Finance Restructuring

India

In-depth Report

Restructuring In India The Tata Group

17 April 2002 Jyotivardhan Jaipuria Head Of Research (91 22) 232 8658 [email protected]

Transformation Of A Giant

Highlights:

Strategy

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One of the enduring themes in India has been the restructuring effort of some of the large corporate houses. We have looked at the Tata group as probably the best example of a group that has gone through a great deal of restructuring over the past few years and has survived the slowdown in economy and the lower margins. We believe the Tata group’s restructuring had three elements: 1. Changing group ethos: Restructuring of the Tata group is more interesting because prior to restructuring companies they tried to make the group more cohesive and evolve a common set of values across the companies. 2. Restructuring of companies internally: This included cutting costs and improving efficiencies to make the companies globally competitive e.g. Tisco is amongst the lowest cost producers of steel in the world, Tata Tea has the world’s largest integrated tea operations, TCS is Asia’s largest software services exporter. 3. Restructuring of the product portfolio of the group by identifying seven core business areas and selling off businesses that did not fit within these seven areas. (sell-offs include cement, pharmaceuticals, toiletries etc.). While investors could fault the pace of restructuring, willingness of the Tata group to divest businesses is in contrast with most other business houses in India. Having identified the business areas it wants to focus on, the group has been aggressive in its capex plans and acquisitions (including privatization such as VSNL and CMC) in these sectors. Another criticism of the Tata group has been the inability of some of the key businesses of the group to earn a Return on Capital Employed (RoCE) greater than the Cost of Capital. We believe: 1. The poor return partly stems from the economy-linked nature of the business. Some of these businesses should show strong growth in profitability and RoCE once the economy revives. 2. The group has been making a conscious shift away from commodity business to brand businesses and services that have a more sustainable return. This includes an aggressive thrust into knowledge-based industries, as also more sophisticated products in existing commodity business areas. From an investment perspective, Telco remains our top pick amongst Tata group companies that we cover. A high leverage to improvement in the economy and restructured operations should drive share prices, in our opinion.

DSP Merrill Lynch Limited Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc.

Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report. RC#03410701

Restructuring In India - The Tata Group – 17 April 2002

CONTENTS n Section Overview

Page

1. Restructuring Initiatives - Successes & Challenges

3

Company Profiles Tata Power Co. Ltd. (TPC)

Investing In Light

Tata Iron & Steel (TISCO)

Fighting Externalities

13

Elephants Can Dance Too!

17

Leading The Way

21

Moving Into International Arena

25

Restructuring For A Better Tomorrow

29

Tata Engineering & Locomotive Co. Ltd. (Telco) Tata Consultancy Services (TCS) Tata Tea Ltd. The Indian Hotels Company

2

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Restructuring In India - The Tata Group – 17 April 2002

1. Restructuring Initiatives - Successes & Challenges As the initial euphoria of opening up of the economy since 1991 subsided, corporate India was hit by the negative effects of facing up to global competition. Global deflation and reduced margins were soon to be the reality for corporate India. As we have stated in our earlier strategy reports, corporate India was left with only one option – restructure and cut costs or perish. History is full of examples of industrial groups that thrived in the industrial Raj but failed to adjust to the competitive era of a liberalized economy. On the other hand, there were groups that restructured themselves and survived and have prospered in the greater freedom that they now enjoy. We have looked at the Tata group as probably the best example of a group that has gone through substantial restructuring over the past few years and has survived the slowdown in economy and the lower margins. It is now trimmer and ready to venture into new areas. We believe the restructuring of the Tata group had 3 elements: 1.

Changing the group ethos: Restructuring of the Tata group is more interesting because the issues were not only of adjusting to a different economic environment but also of trying to make the group more cohesive.

2.

Restructuring of companies internally: This included cutting costs and improving efficiencies to make the companies viable in the new economic environment.

3.

Restructuring of the product portfolio of the group by identifying seven core business areas and selling off businesses that did not fit within these seven areas.

Our views presented in this report are post discussions with most senior executives in the Tata group including Mr. Ratan Tata and CEOs of the companies included herein.

Initiation By Fire In 1991, Mr. Ratan Tata took over as head of the Tata group in the backdrop of an economy that was still euphoric from unlocking of the shackles of the industrial licensing era. Yet, realization soon dawned on corporate India that more freedom also meant more competition and they would need to restructure themselves and be more focused to survive in the new age. For Mr. Tata, the problem was more acute than that faced by other group heads. The Tata group was a loose collection of companies enjoying much greater autonomy from the group CEO than probably any other group in the country. He had his task cut out for him. He had to: •

focus on changing the group culture as well as

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restructure the product portfolio of the group.

The proverbial chicken and egg problem was where to begin first. He chose to focus on group culture first. This meanwhile gave the companies time to carry on an internal restructuring exercise before the group could decide whether they were adding value in the new economic circumstances or not.

Changing The Group Ethos We believe this is always more difficult than selling product portfolios. The process involved replacing existing managements in many companies with younger and more dynamic management. It also brought about a more common

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Restructuring In India - The Tata Group – 17 April 2002

set of values across companies so that companies within the group thought and acted like one. There have been four distinct changes in the Tata group culture over the past few years: 1. Greater say in management of companies: The Tata group operated as a confederation of loose entities where the professional management of each of the Tata companies in operation had total control on the companies and ran it as their fiefdom. However, they still fell back on the Tata name when it suited their purpose like raising funds or asking the central Tata management for a bail-out. There is now greater control on strategic decisions taken by the companies within the Tata group including appointment of CEOs. However, management autonomy enjoyed by professionals in the Tata group in day-to-day functioning of the companies is still much higher than that in most other groups in India. 2. Raising ownership limits: The Tatas managed most of the companies with very small stakes. One of the anecdotes a decade ago used to be the fact that the Birlas had a higher stake in Tisco than the Tatas. While the brand name of the Tatas ensured that there would be very little threat to loss of management control, the Tatas decided to increase stake in most major companies. They now have a stake of at least 26% in all major companies making it morally and legally easier to manage them. Table 1: Trend In Tata Shareholding

Tisco Telco Tata Electric Companies

Tata Shareholding March 1991 7.5% 15.3% 1.7%

Present 26.4% 32.2% 32.2%

Source: Media

3. Creating a common brand equity: The Tata name has historically been associated with a reputation for honesty and integrity. However, there was no formal set of values running across the various companies in the group. There is now a common code of operation in the group that is followed by all the companies and reflects what the Tata brand name should stand for. This is both at the company level (adopted by the Board of every company) as well as at the individual level (agreed upon by every employee in the Tata group). We believe inculcation of a common set of values that all companies follow has been the most difficult task in the restructuring process. 4. Creating common standards: This involved having a common quality standard, which each company would adopt, so that the consumer had the assurance of getting a certain minimum from any Tata product.

Restructuring The Companies For most investors this is the more visible and exciting part of restructuring of a company or a group. However, we must remind investors that given the protected nature of the economy, it was more important to create the psychological framework so that there was minimal resistance to the changes that were being implemented at the company levels. n Companies Given Time To Restructure As mentioned earlier, the group decided to carry out restructuring at the cultural level before considering the product portfolio. This gave the companies time to restructure and adjust to the changing environment. The restructuring in all companies had a common theme – become globally competitive, gain the top 3 position in the market and work to ensure returns on capital employed higher than costs. We highlight below some of the restructuring efforts in a few of the Tata group companies. We have given details of companywise restructuring in some of the larger Tata group companies later in this report.

