Decrypt 2018 The Financial Colosseum’18

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About the steel industry in China

After the oil and gas industry, the steel industry is the second largest one in the world with an
approximate turnover of 734 billion USD. China is the market leader commanding 49.6% of total
market share. Struggling with an oversupply problem, the Chinese have been exporting their
overcapacity to the world. Overcapacities in the sector became the new normal when China ramped
up its production and flooded the markets, including the United States, with cheap steel: US steel
imports peaked in 2015, when the trade deficit reached 745.66 billion USD. This figure fell to around
734 billion USD in 2016. In 2015, as a result of weak demand from China’s domestic construction
sector and an overall decline in GDP growth, the Chinese steel industry encountered its first annual
contraction in about 25 years.

China produced 81.13 million tonnes of crude steel in May, up 5.8% from March and 8.9% from the
same month last year. A total of 1.6 billion tons of steel was produced last year, globally and half of it
was by Chinese plants. However, despite it being responsible for 800 million tons of steel a year,
China is believed to have a further 300-400 million tons of production capacity on top of this. China’s
steel sector plans to shrink capacity by 100-150 million metric tons over the next five years, which
puts the future of it in a difficult position.

China JitKuai Steel Group

China JitKuai Steel Group Corporation Limited is a leading state-owned conglomerate functioning
majorly in the steel industry. It was established in March 2013 by consolidation and restr ucturing of
two state owned prominent players in the steel industry – Jituan Group Corporation and Kuai Steel
Group Corporation. The Chinese government, to combat the overcapacity issue in the Chinese steel
market initiated the merger. Before the merger, both companies were reeling in losses. The
integration of their resources acted as a catalyst in helping revive the fortunes of Jituan and Kuai.

The JitKuai group operates through three subsidiaries operating in different industries:

1. Jituan Steel Ltd.

Jituan Steel Ltd., the first subsidiary, is a modernized globally leading integrated steel company and
the core enterprise of China JitKuai Steel Group Co. Ltd. The merger of Jituan Group Co. and Kuai
Steel Group Co., in 2013, gave rise to China’s largest steel producer – Jituan Steel Ltd.

The company produces high-grade steel for the automobile, shipbuilding, pipeline, household
appliance, and other sectors, primarily for the domestic market. The company’s steel is also used for
tool & die equipment, springs and bearings, and for the aerospace and commercial aviation
industries. The company is a major supplier to international automakers. Jituan Steel Ltd. is the first
and only company in China to produce using the smelt reduction technology. Smelting reduction
usually produces hot metal from ore in two steps. Ores are partly reduced in the first step and then

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final reduction and melting takes place in the second stage. Jituan adopted this technology in 2012,
and has increased production exponentially since then.

Since 2010, owing to fears of a worsened oversupply condition in China’s struggling steel industry,
the Yongming project in Eastern China which Jituan Steel had invested in, was put on hold. The 10
million-ton-a-year project was finally approved by the National Development and Reform
Commission, China’s top planning agency, in 2017. The first blast furnace of the Yongming plant is
expected to begin operations in January next year while production of hot rolled steel products will
start in 2020.

Problems

With a gradual slowdown of demand since 2015, in the domestic steel sector, the Chinese
government initiated a drive to cut overcapacity beginning in the fiscal year ‘15- ‘16 by 10%. Besides,
with intensifying concerns regarding the impact of emissions by the steel industry on the
environment, in December 2016, a government policy researcher was reported saying, “If we are to
solve the emissions problem more effectively, reducing capacity is a part of it”. China’s National
Development and Reform Commission, seeking to further address the accelerating steel
manufacturing capacity had introduced an additional 20% cut in production towards the end of the
fiscal year 16-17 which was to be put into effect from the fiscal year ‘17- ‘18. To restrict ways in
which steelmakers could invest in new capacity, the commission has introduced a new law, limiting
the emergence of new plants. To be allowed to invest in new factories, steelmakers would need to
have healthy, above-industry-average capacity utilization and R&D investment, and a commitment to
green cars and exports, among other conditions.

“It basically means, more or less, no newer factories. The government wants us to use existing idled
factories” a China-based executive working with a global steelmaker said.

“Our biggest concern is that the new policy, as proposed, places obstacles to a healthy, spontaneous
development of the industry,” said one of the two industry officials representing steelmakers. “It
deprives us of the discretion we have in freely formulating business plans and invest without
interventions.”

In addition to the aforementioned problems, operating in a labour-intensive industry, Jituan Steel

Ltd. is currently facing a major issue regarding their workforce. Over 250 workers were dismissed by
the company for trying to organize themselves into a trade union. This has sparked massive strikes
among the workers. They are now demanding a 15% hike in wages along with the permission to
form trade unions. The standoff between the management and the labour is affecting Jituan’s
production.

Furthermore, Jituan Steel Ltd.’s Planning and Development Department [P&D] and Human
Resources Department [HRD] have been at odds with each other. While the P&D Department is

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responsible for maximising productivity, the HRD looks after the welfare of the employees. The P&D
Department is planning to increase the duration of working shifts to compensate for the lost labour
hours due to the ongoing protests. The department feels it is the only way to curtail the losses being
incurred given the uncertainty regarding how long the labour strikes will last. However, the HRD
doesn’t agree with this. It feels that this will further damage the relationship between the workforce
and the management. The HRD is struggling to come up with an alternative solution which will
reduce Jituan’s losses and not further aggravate the workforce.

