June 23, 2003 | Business World

Busting business cycles

Being the lowest-cost steel producer isn't enough. Tisco wants to consistently deliver positive EVA

B. Muthuraman, managing director, Tata Iron and Steel Company (Tisco), is making a live webcast to the 43,000 employees of the company. Dubbed the MD Online, this interaction has become a regular feature since Muthuraman took over. It is held on the first Monday of every month and any employee can ask Muthuraman any question on any issue.

This is the first webcast after the record results this year. Just four days ago, Tata Steel has declared a net profit of Rs 1,012 crore for the year 2002-2003 - almost five times higher than the previous year's profit, a performance unprecedented in the company's 97-year history. It has declared a whopping 80% dividend for its shareholders.

It is also the first time in recent history that Tisco has turned EVA (economic value added) positive. EVA is an indicator of how much wealth a company has created for its shareholders after taking into account even the cost of capital. For the first time in recent times, Tata Steel has delivered a return that is higher than its cost of capital. And Tata Steel shares are doing great.

In such a situation, almost every other CEO would have reached for the bubbly. Instead, Muthuraman proffers a sobering thought in his webcast: had steel prices not improved last year, Tata Steel's profit would have been significantly lower, maybe by even as much as Rs 500 crore. As the lowest-cost producer of steel in the world, Tisco made pots of money as prices rose sharply. But what if steel prices had headed south?

That's a question that has perennially haunted Tata Steel. And even though Muthuraman's predecessor J.J. Irani had transformed Tata Steel from an insular domestic steel manufacturer to a global player of some reckoning, the inability to weather the cyclical nature of the steel industry has continued to dog the company. The pattern is predictable: Tata Steel makes pots of money when steel prices rise. And then proceeds to lose the gains when prices tank.

That is the crux of the problem. If Tisco doesn't create enough wealth in the long term, why should the Tata group, which owns 26.41% of Tisco, stay invested in the company? Steel has chronically been a value destroyer. Sure, Tata Steel may have destroyed less value than the Jindals and the Ispats of this world, but it surely hasn't created any.

The problem is aggravated by the fact that Tata Steel is one of the biggest companies in the Tata group portfolio and easily one of the biggest profit and cash generators. But, till last year, it did not provide a return higher than the cost of capital, not in recent times at least.

A year ago, Muthuraman began to decisively work on this. "We have inadvertently ignored the shareholder. It's time to fix that," he had said. Simple words, but it's one heck of a task. Wondering why? We'll come to that in a bit.

First, let's understand the background. Through the 1990s, growth had been placed on a back burner and the company first strove to be operationally efficient and earn the right to grow. By the end of 2002, the cost-cutting binge had ensured that Tata Steel was, globally, one of the lowest-cost producers of steel. But it was still puny compared to other global steel companies. For instance, the largest Korean steelmaker, Posco has a capacity six times that of Tata Steel. By the end of 2002, Tisco was also beginning to generate enough free cash flows for investment. The question: where should it invest that money?

The answers were not entirely obvious. Irani had already reached the last lap of his tenure. By then, the future of the manufacturing sector in India was itself under a cloud. Like many other industrial groups, the Tatas, too, had begun to see services as the next big thing. That's how Bombay House mooted a plan to invest Rs 5,000 crore of Tisco's free cash flows in telecom. It looked at the example of German steel giant Mannesman, which had diversified into telecom to beat the commodity cycles and open up new avenues for growth.

But when the Tata Steel board evaluated the plan to diversify into telecom, it did not see any returns coming for a long while. The plan was junked. By then, Muthuraman was firmly in the saddle. Soon after taking charge, he realised that Tata Steel had to learn to manage both shareholder value and growth. Tisco's chief of strategic finance N.K. Misra explains: "A company in a capital-intensive industry has to be able to attract capital." But to do that, Tisco had to find a measure that would help it evaluate the trade-offs between growth and shareholder value more critically.