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Restructuring In India - The Tata Group – 17 April 2002

One of the best examples of restructuring is probably Tisco which found itself suddenly open to competition from global players. In the late 1990s, the company sold off its cement business as well as its stake in Tata Timken in a move to streamline its non-steel presence. In its steel business, the company undertook a major restructuring program involving modernization of its facilities, changing product mix to higher value products and cost cutting. The company has now emerged amongst the lowest cost producers of steel in the world. Telco has similarly been an example of a company that withstood the slowdown in its business due to restructuring efforts. The restructuring effort was 3-fold divestment of non-core holdings, cost cutting and revamping of product portfolio. The cost cutting initiatives included manpower reduction by nearly 30% and material cost savings by value engineering efforts and rationalization of processes and supplier base. The revamp of product portfolio through new offerings in the multi axle vehicles helped wean market share away from Ashok Leyland. We have seen similar restructuring efforts in the other Tata group companies. Indian Hotels has shifted towards a lower capital employment strategy by expanding through management contracts/joint ventures. It has, of course, also reduced manpower and restructured global operations in the USA and Sri Lanka. In Tata Tea, the acquisition of Tetley provides a global distribution reach to the company and enhances its presence in the branded tea market. Tata Tea has the world’s largest integrated tea operation. Tata Power is expanding into a national energy company and has also firmed up plans to leverage its existing infrastructure in the telecom space. TCS is Asia’s largest software services exporter and is looking at growing both up the value chain as well as inorganically (example: its acquisition of CMC).

Rationalizing The Product Portfolio Restructuring of the product portfolio again was not an easy exercise, as can be gauged by the fact that there was a need to start with the basic fact of taking an inventory of the companies constituting the Tata group. The Tata group comprised 85 companies (300 companies including all subsidiaries and associates) in 45 industry groups. Of course, the ABC analysis works in the Tata group companies also. Of the 85 companies, the 11 biggest account for 85% of the revenues and 90% of the profits of the group. On a broad level, the group is looking at cutting the number of companies to 40-45 in 14 business segments. n Focus On 7 Core Businesses …. The group has defined 7 core areas it will operate in as under: Table 2: Focus Business Segments Sectors Engineering

Materials Energy Chemicals Consumer Products Communications & IT

Services

Sub-sectors Automotive Engineering Products Engineering Services Metals Composites Power Chemicals Consumer Goods Telecommunications Information technology Control Systems Hotels, Property Development Financial Services International Operations Other Services

Main Companies Tata Engineering, Tata Cummins, Tata Auto Component Systems Voltas Stewarts & Lloyds of India, Tata Korf Engg. Services, Tata Construction & Projects Tata Steel, Tata SSL, Tata Refractories, Tata Sponge Iron Tata Advanced Materials Tata Power, Tata BP Solar India Tata Chemicals, Tata Pigments Tata Tea, Tata Tetley, Tata Coffee, Titan Industries Tata Telecom, Tata Teleservices, Tata Internet Services, Tata Elxsi Tata Consultancy Services, Tata Infotech, CMC Tata Honeywell, Nelco Indian Hotels Company, Tata Housing Development Company Tata Finance, Tata-AIG general Insurance, Tata-AIG Risk Management, Tata-AIG Life Insurance Tata International Tata economic Consultancy Services, Tata Financial Services, Tata Strategic Management Group

Source: Tata group

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Restructuring In India - The Tata Group – 17 April 2002 n ….. And Getting Out Of The Rest The group has embarked on a process of selling out of businesses that do not fit within these seven core areas. The Tata group has been amongst the most ruthless in terms of exiting from non-core businesses. This has included sale of some businesses as well as selling out its stake to its MNC joint venture partners. We list below some of the prominent examples of businesses sold: •

Toiletries (Tomco) and cosmetics (Lakme) to Hindustan Lever

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Cement - ACC to Gujarat Ambuja and Tisco to Lafarge

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Oil (Hitech Drillling) to Aban Lloyd

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Pharmaceuticals (Merind) to Wockhardt

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Paints (Goodlass Nerolac) to Kansai

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White Goods to Electrolux & UPS (Tata Liebert) to Emerson

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Stakes in bearings (Tata Timken) to Timken, IT (Tata IBM) to IBM and telecom hardware to Lucent

n Future Focus On Knowledge-based Businesses Apart from focusing on the identified seven core business areas, the group is exploring prospects in the following ‘knowledge-based’ businesses: •

Information Technology – This will not only include computer services but also design and application areas.

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Telecom – Here the group is interested only in being a service provider and sees no role in telecom hardware.

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Convergence – In the IT/telecom convergence, the group will focus on connectivity.

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Biotechnology – Here they would also like to explore convergence between conventional and non-conventional medicines.

Within the seven core areas, the company will be exploring new and profitable offshoots e.g. in metals they will look at opportunities in advanced metals and composites.

The Report Card We believe the restructuring of businesses has made the Tata group leaner and more competitive. While investors do tend to criticize the pace as being too slow, we believe the willingness to sell businesses and the divestment of businesses exceeds that of any other group in India. Moreover, we believe the framework has been laid for a more accelerated restructuring of the product portfolio. Another criticism of the group has been the inability of some of the key businesses of the group to earn return on capital employed (RoCE) greater than the cost of capital. This is partly due to the economy-related nature of these sectors. We believe returns will increase as the economy improves. However, some of these businesses may still not earn adequate returns. The Tata group is therefore shifting its focus from generic or product-driven businesses to brand-driven businesses and services where returns may be more sustainable. n Divestments And Acquisitions Accepted By The Group Willingness to sell businesses: We believe the greatest positive of the Tata group restructuring has been the willingness of Mr. Tata to sell out of businesses. While this is commonly accepted in Western countries, in India, traditionally, asset ownership was taken as a benchmark of power and progress amongst corporates. Moreover, we believe this is not the end of Tata group restructuring but just the beginning. We are likely to see more businesses being exited.

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Restructuring In India - The Tata Group – 17 April 2002

Greater aggression in the group: The group has traditionally been a conservative group and has tended to be slow in decision making. There are enough signs, however, that this has changed. Apart from some of the restructuring initiatives highlighted above, the group has been an active bidder in the Government privatization process. It has bagged two companies – VSNL and CMC amongst tough competition. Pace of restructuring – slow but irreversible: Investors have often raised concern on the pace of restructuring. While in hindsight, we agree that the pace could have been hastened, the bigger challenge was changing the mind-set of the people internally so that they accept the restructuring process. We believe the framework has been laid for a more accelerated restructuring of the product portfolio. Second, it may be pointed out that portfolio divestment in the Tata group exceeds that of any other group in the country. n Shifting Group Focus To Knowledge-based Sectors Inability of businesses to earn returns greater than cost of capital: Another criticism has been the inability of some of the key businesses of the group to earn return on capital employed (RoCE) greater than the cost of capital. Investors have argued that the group would be better off by divesting these businesses. We would, however, highlight 2 aspects to this: •

These businesses (steel, automobile etc.) are highly leveraged to performance of the economy and the downturn in the economy has adversely hit returns. The returns will increase once the economy bounces back.

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Second, given lack of an exit policy for industry, it is not possible to shut down a large business even if it is unviable.

The Tatas for their part are making efforts to improve viability of all their companies including adding new business areas or adding higher value products in the same business line. A good example is Tisco where the company is looking at newer metals (titanium) in an effort to increase returns. Shift from generic-driven to brand-led businesses: The group has also been making a conscious shift towards brand-driven businesses and services. In FY91, brand businesses accounted for around one-fifths of sales. Now they account for over one-half of sales. Moreover, the company has planned an aggressive thrust into new economy businesses that will increase this trend even further ahead. Chart 1: Sales Breakdown Of The Tata Group FY00 Communications Services & IT 10% 9%

Engineering 30%

FY01

Materials 22%

Communications & IT 12%

Consumer Products 13% Chemicals Energy 8% 8%

Services 11%

Engineering 27%

Materials 23%

Consumer Products 11% Energy 9% Chemicals 7%

Sources: Tata group

In terms of profits similarly, brand businesses and services are playing a more significant role. While the commodity businesses are more cyclical, profits in IT services have shown secular growth.

