thus, over time, operating margins for the combined entity could move up to 18 per cent or even higher from current levels of around 14 per cent. Tata Steel's earnings will see a jump in FY0& to around Rs 85 from Rs 63.3 in FY06, but thereafter, the EPS is likely to stay there. At Rs 490, the stock trades at around six times estimated FY08 earnings.

There is, no doubt, a case for re-rating of the stock as it acquires global scale, but the process of integration could take time. The near-term upsides appear to be priced in though in the long-term the stock should be an outperformer.