The Corporate Communications Office [CCO] of the JitKuai Group, which is responsible for public
relations, has also expressed its concerns regarding the move. The public image of the group had hit
a low due to allegations of labour law violations in the past. The Chinese group had come under
heavy scrutiny by the international media, regarding accusations of exploitation of its workforce and
employing underage workers in factories. The ongoing strikes have not helped its case either. The
suggested move has garnered strong objections from the CCO of the China JitKuai Steel Group. They
feel this move will tarnish the image of the group further.

Moreover, the devaluation of the Chinese currency and the ongoing trade wars has also been a point
of concern for the company. China's currency has shed almost 10% of its value against the dollar
since the trade dispute started to intensify. It was a good thing for Chinese exporters but its effect
now has been blunted by tariffs.

Competition

Jituan’s main competitor globally EisenTolle is a German multinational conglomerate, established in

1987, with a focus on steel production. It is the world’s largest steel producer with 360,000
employees across 50 countries. It has a massive global presence and holds nearly 15% of the global
steel market. It currently conducts its operations in Europe, North America and South Asia. Its
revenue for the financial year ‘17- ‘18 was 68 billion USD, and it produced 101 million metric tonnes
of crude steel in 2017.

EisenTolle’s method of expanding globally has been through acquiring and turning around struggling
companies. EisenTolle has previously acquired 16 companies, 14 of them being in the steel industry.
Its most recent acquisition was Vikalp Stainless Steel Ltd., an Indian stainless-steel producer. It was
the market leader 25 years ago but, in 2015 it was at the brink of declaring bankruptcy. Its fall from
its glory days was attributed to its failure in adapting to the changing Indian economic environment.
EisenTolle then took over Vikalp Ltd. and completely revamped the company. It is now on its path to
re-join the top ranks of stainless-steel producers in the country.

This year, EisenTolle is on the verge of starting operations in China. It acquired China’s Liux Steel Co.
– a private steel producer which was in heavy losses and is expected to begin operations of the Liux
plants in December. Jituan’s management is highly concerned about this development, especially,
keeping in mind EisenTolle’s successful past in turning around and reviving failing companies, its
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experience of 31 years in the industry and its colossal global market presence. This acquisition has
the capacity to drastically reduce JitKuai’s market presence in China. This will also lead to a fal l in
steel prices in China, given the Chinese steel industry’s overcapacity issue. The Chinese government’s
plans of reducing production by 30% combined with this will be a big blow for the Chinese Group.

Jituan Steel Group (in million USD)

YEAR REVENUE FROM OPERATIONS PROFIT BEFORE TAX

FY’13-14 8600 1300

FY’14-15 8300 1100

FY’15-16 7000 750

FY’16-17 6500 350

FY’17-18 5000 100

2. Kuai Erhohen Fund Management Corporation Limited

The second subsidiary, Kuai Erhohen Fund Management Co. Ltd is an emerging asset management
company in China which started operations in 2003. It is amongst the earliest joint venture fund
management companies in China as well as the earliest one that was established by a domestic trust
company and a foreign asset manager. Kasse Erhohen and Kuai Trust Co. came together in 2003 to
form Kuai Erhohen Fund Management Co. Ltd. Kuai Erhohen Fund Management is an indispensable
member of JitKuai Steel’s financial development strategy. It contributes 10% of total revenue of the
JitKuai Group.

Kuai Trust Co, its domestic partner, has a registered capital of USD 7 billion. It is a top player in the
finance industry in terms of investment performance and asset quality.

Kasse Erhohen, its foreign shareholder, is a global leading private equity investing group with over 50
years of experience in the industry. The firm has more than $50 billion in private equity assets. Its
active portfolio consists of more than 150 companies and is highly diversified by stage, sector and
geography. Kasse Erhohen is an experienced partner to management teams seeking to build durable
companies with sustainable value. Having set up its German office in 1994, Kasse Erhohen is among
the first international private equity management institutions to invest in China. So far, its
investment in China has totalled over 6.5 billion USD.

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Problems

Kuai Erhohen is currently facing a confidence crisis. Investors are losing faith in the company. In
2017, Kuai Erhohen credit rating had fallen from BBB to BBB- (Fitch Ratings). The firm’s clients are
losing confidence in the company and starting to pull out their investments. The management of Kuai
Erhohen believes the drop in the credit rating is due to macroeconomic factors and out of the
company’s control. However, action needs to be taken to provide the clients of Kuai Erhohen with
surety.

3. Jituan Resources Limited

Jituan Resources Ltd. is the third subsidiary of the China JitKuai Steel Group. It is a service provider of
metallurgic raw materials with business comprising mineral resource investment, trading and logistic
services. Established in July 2012, Jituan Resources has a total asset value of USD 3 billion with an
annual sales revenue of USD 2 billion.