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Restructuring In India - The Tata Group – 17 April 2002

Table 3: Businesswise Breakdown Of Profits

Materials Consumer products Energy Chemicals Engineering Communications & IT Services

FY2000 PAT % of total 4213 21.2% 2231 11.2% 4712 23.7% 1434 7.2% 953 4.8% 4121 20.7% 2212 11.1% 19876 100.0%

FY2001 PAT % of total 5631 51.3% 248 2.3% 3967 36.1% 1409 12.8% -5236 -47.7% 7232 65.8% -2267 -20.6% 10984 100.0%

Source: Tata group

n Need To Improve Human Resource Management The group has traditionally been resistant to change. As a strategy they are now recruiting younger people and providing greater mobility across functions. The group has also been looking at drawing people from outside – there have been recent high level hires from reputed companies signaling a change in strategy. However, there is still a need to improve salary levels and provide a proper career path for individuals. n Greater Focus On Minority Shareholders’ Interests One of the common investor concerns with the conglomerate groups across the globe has been that they take decisions based on the interest of the group as a whole without considering the interest of the minority shareholder in the individual operating companies. Cross-holdings amongst group companies to fund their expansion plan was common amongst all groups in India too. The Tata group also has employed cross-holding in the past. Some of these have been profitable for the companies that invested in them. Going forward, the group’s plans in sectors such as telecom will mean that there is a need for some companies to contribute to these ventures. However, to protect the interests of minority shareholders: •

The Boards of each individual company will look at the investment as an independent decision and its effect on the plans of their company.

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The Tata group would not ask the associate companies to invest in any bailout package of any sister company e.g. following the Tata Finance fiasco, funding was by Tata Sons and group companies did not participate in the bailout

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The group may consider offering shares to shareholders of Tata companies directly in the new ventures.

One positive step towards protecting shareholder interests was the move of Tisco not to invest in the telecom plans of the Tata group. However, balancing minority shareholder interests against group financing plans is likely to remain a key challenge going forward.

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India Electric Utilities 15 April 2002

Tata Power Co. Ltd.

Suhas Harinarayanan (91 22) 232 8654 [email protected]

Investing In Light

Michelle Ring Director (65) 330-7210

Rs114.55

Net Income (mn): EPS: P/E: EPS Change (YoY): Cash Flow/Share: Price/Cash Flow: Enterprise Value/EBITDA: Gross Dividend: Gross Yield:

Long Term BUY

Reason for Report: Company Overview

Price: Estimates (Mar)

BUY*

Highlights:

2001A

2002E

2003E

3896 19.70 5.8x -6% 30.04 3.8x 4.8 5.0 4.4%

4627 23.39 4.9x 18.7% 38.18 3.0x 4.4 5.01 4.4%

5319 26.89 4.2x 15.0% 45.84 2.5x 3.4 5.01 4.4%

•

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Opinion & Financial Data Investment Opinion: Volatility Risk: Mkt. Value / Shares Outstanding (mn): Book Value/Share (Mar-2001): Price/Book Ratio: ROE 2002E Average: LT Liability % of Capital: Est. 5 Year EPS Growth: 2002E P/E Rel. to Home Mkt:

C-2-2-7 Above Average Rs22,680.9 / 198 Rs191.00 0.6x 11.7% 38.3% 12.0% 0.4

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Stock Data 52-Week Range: Symbol / Exchange: Bloomberg / Reuters: Exchange Rate: Free Float: Average Daily Turnover (th):

Rs148.75-Rs90.00 TPWFF / Bombay TPWR IN / TTPW.BO INR48.8600/USD 65% 301

*Intermediate term opinion last changed on 09-Oct-2001. For full investment opinion definitions, see footnotes. All figures are in local currency (Indian rupee) except where otherwise noted.

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From a modest beginning as the sole generator of electricity for Mumbai, Tata Power has grown aggressively into a national player with interests in energy and communications infrastructure. As part of its aggressive growth plans, the company has worked assertively on its capex plan to utilize its surplus cash including investments in telecom and a possible acquisition of Enron’s stake in DPC plant. We believe the key challenges facing the company are: a) making a success of its telecom investments (including its stake in VSNL) in the wake of crashing broadband prices and intense competition from Bharti and Reliance. Its telecom plans, we believe, are still evolving. b) funding a probable purchase of the Dabhol Power Company (DPC), which will multiply its exposure to the SEBs (currently at only 5% of its assets), apart from identifying a probable buyer for the generated power. YTD, the stock has underperformed the BSE30 by 13% (absolute return of 5%) and at current valuations, continues to trade at 40% discount to regional peers. We reiterate BUY.

Stock Performance

Tata Power

Apr-02

Mar-02

Feb-02

Jan-02

Dec-01

Nov-01

Oct-01

Sep-01

Aug-01

Jul-01

Jun-01

May-01

DSP Merrill Lynch Limited Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc. Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Apr-01

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.

150 140 130 120 110 100 90 80 70 60

Adj. BSE Sensex

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Restructuring In India - The Tata Group – 17 April 2002

From A Mumbai Power Generator To A National Leader In Energy Tata Power had its origins as the licensee for electricity generation, transmission and distribution for the city of Mumbai. In the late 90s, the company embarked on an aggressive strategy with the aim of becoming a national player in energy and communications infrastructure. This involved: •

Expansion of its existing power business outside Mumbai

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Thrust into the new areas of telecom, oil and gas.

What Drove The Change? We believe the driving force behind the company’s aggressive growth strategy is the man at the helm, Mr. Adi Engineer. We highlight two key elements of change: More aggressive strategies: This is reflected in most of the actions of the company, whether it is aggressive implementation of its telecom capex plans or bidding for the Right of Way (RoW) in Bombay or for the Enron power project. Use of surplus cash for company expansions: Tata Power has been amongst the most durable cash generation businesses of the Tata group of companies. But it invested the surplus cash in other group companies that were not symbiotic with its core business. Mr. Adi Engineer has now initiated a welcome change by investing the surplus cash in businesses that collaborate well with Tata Power’s corporate vision of becoming a leader in the energy and communications infrastructure. By emerging from the limits of its licensee business in Mumbai, Tata Power is embarking on a more exciting growth phase, in our view.

Implementation Of The Strategy n Expansion In Power Outside Mumbai The company has already added 464MW of new CPP/IPP capacity while limiting exposure to SEBs at below 5% (see In-depth research publication on Tata Power: Defensive Growth, 10 October 2001 for details). Table 1: Tata Power’s Generation Assets Facility Thermal (Mumbai) Hydel (Mumbai) Jojobera (CPP) Wadi (CPP) Belgaum (IPP) Total Source: Tata Power

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Installed Capacity Year of Commercial (MW) Operations 1330 1965 452 1910 308 1995 75 1999 81 2001 2,256

Type Thermal Hydel Thermal Thermal Thermal

Its expression of interest in bidding for the foreign equity in Dabhol exemplifies the new aggressive stance of the company. It has also expressed interest in bidding for the distribution circles (Delhi, Kanpur, Karnataka) that are being privatised. We would be looking at the Dabhol bid in greater detail later in the report. n Entry Into Telecom The company does not plan to enter the telecom services business but restrict itself to infrastructure facilities in the telecom business. In pursuit of its strategy, it has already established a Mumbai-wide OFC network of approx. 485km. In addition, it has won the bid to use the right-ofway (RoW) of BEST. It has, under wraps, a plan to expand its broadband services in other cities in pursuit of its ambition to launch an all-India network. The company has also invested Rs6bn as its share towards the purchase of VSNL by the Tata group. The company’s telecom plans, we believe, is still evolving especially post the acquisition of VSNL and will likely be in line with the game plan of the Tata group in telecom. n Energy Business The company’s ambitions in the oil and gas business are being undertaken through Tata Petrodyne, its 100% subsidiary. Tata Petrodyne has between 10% to 15% participatory stakes in different oil & gas exploration and production consortiums. Estimated capex is Rs1bn in FY02 towards developing the Lakshmi gas project that is expected to begin commercial production in July 2002.