That's how Muthuraman discovered EVA. His first priority was to ensure that Tata Steel had to turn EVA-positive by 2007. Simply put, that meant that by that year, its rate of return had to be higher than its cost of capital (both debt and equity). But there was another more important target: Tisco had to deliver positive EVA through the business cycles and grow it every year as well. That was a real challenge because no steel company anywhere had ever been consistently EVA positive, leave alone growing it consistently. (Tisco was pure lucky that steel prices improved and it could turn EVA-positive within a year.)

So, can Muthuraman deliver on his ambitious targets? The jury is still out on that one. But the indications are that the EVA journey is already significantly altering the DNA of India's second-largest private sector company. Irani's era was essentially about optimising the hard assets and tonnages. It was about achieving operational efficiency by ruthlessly modernising the plants.

Now, under Muthuraman's leadership, the focus is on smartly managing the intangibles - building brands, developing stronger customer relations, chasing growth aggressively and, above all, aligning all 43,000 employees, from the shop floor assistant to the CEO, to the new performance metric of generating greater shareholder value.

Shareholder Value
Today, every third sentence spoken by the Tisco MD seems to have 'EVA' in it. Muthuraman breathes, sleeps and eats the word, and is trying to get the rest of the company to do so as well. Every sign, placard and memo in Jamshedpur has it. Muthuraman chose EVA because it offers more insights into the true economic value of a company.

Explains Misra: "This is the measure that relates best to the concept of wealth created." For instance, in the traditional methods of accounting, the calculation of net profit only takes into account the interest cost of the debt raised and not the cost attached to the equity raised. Explains Anurag Dwivedi, vice-president, Stern Stewart, the originators of EVA and consultants to Tisco: "Only if a company generates enough wealth over and above the weighted average cost of capital can it call itself economically profitable and is said to be creating wealth for its shareholders.'

There are some things going Tisco's way in its EVA journey. First, interest rates have come down drastically and, therefore, Tisco's weighted average capital costs have dipped in the last few years. Then, initiatives like total operation performance (implemented in Tisco by McKinsey and Company) have helped Tisco push down costs a great deal. For example, although the hot-strip mill has an installed capacity of 2 million tonnes, Tisco now produces 2.8 million tonnes. Though the fixed costs are apportioned over the installed capacity, the excess production adds a lot to the bottomline. Similarly, the sintered products plant now operates at 200% capacity, again adding to the bottomline. In the next few years, Tisco will undertake an all-round debottlenecking exercise to improve efficiency of the plants. McKinsey is also working on Enterprise Value Management and Retail Value Management to get similar efficiencies in these areas. So, a serious cost push will make Tisco a more efficient company and grow the bottomline and, hence, EVA.

But Muthuraman is not content with those advantages. His first step was to fix accountability for EVA and monitor it carefully. There are three elements that need to be monitored constantly for EVA - cost, capital employed and revenue. So four EVA centres - the steel business, the non-steel business (other metals and minerals like ferro-chrome), iron ore and mining, and shared services like power and gas - were set-up to monitor these parameters. Plus, accountability was fixed for the dozen subsidiaries that Tata Steel has stakes in as the performance of these companies would also impact the overall EVA. "Accountability of capital at lower levels in a company tends to be low. So you need close monitoring," says a senior manager.

Yet, Muthuraman's biggest challenge was to actually get the entire company to believe in this exercise. The EVA definition is a sure-shot eye glazer. Even in its simplest terms, it is the operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. Imagine the task of getting this message across to 43,000 workers! Thus started a communication drive, called the EVA Drill Down, that was unprecedented in Tata Steel. To get the message across, parables and presentations are being used. The chief of Tisco's improvement group, Bimalendra Jha, says: "There's a finance manager in every individual. We tried to tap into him."

The challenge now is to get this down to the last maintenance guy on the shopfloor. Says Stern Stewart's Dwivedi: "Each worker should have an idea of how his work will impact the final EVA of the company." Stern Stewart benchmarked Tata Steel against global giants like Posco, China Steel and Bao Steel, and found that it stacked up well. The World Steel Dynamic Report, which ranks global competitiveness on a number of parameters, ranks Tata Steel third after Posco and Bao Steel. Its EBIDTA margin is just behind China Steel, a Taiwanese company that controls 80% of the domestic market in its country.

