Sharpen the knives: Cutting costs key challenge

Even as India celebrates a new milestone in its corporate history, the stock markets stamped their mark of disapproval on the landmark Tata-Corus deal. It���s easy to dismiss that as a short-term view, but high market valuations have made investors nervous and impatient too.

And, the Tata group has obviously paid much more than it had originally planned ��� 34% more than its first bid and 70% more than the price before it announced its bid. Putting that behind may be tough for investors, but for the company, it���s time to look ahead .

A mammoth task lies ahead, that of making two companies, differing hugely in scale, profitability, culture and technology, operate as one. But some things are clearly going in Tata Steel���s favour. One is steel prices, which have been treading firm ground, something that is reflected in the December 2006 quarter results of steel companies.

If consolidation picks up pace, as many expect it will, this trend may stay the course over a longer period. That has the potential of shortening the payback period.The other is benefiting from scale.

Corus is focused on the developed markets, while Tata Steel has been spreading its wings in Asia. Now, from 5 million tonnes, it will have 24 million tonnes, being sold across key markets of Europe, India, and other Asian markets. A combined distribution network can mean more of the group���s output being sold in emerging markets, spurring turnover growth even as developed markets deliver on price realisations.

But Tata Steel could win the game simply by cutting costs. Corus has an earnings before interest, tax, depreciation and amortisation (EBIDTA) margin of 10% compared to Tata Steel���s 30%. That results in a combined EBIDTA margin of 14%, due to Corus��� size, which is five times bigger than Tata Steel in revenues. Improving Corus��� margins is imperative for Tata Steel to gain from the merger, which is easier said than done.

Flat products contribute to nearly half of Corus��� revenues and its EBIDTA margin is about 12% but long products (30% of sales) is the main problem area, with very low margins. Tata Steel will have to either tweak costs in this division, or shift production to lower cost locations over the next few years.

In terms of expenditure heads, raw material as a percentage of sales is about 45% for Corus compared to Tata Steel���s 28%. Its ability to help Corus lower its input costs is key, possibly through supplying semis from lower cost production bases. A glaring difference is in employee costs, where Tata Steel���s employee cost to sales figure of 8.3% pales in front of Corus���s 18.2%.

These will be the two major fronts on which Tata Steel will focus on, to improve profitability, even as it expands distribution into other countries to grow sales. Tata Steel has an ambitious group EBIDTA target of 25%, which means doubling Corus���s EBIDTA from its 2005 levels. That may take some years, but success will transform its financials and more than compensate for the short-term pains. Tata Steel will be up to the task, but some investors may prefer to wait and watch.

(Calculus gives an independent view of the impact of news and trends, mainly concerning companies, industries and markets. The column appears Tuesday to Friday)