Key Challenges a)

Funding asset building plans: The company has traditionally been a surplus cash company and has a huge cash reserve. However, given aggressive capex plans, the company is likely to see increased funding requirements that will mean increased debt burden and could even lead to an expansion of the equity base.

b) Enron integration can be a challenge: The company is one of the bidders for Enron’s stake in the DPC plant. A successful bid will be the start and not the end of Tata Power’s challenges. Two key challenges in integrating Enron within the company would be: •

Fund raising: The bid for Enron’s stake is likely to mean an investment of over half a billion dollars. This is equal to the present market cap of the company and would mean a substantial equity dilution to maintain corporate leverage.

•

Increased SEB exposure: Tata Power’s current exposure to State Electricity Boards (SEBs) stands at only 5% of its assets. Its exposure to the troublesome SEBs will multiply post Enron depending on the sales contracted to MSEB. However, we expect the take-over contract to build sufficient safeguards to reduce credit risk to Tata Power.

Restructuring In India - The Tata Group – 17 April 2002

c)

Regulatory risk: Future expansion in power is largely dependent on the pace of reforms in the sector, which unfortunately, has been slow until now. The Government has recently taken some encouraging measures to improve the health of the SEBs and open up the transmission sector for private investors.

d) Profitability of telecom business: With increasing investments in the telecom business, the company’s future profitability will become more volatile. First, the telecom business has a high gestation period. Second, increasing competition is likely to erode pricing power and margins. As an example, broadband backbone tariffs have crashed 50% in the last one year. Third, the telecom plans of the company are linked to that of the whole group. The plans are still evolving and to that extent could see variations in the coming months. Below, we outline in detail developments in the two most important growth plans at Tata Power – telecom and the Dabhol acquisition.

redrafting of the above plans, as VSNL comes with its own infrastructure, a free NLD license and is a completely debt-free company. The company’s telecom plans are still evolving post the acquisition and we believe that it will track the group strategy on telecom but will largely be restricted to the infrastructure portion of the telecom space. Besides direct investments in the infrastructure segment of telecom space however, Tata Power is also indirectly exposed to the services part through its investments in other group companies involved in telecom. •

Tata Power currently has a 49% stake in TTSL, which has the license to provide wireline services in 15 states. Operations are already ongoing in 2 states Andhra Pradesh and Maharashtra.

•

Tata Power is a 40% stakeholder in the Tata group entity that emerged as the strategic partner for VSNL. It has invested approx. Rs6bn as its share of the investment into VSNL.

Acquisition Of Dabhol Telecom Thrust Tata Power’s telecom plan is premised on the utility’s ability to leverage off its existing infrastructure. This it proposes to do in the role of a “carrier’s carrier”. This means leasing out existing infrastructure to telecom companies and not being directly involved in the service aspect of the business. The company’s stated telecom plans are as follows. Stage I: To grow within Mumbai where it has the right-ofway (RoW) for 1,200km. 485km of optic fiber cables (OFC) have already been laid, customers have already been signed for 50% of the network and 30% of fibers lit. Customers signed include Bharti, Orange, Satyam, and Hathway. The venture received a boost when Tata Power won a competitive bid for the BEST RoW (in south Mumbai) to lay OFC using electric poles owned by BEST. Stage II: To expand to other metros — Chennai, Delhi, Hyderabad and Pune. The venture will be symbiotic with the efforts of Tata Teleservices Ltd. (TTSL), the fixed service provider in these circles. Pune operations will kick-off by end-2002 while the other cities will be operational in FY2003. Stage III: Finally, a 'busy route highway' to link these cities. This will see the company forming partnerships and relationships with other players in the arena apart from building its own network. By 2002-03, the company expects to have 5,500km of backbone through a mix of new, bought and swapped assets. Tata’s use of its existing infrastructure and rightof-way should make the cost of entry into the telecommunications business relatively low (company estimates costs to be 15-20% lower than for a new network). Meanwhile, the acquisition of VSNL by the Tata group, we believe, could result in significant

Tata Power has expressed interest in acquiring the foreign stake (Enron, GE, & Bechtel together hold 85%) in Dabhol Power Corporation (DPC). The Dabhol project is a US$3.1bn project, with debt of US$2bn and equity of US$1.1bn and has been put to sale owing to the inability of the contracted consumers, the Maharashtra State Electricity Board (MSEB) to pay for the power supplied. n Financing Will Be A Challenge The project will be an investment in the books of the bidders and consequently, the lenders to DPC will not have recourse to the balance sheet of the companies. However, financing is likely to be a challenge for Tata Power with the minimum outgo likely to be half a billion dollars, close to market capitalization of the company. We believe if Tata Power is successful in winning Enron, it will require a substantial equity dilution. However, a successful Enron bid could transform the size of the company into a much larger player both in the power sector as well as on the stockmarkets. n BSES As A Customer – The Other Challenge BSES bought approx. 2,896mn units (approx. 50% of its total sales) from Tata Power in 2001. If BSES buys DPC or when the Electricity Bill 2001 comes into force, BSES may attempt to reduce power purchase from Tata Power. We do not foresee such a scenario, as the interests of the licensees (Tata Power has the license to generate, transmit and distribute power for Mumbai city until 2014), we feel, would be protected in either case.

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Restructuring In India - The Tata Group – 17 April 2002

Chart 1: Sales Of Tata Power To BSES

Table 4: Cash Flow Estimates (Rsmn)

120% 100%

3,500 3,000 2,500 2,000 1,500

80% 60% 40%

mn KWh

5,000 4,500 4,000

1,000 500 -

20% 0% FY95

FY96

FY97

FY98

TWPR to BSES (RHS)

FY99

FY00

FY01

% of total sales of BSES (LHS)

Source: BSES, ML research

Table 2: Earnings Model (Rsmn) Sales % chg. Y-o-Y EBITDA EBITDA margin Interest Depreciation Other income Extraordinary inc/(exp.) Profit before tax Profit after tax Distributable profits Reported EPS EPS % chg. Distributable EPS ROE Interest cover x

FY00A 27,895 21% 8,183 29.3% (2,800) (2,018) 1,695 1,580 6,640 4,696 4,185 20.9 42% 18.6 13.6% 2.9

FY01A 33,304 19% 7,954 23.9% (3,109) (2,046) 1,545 927 5,271 3,896 3,633 19.7 -6% 18.4 10.5% 2.6

FY02E 38,448 15% 10,073 26.2% (3,164) (2,926) 1,631 350 5,963 4,627 4,019 23.4 19% 20.3 11.7% 3.2

FY03E 44,923 17% 12,182 27.1% (3,036) (3,748) 1,439 6,838 5,318 4,644 26.9 15% 23.5 12.3% 4.0

FY01A 36,000 15,052 25,198 76,250 24,560 1,835 12,145 38,540 37,710 76,250 191 0.4

FY02E 40,137 19,648 19,643 79,428 23,069 2,015 13,097 38,181 41,247 79,428 209 0.5

FY03E 40,841 19,240 22,952 83,034 20,929 2,246 14,383 37,558 45,475 83,034 230 0.4

Source: Tata Power, Merrill Lynch

Table 3: Balance Sheet (Rsmn) Net fixed assets Total investments Total current assets Total assets Long-term debt Short term debt Total current liabilities Total debt Tangible net worth Liab & owners equity BV per share Net debt/equity Source: Tata Power, Merrill Lynch

12

FY00A 28,558 27,608 17,626 73,791 23,279 2,141 12,048 37,468 36,323 73,791 161 0.7

Year to Mar EBIT (Net other income) Add:depreciation Less:taxation Less: misc. exp Net change in working capital Net funds from operation Issue of equity Inc/(dec) in debt (Dividend paid) Net cash from financing (Addition to fixed assets) (Inc)/dec in investments Net cash from investing Merger related adjustments Total inc/dec in cash & eq. Source: Tata Power, Merrill Lynch

