How the new Bankruptcy Code could change domestic steel

Bankruptcy proceedings initiated against five companies may spur consolidation, creating an oligopolistic market in steel

Five of the 12 bad loan accounts referred for resolution under the Insolvency and Bankruptcy Code, 2016, are from the steel sector. Their total debt, as on March 31, 2016, stood at ~1.4 lakh crore. Together these companies account for about 17 per cent of India’s installed steel capacity. The question is: Will this be a make-or-break for the steel sector that has been reeling from a weak demand and cheap imports in the last couple of years? Or, will it really be more of the same?

Lenders have taken five companies — Bhushan Steel, Bhushan Power & Steel, Essar Steel, Electrosteel Steels and Monnet Ispat Energy — to the National Company Law Tribunal (NCLT).These companies are holding hectic parleys with their legal teams trying to understand the procedures of the bankruptcy code; potential investors too are busy studying the implications in the hope of consolidation. There is a buzz in the sector.

On the face of it, the insolvency Act is along the lines of what it is in other parts of the world. An insolvency professional is appointed, who takes management control, while the board is suspended. He constitutes a creditors’ committee, then goes for bidding. The best bid is selected and closed. The new management takes control of the plant. If that doesn’t happen, the company is liquidated. But there is a catch.

“The framework is exactly similar to what happens overseas. But we have to see how it is implemented in India,” says JSW Steel Joint Managing Director and Group CFO Seshagiri Rao.

JSW had submitted a bid for Monnet Ispat in February. Lenders, however, found the 70 per cent haircut too steep and put it on hold. As the matter now moves to NCLT, the moot point is: Will the process lead to consolidation in the sector?

According to ICRA, the insolvency proceedings for stressed accounts may lead to consolidation in the steel sector, whereby stronger steel players with healthy financial profile would have a chance to increase their market share by bidding for these assets at attractive valuations.

“In such a scenario, the steel sector, faced with a weak demand and an overcapacity situation would benefit in the long run,” adds ICRA Senior Vice-President and Group Head for Corporate Sector Ratings Jayanta Roy.

A Credit Suisse report says Tata Steel and JSW Steel are already operating at 90 per cent plus utilisation levels and planning expansions. Acquisition of these capacities can raise the share of the major four manufacturers, including SAIL and JSPL, to 60 per cent of domestic capacity.

“In the flats segment, they could reach an oligopolistic 90 per cent plus share,” the report said.

But consolidation would mean taking steep haircuts and Credit Suisse has put the average haircut at 56 per cent, given the unsustainably high debt.The companies facing insolvency have, of course, their defence for the high debt. Weak demand, surge in imports and coal block cancellation, are the reasons cited for their troubles.

“When we went for project appraisal, we had coal blocks. By the time the loan was disbursed, the coal blocks were cancelled,” says a promoter of a company facing insolvency.

The ICRA report corroborates that profitability and coverage indicators of these accounts hit rock-bottom in FY2016 as a result of commodity price meltdown and onslaught of cheaper imports. But it also points out that while the operating profitability of most of these accounts improved in FY2017 on the back of improved prices, net profitability remained in the negative territory due to significant interest burden. Interest coverage ratio for most of these accounts remained below 1.0 time and total debt-to-operating profit ratio remained stretched at about 26.0 times even in FY2017, when financial performance of steel players improved following favourable government policies.

Operating margin on 18 large mid-sized steel companies in India, accounting for around 60 per cent of the domestic installed capacity, improved to around 14.4 per cent in Q4 FY2017 from the low of 6.1 per cent in Q3 FY2016. “Interest coverage ratio too improved from 0.48 to 1.74 during this period. Nevertheless, the sector remained leveraged,” ICRA said.

Whether that will call for some hard decisions from the banks is unclear. Most in the industry feel otherwise. In cases where the existing promoters are on board with a change in management, it will happen. Elsewhere, especially for larger accounts, it is most likely that the loans will be restructured.

“The bidding criteria has not been specified either by the Reserve Bank of India, the government of India or the banks. A prospective investor may be more inclined to submit a proposal where he will put in equity in the company and strengthen the balance sheet of the company for sustainable operations but may service only 40-60 per cent of the debt because it’s not sustainable,” an industry source points out.

“In contrast, the existing promoters are likely to bring in less equity but would run the plant and service the debt over 40-50 years.”

Notwithstanding the financial stress and default, will the sector largely operate the way it has been operating for so long? “It all depends on how banks play this game,” says a potential investor.