Yet, none of the companies ahead of it have consistently managed positive EVA - EVA has almost always tanked in the years in which steel prices have gone down. Tata Steel, for instance, declared an EVA of Rs 238 crore in 2002-03, but what of the next year and the year after that? In fact, a consistent EVA performance is associated more with consumer product companies like Coca-Cola globally, or ITC in India. So, the challenge for Tisco is to manage incremental performance. Says Dwivedi: "It's all about managing the delta now."

Managing The Delta
"I would rather own a market than a mill," says a poster in Muthuraman's office. Tisco's brand management and corporate marketing chief Kabir Seth says: "Muthuraman brought to his leadership something that no other leader had." Seth is referring to Muthuraman's marketing and sales savvy. He can get lyrical about blast furnaces, but he can appreciate the fact that the value of a company increasingly lies in the intangibles. He does not find it odd that Coca-Cola is the world's most valuable brand. But how does this relate to EVA?

Well, if Tisco has to consistently improve its EVA, it needs to influence consumption. And this is where branding comes into play. It should be able to ensure that customers of the company's products continue to buy them even in a downturn. Says Misra: "We have to neutralise the cyclical nature of our products to consistently improve the delta EVA." Adds Muthuraman: "The price of steel should be irrelevant to us."

Tisco is also trying a few other tricks to insulate itself from business cycles. A shift from products with volatile prices to those with less volatile prices is one of them. Hot-rolled (HR) coils, for instance, are mostly sold in the spot market and, thus, have volatile prices. Their share in flat products is down from 66% in FY02 to 55% now. Meanwhile, the share of cold-rolled flats, sold mainly through longer-term contracts, is up from 6% in FY02 to 32% in FY03. "This change in mix will help the company withstand the cyclicality of the industry," says Mukesh Agarwal, head of research, Crisil.

The marketing push is not entirely new. It was started off during Irani's last lap, but Muthuraman took it further. All marketing officers were trained in the concept of branding and a brand management department was set up in April 2000. After June 2002, Seth oversaw functions like Brand Management, Process Improvement and Rural Marketing. All of this brought the focus sharply onto brand management.

When the branding exercise was being initiated, Tisco director R. Gopalakrishnan, was roped in for his branding experience in Hindustan Lever. He said the generic 'Tata' brand should not be extended as it meant different things to different people; that each brand should have a separate identity. That gave birth to Tata Tiscon (steel rods for construction), Tata Shaktee (flat products) and Tata Steelium (cold-rolled flat products).

After branding comes selling. Earlier, who the steel was sold to was controlled by the government. So, efficient selling processes and distribution set-ups were not needed. Later, in the 1990s, when the company started taking a closer look at its customers, it realised that 200 customers accounted for 80% of the company's sales, while about 5,000-6,000 others accounted for the rest. It decided to deal with these to sets differently.

For high-value customers, Tisco started a customer value management programme. Under this, cross-functional teams from Tisco studied the customer's uses and suggested improvements. It has done so for Ashok Leyland, and Larsen and Toubro last year. This year, it plans to do so for Godrej and Boyce.

For the retail exercise - typically the housing and construction market - the marketing team decided to overhaul the distribution system. To do so, Tisco even studied the distribution systems of companies like Asian Paints. They had no more than three layers between the producer and the final user. Tisco had 4-5 layers. So the layers were reduced. Tisco's distributors did not have their areas clearly demarcated. This was done and 40 new distributors were added. They were also given the charge of managing the retailers in their areas. The retailers, in turn, were asked to employ people who would do the legwork in the area. Says Tata Steel vice-president (flat products) H.M. Nerurkar: "A lot of them (distributors) are people in their 30s and 40s. If they were older, they saw to it that their sons were involved."

The gain from this was added knowledge about the customer. For instance, the assumption always was that since the North-east is a poor region, the buyers go for thinner sheets for roofing. After this exercise, the company realised that there were affluent pockets where higher grades of galvanised sheets could be sold. Also, since the company insisted on territories for each distributor, their individual earnings increased. That increased loyalty to the Tata brands.