2000A 6,165 475 2,018 (1,944) 14 (2,202)

2001A 5,908 (637) 2,046 (1,375) (495) 2,355

2002E 7,147 (1,184) 2,926 (1,336) 0 (732)

2003E 8,434 (1,596) 3,748 (1,519) 0 (748)

4,527 6 801 (921) (115) (3,098) (3,379) (6,477)

7,801 (270) 1,778 (1,035) 474 (10,290) 12,556 2,266 (710) 9,831

6,821 0 (1,398) (1,090) (2,487) (6,975) (4,596) (11,572)

8,318 0 (1,940) (1,090) (3,030) (4,422) 408 (4,013)

(7,238)

1,275

(2,065)

India Steels 15 April 2002

Tata Iron & Steel (TISCO)

Reena Verma Vice President (91) 22 232-8667 [email protected]

Fighting Externalities

NEUTRAL* Long Term BUY

Reason for Report: Company Overview

Price:

Rs99.95

Highlights:

Estimates (Mar)

2001A

2002E

2003E

Net Income (mn): EPS: P/E: EPS Change (YoY): Cash Flow/Share: Price/Cash Flow: Gross Dividend: Gross Yield:

5385 14.64 6.8x

2339 6.36 15.7x -56.6% 27.37 3.7x 5.00 5.0%

3177 8.64 11.6x 35.8% 31.33 3.2x 5.00 5.0%

35.80 2.8x 5.00 5.0%

Opinion & Financial Data Investment Opinion: Volatility Risk: Mkt. Value / Shares Outstanding (mn): Book Value/Share (Mar-2001): Price/Book Ratio: ROE 2002E Average: LT Liability % of Capital: Est. 5 Year EPS Growth: 2002E P/E Rel. to Home Mkt:

D-3-2-7 High Rs36,781.6 / 368 Rs104.00 1.0x 13.3% 47.9% 10.0% 1.2

Stock Data 52-Week Range: Symbol / Exchange: Bloomberg / Reuters: Exchange Rate: Free Float: Average Daily Turnover (th):

Rs138.00-Rs66.90 TTISF / Bombay TISCO IN / TISC.BO INR48.8600/USD 73% 668

*Intermediate term opinion last changed on 16-Jul-2001. For full investment opinion definitions, see footnotes. All figures are in local currency (Indian rupee) except where otherwise noted.

• •

•

•

•

•

Tisco has actively changed with the times to emerge as one of the most cost competitive producers of steel, globally. Plant modernisation, product upgradation, and right-sizing of manpower have been the focus of the company’s efforts towards improving returns. However, rising trade barriers across global markets and subsidisation of the domestic industry by lenders continue to threaten TISCO’s profitability. After having successfully exit non-core investments viz. cement, Tata Timken, the company has been evaluating profitable growth avenues given the difficult external environment for steel. The company is evaluating investment opportunities in areas like titanium mining and telecoms versus further expansion in steel. We believe the company will take a considered decision regarding future growth plans. Continuous focus on cost competitiveness, room for further product upgradation and a healthy balance sheet, are key drivers of our long-term Buy rating on the stock.

Stock Performance

TISCO

Apr-02

Mar-02

Feb-02

Jan-02

Dec-01

Nov-01

Oct-01

Sep-01

Jul-01

Aug-01

Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Jun-01

Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc.

May-01

DSP Merrill Lynch Limited

Apr-01

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.

150 140 130 120 110 100 90 80 70 60

Adj. BSE Sensex

13

Restructuring In India - The Tata Group – 17 April 2002

Despite being one of the oldest steel companies in India, the average age of TISCO’s plants is currently at 7-8 years. The benefits of modernisation have been comprehensive in terms of cost-heads and products:

What Has Changed? Changing With The Times Over the past two decades TISCO has undergone structural change in response to the changing dynamics of the domestic and global steel industry. Until 1980, the Indian steel industry was characterized by absence of any material competition, low/ no import threats given the high duty structure and assured margins as the industry worked on a cost plus pricing structure. The focus of the players was only to keep on with production with little focus on quality or branding. The market was oligopolistic in nature with little or no product differentiation. Both the big and the small players thrived in this ‘sellers’ market. n Liberalization Spurs Company To Change The scenario changed with economic liberalization. From 1980 onwards, the government began to encourage market reforms in all sectors including steel – a process that is still underway. Cost competitiveness became a necessary precondition to survival as the industry integrated with global markets. Both the preservation of domestic market share against imports and the capturing of export markets hinged on cost competitiveness. Recognising the shift from a sellers’ market to a buyers’ market, TISCO set forth three clear objectives towards gaining a leadership position: 1.

Become one of the most cost competitive producers, globally.

2.

Build strong customer relationships and establish a brand identity for its product.

3.

Identify new areas that would enhance overall profitability of the company.

n Tata Steel – Globally Cost Competitive Towards achieving cost efficiencies and customer retention, TISCO undertook a massive modernization program. This program spanned nearly 2-decades and soaked up investments to the tune of Rs95.7bn. The results are obvious – on a global comparison, TISCO’s direct costs of production are amongst the lowest (Table 1).

•

Raw material consumption has steadily declined from about 4.8t/t of steel in FY91 to 3.6t/t of steel in 1H 02.

•

Labor productivity has improved from 79t of saleable steel produced per man year in FY95 to 182t in FY01.

•

Energy consumption has fallen from 8.72 Gcal/MT to 7.4 Gcal/MT over the past five years. Refractory consumption has nearly halved from 18.5 kg/MT to 9.8 kg/MT.

•

The share of higher-value flat products has risen from 14% in FY93 to 62% currently. A key highlight of TISCO’s modernisation program is that the efficiency improvements have been consistent through the last ten years. Also, it is very creditable that despite the high pressure of investments TISCO has steadily lowered its financial gearing from 1.5x FY93 to around 1x currently. In terms of balance sheet strength, we think TISCO is a clear winner in the Indian steel industry. n Technology - A Key CRM Tool Customer relationship management (CRM) is becoming increasingly important at TISCO, driven partly by its shift towards higher value products. Most of the higher value products involve channel disintermediation; productcustomisation and need for improved inventory management are a natural fallout. Technology has been at the forefront of TISCO’s efforts to improve customer service and manage associated inventory risks. TISCO has adopted SAP and has also extended the same to key customers towards 'locking in' the customer. TISCO is also working on e-Commerce initiatives to attract customers.

Key Challenges n Prolonged Downturn In Global Steel Prices Global cost competitiveness provides TISCO significant maneuverability versus industry peers but does not entirely insulate the company from vagaries of global price cycles. Consequently, TISCO’s profitability is unlikely to escape any prolonged downturn in global steel prices.

Table 1: Cost Of Steel Vs Global Players

Coke Sinter Hot metal Liquid steel HR coil Source: Company, ML estimates

14

CSN 86 20 104 146 200

THYSSEN 120 29 129 172 242

POSCO 65 30 87 123 154

NIPPON 107 29 119 160 221

TATA STEEL 00-01 H1 2001-02 56 56 15 15 73 75 109 109 153 151

NUCOR

150 192

SAIL 99 106 154 233

Restructuring In India - The Tata Group – 17 April 2002

Currently, global steel prices are close to their 10-year lows, and in many markets, prices are hovering close to the cash cost levels of major producers. This makes a sharp further fall in prices appear unlikely. However, we do not expect prices to recover in the near term owing to continued overcapacity in the industry and persistent financial support (by lenders and governments) to inefficient producers. Chart 1: Global Steel Prices Are At A 10-year Trough 700

n Investment Plans – At Crossroads In the late 1990s, TISCO sold its cement business and also exit from investments in Tata Timken in a move to streamline its non-steel presence. However, the company has been evaluating profitable growth avenues given the difficult external environment for steel. In FY01 Tisco announced plans to evaluate the growth opportunity in areas of telecom, ferro-chrome and titanium mining. In the near term, we do not foresee any dramatic investment in these areas owing to two reasons: 1.