Jituan Resources has over 20 long term investment projects both at home and abroad. These
investments have stable prospects and are of great value. Their value hasn’t been realised yet, but
are expected to yield high profits.

With its headquarters in Hong Kong, Jituan Resources focuses on international operations on the
basis of integrated decision-making structure. Jituan Resources has subsidiaries in Australia,
Singapore and Indonesia but it is struggling at capturing market share in these countries. The
company is not being able to adapt its services according to the needs of the different markets. This
is resulting in drainage of cash and an insignificant global presence.

Future Prospects

The Operational Improvement Department whose fundamental requirement is to make

continuous efforts towards the success of the organisation in today’s environment of change
and challenge, has been working on the future course of action for the expansion of the
company to drive growth and profitability. The plan of action is to explore venturing across
the borders of China and evaluate the possibility of a new subsidiary in the steel casting
industry, but right now, they are considering the options of two countries and companies that
can be a feasible choice.

The first company that JitKuai is looking at is Ypivka Co. Ltd. based out of Russia. Russia is
among the very few countries in the world that does not depend on the import of natural
resources necessary for large scale iron and steel production (with the two exceptions of
manganese and chrome). The same is true for energy supply. Russian steelmakers and casting
companies have reliable access to energy, which remains relatively cheap. For an energy
intensive sector like steel, this is an obvious competitive advantage. Ypivka casts high-grade

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steel and iron components, which it then supplies to various markets including dredging,
offshore and shipbuilding. The company specializes in bespoke products and short production
runs. JitKuai, an experienced manufacturer of steel, does not yet operate in this market
segment and intends to implement a number of operational revisions, after which an improved
market position and a growth in revenues is expected. Currently for Ypivka, the volatility of
supply of the raw material source along with increase in competition has created huge crunch
in their operating margin.

Another prospect company that JitKuai encounters is Navrachna Ltd. based out of India. India being
one of the emerging economies overtook Japan to become world’s second largest producer of crude
steel in February, 2018. India’s growth in steel production is attributed to the apt policies
undertaken by the government. The government has undertaken a host of steps to curb imports,
push local demand with implementation of the GST and infrastructure projects, to encourage the
domestic market. A truly remarkable feat achieved by India is the low cost production of steel,
yielding high growth prospects and increasing amounts of revenue, giving it a stronghold financially.
Navrachna Ltd. 0 casts steel and iron components. The company operates in both upstream and
downstream sectors. It is involved in extraction of iron and steel and processing the material into
finished components. It is the first casting company in the world to use the Corec Technology for
producing hot metals. The company doesn’t have a large number of mines under its hood. This
affects availability of raw material and reduces capacity utilization. Navrachna Ltd. is looking for a
merger mainly to maximise capacity utilisation. Recent amendments to the Environment Protection
Act are also expected to increase Navrachna Ltd.’s cost of production.

Now, in order to evaluate the two companies the following statistics are applicable to them-

The nominal risk-free rate in Russia, represented by the yield on the long term 10 year Russian
bond is, 9.23% while the same on the long term 10 year Indian bond is, 7.82%. The average long-
term historical equity risk premium in Russia is assumed at 7.95% and in India is assumed at
7.10%. Ypivka’s corporate tax rate is 20% and on Navrachna Ltd as per Indian tax laws is 25%.
Ypivka’s target debt-to-equity ratio is 0.8 and it is currently operating at its target debt to
equity ratio. However, Navrachna Ltd.’s target debt-to-equity ratio is 0.9 but it is currently
operating at a ratio of 1.06. Ypivka’s cost of debt is an estimated 1.05 percent over the 10-year
Russian bond and Navrachna Ltd.’s cost of debt is an estimated 2.25 percent over the 10-year
Indian bond. The beta for Ypivka and Navrachna Ltd., are 1.14 and 0.97, respectively.

The current year cash flow of Ypivka is $42,100,000 and the cash flow is expected to grow by 8%
in the first three years and at a rate of 10% for the next two years. The long term growth rate
post five years is expected to be stable at 6%. Their net debt is $30,600,000 and the number of
shares outstanding is 1,830,000.

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The current year cash flow of Navrachna Ltd is $34,400,000. The cash flow is expected to grow
by 6% in the first three years and at a rate of 11% for the next two years. The long term growth
rate post five years is expected to be stable at 8%. The company has a net debt of $25,100,000
and 1,146,000 outstanding shares.

Question 1
The looming trade war and the tariffs have been affecting the metal industry in China directly.
While the developments outside the company have proven to be a fair blow on their operating
efficiency, the various internal issues have triggered it further, as JitKuai reported a loss of $ 25
million in the first quarter of ’18-’19. What according to you should be the immediate steps that
the company should undertake to revive the profitability of the company and ensure it does
not lose its foothold in the industry?

Question 2

Given the future plan of action of the company, and the details of the potential acquiree’s
mentioned, based on the metric of NPV and the IV of the stock (to be calculated using WACC), as
well as the synergies of JitKua i Group with the both of them, w hich company do you think they
should go ahead to acquire? Attach an Excel Sheet to show your proper calculations.

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