To find out how branding can work in steel, Tisco brought in Feedback Ventures to do a study for them. Feedback found chicken farmers in Karnataka, of all people, asking for 'Tata' galvanised wire ropes. A bit of probing showed why. Local products lost their galvanising and corroded easily. Corroded ropes wounded chicken, which then died, causing losses to farmers. So the indications were that there was a market for branded steel products and it was not too small.

Unlike aluminium, the steel industry is highly fragmented. (Worldwide, Oslor, the top player, accounts for only 5% of the total steel production.) So is the Indian market. Moreover, the lower end of this is occupied by cheap products from small players. Tisco decided to tap this market by going retail. A Tisco executive says that small steel products branded or co-branded with other downstream manufacturers could well account for 8-10% of sales in the next few years. What is even better news is that this portion of the sales will be relatively price insensitive. A change in the world prices of steel will not affect wire rope sold to a Karnataka farmer just as a fall in vegetable oil prices will not impact the price of Hindustan Lever's Liril in the short run.

This is a practice that international commodity companies also adopt. The Canadian Alcan brands its aluminium foils and other food grade packaging material to extract a premium. These products are produced through patented technology. Other Indian companies have also tried to brand steel. Essar was the earliest to do so three years back. It called its steel 24-carat. Ispat has also branded all its products.

Where Tisco is moving ahead of just brand-building is that it is also gearing its retail network to prepare for brand selling. It has started the Retail Value Management programme, which is now being rolled out in parts of the country. As part of this, the retailer hires sales people who are managed and trained by Tata Steel to virtually storm the area. In Kanpur, a sales team made its pitch to local architects who influenced what kind of steel is finally used in construction. Tata Tiscon, a long product used for construction, has doubled its marketshare in the region in the last four years. Says Nerurkar: "We are getting Rs 1,000-2,500 premium per tonne." Sales of branded products have doubled to account for 28% of sales at Rs 1,500 crore.

The Growth Agenda
Meanwhile, coming back to the question: where should Tata Steel put the piles of free cash flow it is generating today? Should it plough it back into the steel business itself despite the fact that it will remain a cyclical sector? Or should it invest in an entirely different area that will neutralise the cyclicality problem?

Tisco has decided to do both. On the one hand, it is investing in the steel business to build up scale. On the other, it is moving into other areas to insulate itself against the next down cycle.

Richards Bay in eastern South Africa started off as a holiday town known for the bird and aquatic life. Now a thriving industrial town and port, it is in the news because India's largest steel company is setting up a 20,000 tonne ferro-chrome plant there. Relatively, Tata Steel is a bigger player in ferro-chrome than it is in steel. While it has just a 13% marketshare in steel in India, it has 60% of the Indian market and 4% of the global market for ferro-chrome. This plant will take the global share up to 6%. Tisco deputy managing director T. Mukherjee says: "A ferro-chrome project in South Africa makes immense sense as power costs are much less and the process for making chrome is very power intensive."

Tata Steel will ship all its chrome ore from India (it owns chrome-ore mines). This, according to some estimates, will translate into production costs of $80-90 a tonne, which is lower than the industry norm. Some of the chrome may be shipped to the European markets and some will find its way back into India, where it will be marketed by the group's trading house as a finished product. So, while the production costs will be in rands (South Africa's currency) the profits will be in dollars. Between that and the local tax breaks that are available to South African industry, the ferro-chrome project should be good for the topline and the bottomline.

Recently, Tata Steel also announced it will expand capacity in Jamshedpur by one million tonnes at a cost of Rs 1,700 crore. There are also plans to make titanium dioxide, which is used in paints. Feasibility studies are on in Kerala and Tamil Nadu, where the deposits are. India has the world's largest deposits of this mineral. "The fortunes of this industry are related to standard of living and it should be a sunrise industry in India," says Mukherjee. Also on Tisco's agenda is a plan to expand iron-ore capacity. The company exports 2 million tonnes of iron ore annually and plans to take that amount up to 5 million tonnes.

One can expct the first big Tisco takeover soon. The scouts are out in Asia and in India. Says Muthuraman: "I spend 50% of my time on growth issues now."