Weak outlook for free cash generation from existing operations.

2.

Poor experience with diversification in the past.

600 500 400 300 200

HRC Price - US$/Ton (EU)

Jan-02

Jan-01

Jan-00

Jan-99

Jan-98

Jan-97

Jan-96

Jan-95

Jan-94

Jan-93

Jan-92

100

CRC Price - US$/Ton (EU)

Tisco is also evaluating further expansion of its steel capacity through the brownfield route. While TISCO’s own capacity utilisation has been close to peak levels, we think TISCO should wait for an improvement in the domestic industry’s supply-demand imbalance before making fresh cash commitments. In the interim, we think TISCO could consider increased dividend payout or share buy-back as alternate uses of any free cashflows.

Source: Bloomberg

Chart 2: Tisco: P/B

Apr-02

Apr-01

Apr-00

Apr-99

Exports will become more difficult both in terms of market access and price competition.

Apr-98

2.

Apr-97

De-linking of steel price cycles in various markets. Given the rising trade protectionism, local supplydemand dynamics will likely become the primary driver of steel prices in each market.

Apr-96

1.

Apr-95

Recent Sec. 201 proceedings in the US and expected retaliatory policies from other countries highlight the rising barriers to global trade in steel. We see two clear implications:

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Apr-94

Ineffective

Apr-93

n Trade Barriers May Render ’Global’ Prices

P/BV (TISCO) (RHS) Source: ML Research

n Continued Pressure On Domestic Steel Prices The (mis)fortunes of the steel market in India have been similar to global trend. With the exception of long products, domestic steel prices across products are close to 9-year lows. Domestic steel prices continue to be hit by: •

High domestic overcapacity

•

Redirection of exports into the local market owing to rising trade barriers

•

Scale compulsions of producers allowing limited flexibility to cut production

In the last 12-18 months, the problem of low domestic prices has been compounded by erosion/ inversion of margins across the product chain. Consequently, producers who undertook product upgradation as a counter-cyclical measure, have been severely hit.

15

Restructuring In India - The Tata Group – 17 April 2002

Table 2: Profit & Loss Yr to 31 Mar (Rs mn) Turnover Operating costs EBITDA EBITDA margin (%) Depreciation Operating profit Recurring ’other’ items EBIT Net interest income(exp.) Profit before tax Tax Profit after tax Preferred dividends Recurring net profit Net margin (%) Non-recurring items Reported net profit

Table 4: Cash Flow 2000A 60,940 (48,609) 12,331 20.2 (4,265) 8,066 525 8,591 (3,600) 4,991 (540) 4,451 0 4,451 7.3 (225) 4,226

2001A 68,386 (51,366) 17,020 24.9 (4,923) 12,098 551 12,649 (3,766) 8,883 (490) 8,393 (150) 8,243 12.1 (2,858) 5,385

2002E 68,508 (54,089) 14,418 21.0 (5,410) 9,009 551 9,560 (4,386) 5,175 (388) 4,786 (130) 4,657 6.8 (2,317) 2,339

2003E 75,715 (58,979) 16,736 22.1 (5,681) 11,055 551 11,606 (4,344) 7,262 (1,290) 5,972 (130) 5,843 7.7 (2,665) 3,177

Source: Company; ML estimates

Yr to 31 Mar (Rs mn) Recurring net profit Forex adjustments Depreciation Changes in working capital Other non-cash flow items Gross cash flow Net capital expenditure Loans to associates Free cash flow Net acquisitions Non-recurring items Other items Cash available for dividends Dividends paid Equity issued (Inc)/dec in net debt Opening net cash/(debt) (Inc)/dec in net debt Closing net cash/(debt)

2000A 4,451 0 4,265 3,549 0 12,266 (7,920) 0 4,345 (138) (225) (2,808) 1,174 (1,719) 0 (545)

2001A 8,243 0 4,923 2,170 0 15,336 (6,063) 0 9,273 (343) (2,858) (730) 5,342 (2,176) 0 3,166

2002E 4,657 0 5,410 1 0 10,067 (5,485) 0 4,582 (1,384) (2,317) 0 880 (2,152) 0 (1,272)

2003E 5,843 0 5,681 35 745 12,303 (5,582) 0 6,721 (500) (2,665) 0 3,556 (2,152) 0 1,404

(45,609) (545) (46,154)

(46,154) 3,166 (42,988)

(42,988) (1,272) (44,260)

(44,260) 1,404 (42,857)

2000A 51.0 8.7 12.4 9.2 129% 2.4 4.0 34.8

2001A 27.4 6.8 22.3 14.1 112% 3.2 5.0 34.1

2002E (56.6) 15.8 14.2 10.4 161% 2.0 5.0 78.6

2003E 35.8 11.6 20.9 11.1 150% 2.6 5.0 57.9

Source: Company; ML estimates

Table 3: Balance Sheet Yr to 31 Mar (Rs mn) Fixed assets Investments in associates

2000A 74,241 5,877

2001A 75,381 6,220

2002E 75,456 7,604

2003E 75,358 8,104

Inventory Trade debtors Other working capital assets Cash & cash equivalents Current assets

7,162 11,827 8,998 4,419 32,405

6,823 12,793 9,756 5,134 34,506

6,835 12,816 9,773 5,134 34,558

7,554 14,164 10,801 5,134 37,653

(26,148) (3,769) (29,916)

(29,703) (4,153) (33,856)

(29,755) (4,161) (33,916)

(32,886) (4,599) (37,484)

Total net assets

82,606

82,250

83,702

83,631

Capital & retained earnings Shareholders funds Preferred shares Long-term debt Deferred liabilities Capital employed

35,803 35,803 1,500 45,304 0 82,606

38,281 38,281 1,400 42,569 0 82,250

27,468 27,468 1,400 43,833 11,000 83,702

28,493 28,493 1,400 41,992 11,745 83,631

Working capital liabilities Short-term debt Current liabilities

Source: Company; ML estimates

16

Table 5: Ratios Yr to 31 Mar EPS growth – reported (%) PE – reported (X) ROE (%) ROCE (%) Gearing Interest cover (X) Dividend yield (%) Dividend payout (%) Source: Company; ML estimates

India Autos/Car Manufacturers / ADR

Tata Engineering & Locomotive Co. Ltd.

15 April 2002 Prakash Joshi Assistant Vice President (91) 22 232-8673 [email protected]

Elephants Can Dance Too!

BUY* Long Term STRONG BUY

Reason for Report: Company Update

Price – Local/ADR: Rs127.35/US$2.60 12 Month Price Objective: Rs155/US$3.15 Estimates (Mar)

2001A

2002E

2003E

Net Income (mn): EPS: P/E: EPS Change (YoY): Cash Flow/Share: Price/Cash Flow: Enterprise Value/EBITDA: Gross Dividend: Gross Yield: ADR EPS (US$): ADR Gross Dividend (US$): ADR Cash Flow/Share (US$):

-5003.4 -19.55 -6..5x -802.7% 0.03 4245.0x 20.0 0.0 0.0% -0.41 0.00 0.00

-1129.8 -3.53 -36.1x -77.4% 11.32 11.3x 9.8 0.0 0.0% -0.07 0.00 0.23

1442.1 4.51 28.2x -227.6% 15.95 8.0x 7.6 0.0 0.0% 0.09 0.00 0.33

Highlights: •

•

Opinion & Financial Data Investment Opinion – Local: Investment Opinion – ADR: Volatility Risk: Mkt. Value / Shares Outstanding (mn): Book Value/Share (Mar-2001): Price/Book Ratio: ROE 2002E Average: LT Liability % of Capital: Est. 5 Year EPS Growth: 2002E P/E Rel. to Home Mkt:

C-2-1-8 C-2-1-8 Above Average Rs40,752 / 320 Rs84.80 1.5x -5.5% 110.7% 15.0% 2.7

•

•

Stock Data 52-Week Range – Local: 52-Week Range – ADR: Symbol / Exchange – Local: Symbol / Exchange – ADR: Bloomberg / Reuters: Shares/ADR: Exchange Rate: Free Float: Average Daily Turnover (th):

Rs153.25-Rs59.95 US$3.01-US$1.25 TENKF / Bombay TENHF / OTC TELCO IN / TELC.BO 1.00 INR48.8600/USD 62% 2048

*Intermediate term opinion last changed on 03-Dec-2001. For full investment opinion definitions, see footnotes. All figures are in local currency (Indian rupee) except where otherwise noted. Note: Due to currency factors, the investment opinion for the ADR may differ from the underlying share.

•

If you thought elephants couldn’t dance, this Tata group major may have already proved you wrong. A stupendous Rs5bn loss in FY01 and market share losses across segments invigorated the restructuring efforts that were already ongoing in the company. The restructuring focused on return to profitability through — 1. Revamping product portfolio and revitalizing the marketing team 2. Aggressively cutting all costs – raw material, personnel, interest 3. Disinvesting non-core holdings. Telco’s consistent market share gains in M/HCVs and cars and expanding operating margins (up from 4.5% in FY01 to 10% in Q3 FY02) in FY02 put to rest any fears on the success of the restructuring exercise. Notable among non-operating initiatives are sell off of non core investments (over Rs2.5bn in FY02) and a rights issue for Rs6.7bn – resulting in significant interest cost savings. Telco has prepaid some of its expensive debt and is rescheduling some other. Key challenges ahead are: maintaining growth in CVs over the medium term and achieving cash breakeven in the car business.

Stock Performance 160 140 120

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.

100 80 60

TELCO

Apr-02

Mar-02

Feb-02

Jan-02

Dec-01

Nov-01

Oct-01

Sep-01

Aug-01

Jul-01

Jun-01

May-01

Apr-01

40

DSP Merrill Lynch Limited Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc.Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Adj. BSE Sensex

17

Restructuring In India - The Tata Group – 17 April 2002

Clawing Its Way Back

n Cost And Efficiency Focus

The huge Rs5bn loss for FY01 (its first ever loss and among the largest in Indian corporate history) came when a massive restructuring exercise was already underway at Telco and served to give a new sense of seriousness to the restructuring exercise.

Œ

Material Cost Savings: With raw materials accounting for about two-thirds of the total vehicle cost, biggest cost reduction opportunities exist in the internal manufactures, outsourced components and assemblies. Extensive value engineering efforts, rationalization of processes and supplier base and Internet-based reverse auctions are among the initiatives taken by Telco to cut raw material costs.

Œ

Manpower Restructuring: reduced headcount by 11,500 (about 30%) over 1998-2001 and is targeting another 1,500 in FY02. As a result, personnel cost fell 13% in FY01 and we expect it to decline another 5% over FY02 and FY03. Implementation of a performance-based compensation scheme and redeployment of people are underway to improve management productivity.

Œ

Financial Restructuring: taken firm steps to reduce balance sheet size and improve capital structure. Telco has raised Rs6.7bn through the rights issue, divested over Rs2.5bn of non-core investments, and pre-paid and/ or restructured high-cost debt. Thus, we expect total interest cost to come down 16% in FY02 and by a sharper 20% in FY03, when the full effect of these measures will flow in. Also, the company has written off Rs11.8bn from its share premium account. This includes Rs9.3bn deferred revenue expenditure, Rs2.15bn diminution of fixed assets (capital WIP) and Rs320mn diminution in investments. Although cash neutral, the write-off will make earnings look healthier starting FY03 as the over Rs1.2bn amortization charge will no more be needed.

Œ

These measures along with higher volumes have seen Telco’s operating margins at the 8-10% range compared with 4.5% in FY01.

In this section, we highlight some of the significant moves by the company over the last 18 months and those planned ahead: n Revamping Product Portfolio Œ

There is a shift towards higher haulage heavy commercial vehicles (HCV) and away from the traditional medium commercial vehicles (MCV) for better economics at the transporters’ end. Through new offerings in multi axle vehicles (MAV) range, Telco has emerged a bigger beneficiary of this shift than Ashok Leyland. These vehicles now account for over 40% of Telco’s truck sales vs just 25% last year.

Œ

Relaunch of indigenous 697-engine powered MCVs, cheaper than Telco’s Cummins range ones and those from competition. This helped improve margins for Telco and offered a more affordable vehicle for the customer. Additionally, Telco has also succeeded in bringing down the cost of Cummins engines.

Œ

Indica V2, an improved variant of earlier Indica models and loaded with additional features, has done well. It was recently voted the second most improved vehicle in the 2001 JD Power rating survey. With monthly volumes of over 5,000 units, the Indica project is now at cash breakeven, though still away from net breakeven.

Œ

Pipeline for the next 12 months includes more models in the HCV segment, a new LCV range and a mid-size car on the Indica platform.

Chart 2: Improving Operating Margin

Chart 1: Regaining Market Share In Key Segments

16% UVs (RHS)

Cars (RHS)

25%

70%

13.7% 13.7%

12%

10.0%

10% 20%

65%

15%

60%

10.6%

8%

8.9% 7.0% 8.4%

6%

7.3%

4%

Apr-00

Jul-00

Oct-00

Source: Telco, ML Research

Jan-01

Apr-01

Jul-01

Source: Telco, ML Research

FY00

0% Oct-01 Dec-01

FY99

40%

0% FY98

5%

45%

4.5%

2% FY97

50%

FY96

10%

FY95

55%

18

13.8%

3Q FY02

75%

14%

2Q FY02

LCVs

1Q FY02

MHCVs

FY01

30%

80%

Restructuring In India - The Tata Group – 17 April 2002 Œ

Growth Drivers Looking Up Œ

We see early signs of a domestic cyclical recovery:

Œ

Infrastructure industries grew 4.9% YoY in February 2002. Strong cement (21.1% YoY) and coal (8.3% YoY) volumes principally drove the growth.

•

Witnessing an uptrend in the capital goods and basic goods sector - indicators that we expect should strengthen, as we move into 4Q.

−

Real narrow money (M1) growth indicates that industrial recovery should have started in 3Q FY02, but for Sep. 11. Recovery should now start in 4Q.

−

Agriculture grew 2.8% in 1H FY02 vs 0.5% in 1H FY01. Further, we expect much stronger growth in 2H, as better winter rains (+31% above normal) have led to a 12% increase in gross cultivated area for the rabi (winter) crop. We expect this to help MCV demand (movement of agricultural goods).

Œ

NHDP (National Highways Development Project) road projects are on schedule. Nearly 18% is complete and over 2/3rds of the project with a capital outlay of Rs40bn is currently under implementation. This will provide a strong impetus to truck, tipper and dumper demand over the next 2-3 years.

Table 1: NHDP – Progress Up To Feb 2002 Link Delhi – Kolkata Kolkata – Chennai Chennai – Mumbai Mumbai – Delhi Total

Proposed Under (Km) Completed Implementation 1,458 22% 43% 1,684 4% 96% 1,281 14% 86% 1,422 35% 65% 5,845

18%

73%

Yet to be awarded 35% 0% 0% 0% 9%

LCV market is still languishing with no imminent sign of recovery. Again, competitive pressures have forced fleet operators to shift from LCVs to 3-wheelers. Telco is yet to offer a new value proposition for this segment.

n Car Business … Still Away From Breakeven Œ

In order to achieve net breakeven, Telco needs to ramp-up from current levels of about 5,000 units per month (cash breakeven) to about 7,000 units. The company plans to introduce a mid-car in order to address a wider market, and augment sales. These new variants and products will hold the key to the car business moving to pretax breakeven in the next 12-18 months.

Œ

Indica is also facing increased competition from its look alike, Fiat Palio, launched recently.

Œ

While the company is still looking for a suitable strategic partner for the car project, it could take some time given the state of the global economy. So while we expect an improvement in the car business, we believe positive earnings contribution is still some time away.

n High Earnings Leverage To CV Volumes Œ

M/HCVs and LCVs together contribute about twothirds of Telco’s total sales (by value). Significantly, CVs are among the highest margin contributors in Telco’s overall portfolio of products and outsourcing levels for CVs (esp. MCVs) are relatively lower than MUVs and cars, mainly due to legacy reasons. Thus, as we have highlighted in the past, Telco’s earnings are highly sensitive to CV volumes, which in turn are a function of the industrial, agricultural and investment activity in the country.

Source: NHAI

Table 2: PBT Sensitivity To CV Volumes Growth

Challenges Ahead n Excess Capacity in Goods CVs Œ

The recent upturn in truck demand is driven by fleet replacement rather than fleet expansion. Despite low fleet utilization rates, the need for better operating efficiency is shifting demand towards HCVs vs MCVs. Thus, tonnage capacity creation outstrips current demand and may dampen demand over the next 12-24 months.

Œ

Weak state government finances have severely affected bus order flow from state transport undertakings, though this has hit Ashok Leyland more than Telco given the former’s higher dependence on this segment of the market.

CV Volumes Growth Change in PBT (%)

-400bps 4 (65.2)

-200bps Base Case +200bps +400bps 6 8 10 12 (32.6) 32.6 65.2

Source: ML Research

19

Restructuring In India - The Tata Group – 17 April 2002

Table 3: Earnings Model Year to Mar(Rs m) Net turnover Operating cost EBITDA EBITDA margin Depreciation Amortization of def. rev. exp. Amortization of emp. sep. cost Interest Other income Profit bef tax & extra-ords Extra-ordinary income/ (loss) Tax-current Tax-deferred PAT exc extra-ord items % growth Reported net profit

Table 5: Cash Flow FY01 66,773 63,741 3,031 4.5% 3,474 1,374 167 4,436 1,947 (4,472) (532) (4,472) 608% (5,003)

FY02F 67,567 61,031 6,536 9.7% 3,586 906 259 3,638 273 (1,580) (450) (1,130) -75% (1,130)

FY03F 76,802 68,691 8,111 10.6% 3,659 2,815 423 2,060 515 103 1,442 -228% 1,442

Source: Telco, ML Estimates

Table 4: Balance Sheet Year to Mar (Rs m) Share capital Reserves Less misc. exp not w/o Net worth Loans Accumulated def tax liability Total liabilities

FY01 2559 26924 -8919 20564 29989 3055 53608

FY02F 3199 17512 0 20711 23963 2605 47279

FY03F 3199 18954 0 22153 21723 2708 46584

Fixed assets Investments Total current assets -Inventories -Debtors -Other assets -Cash & bank Total current liabilities Net current assets Total assets

38236 13872 27658 11051 7545 7908 1155 26158 1500 53608

35200 10704 24806 9626 6849 7405 926 23430 1375 47279

33491 10204 26723 10100 7575 7996 1052 23834 2889 46584

Source: Telco, ML Estimates

20

Year to Mar (Rs Mn) Profit before tax Less taxes paid Depreciation Less prev period expenses Less net misc/ VRS exp cap Changes in working capital Cash from operations

FY01 -5003.4 3.0 3473.7 0.0 -1047.0 7642.3 5068.6

FY02F -1579.8 0.0 3586.3 0.0 -411.3 -104.2 1491.1

FY03F 2060.1 0.0 3659.1 0.0 0.0 -1902.8 3816.5

Capex inc capital WIP (Inc) / dec in investments Cash from investing

-1868.2 -1864.4 -3732.6

-2700.0 2847.5 147.5

-1950.0 500.0 -1450.0

Inc / (dec) in share capital Inc / (dec) in share premium Inc / (dec) in debt Dividends paid Dividends taxes paid Cash from financing

0.0 0.0 -53.8 -639.6 -140.7 -834.1

639.7 3518.4 -6025.7 0.0 0.0 -1867.6

0.0 0.0 -2240.0 0.0 0.0 -2240.0

Total cash flow Opening cash Closing cash

501.9 652.7 1154.6

-229.0 1154.6 925.6

126.5 925.6 1052.1

Source: Telco, ML Estimates

India Computer Services

Tata Consultancy Services

15 April 2002 Mitali Ghosh (91 22)232 8661 [email protected] Vijay Bhayani (91 22) 232 8674 Girish Pai (91 22) 232 8657 Tien Yu Sieh (852) 2536 3025

Leading The Way Reason for Report: Company Overview

Highlights:

IT Services

• •

•

• • •

Established in 1968, Tata Consultancy Services (TCS) pioneered the offshore delivery model. It is India’s largest IT services company with an FY01 rev. of $690m and nearly 18,000 consultants (nearly 2x Indian peers’). TCS has a diversified revenue mix across services, domains and geographies. Products of TCS form 6-8% of revenues, including a wide variety of products like the software development tool, MasterCraft, the universal, integrated banking package, Quartz, the cement industry focused management tool, Cempac etc. We understand TCS is now focusing on growing its products business and leveraging its IPRs. At 800 clients, TCS has more than twice the number of annual active clients than its closest Indian peers’. It has more than 85 Fortune 500 clients. One of the most recent client wins was the US$40m+, 3-year contract from United Utilities Water Plc., UK. TCS outperformed industry during the 9-month ended Dec '01, with EBITDA growing by 49% YoY, on 340 bp margin expansion. It is TCS’ vision to be among the global top 10 consulting firms by 2010, with the edge of having downstream delivery capabilities. Key features of TCS’ business profile are: • Domain expertise built over 3 decades. TCS is also focusing on capturing its project experience into components/ brands e.g. Cempac, Quartz which help it showcase its domain knowledge to clients. • TCS invest 4% of revenues annually (vs less than 1% by Indian/global peers’) on R&D. • TCS has made significant progress in implementing its inorganic growth strategy, as reflected in its acquisition of CMC in Aug. 01.

DSP Merrill Lynch Limited Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc. Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.

21

Restructuring In India - The Tata Group – 17 April 2002

Company Overview Established in 1968, TCS is a division of Tata Sons Ltd., the holding company of the Tata group. TCS is the pioneer of the information technology (IT) industry in India, and is India’s largest software and services company. It was the pioneer of the offshore delivery model and undertook the first international assignment in 1971. It has nearly 18,000 consultants and its 51% subsidiary CMC, has another 3,200 consultants, thereby it has a total of about 21,200 consultants, about twice the number of its closest Indian peers. Its FY3/01 total revenues of $690m, was more than 50% higher than its closest peer in software exports in FY01 viz. Infosys.

Diversified Revenue Base TCS offers end-to-end IT consulting and services across diverse technology areas and industry verticals, as below. Table 1: Revenue Mix By Service Practice Year-ending March 01 60.4% 25.9% 5.4% 4.6% 2.9% 0.8%

Application Development & Maintenance E-Business Architecture & Technology Consulting Engineering Large Projects Others

Table 2: Revenue Mix By Industry Practice (%) TCS 39 18 19 7 4 13

Infosys 34 18 18 9 n.a. 21

Wipro 12 7 32 n.a. n.a. 49

Source: TCS, Infosys, Note*: BFSI : Banking, Financial Services and Insurance

Table 3: Revenue Mix By Geography Year-ending March 01 Americas Europe Others India

TCS 66 20 7 6

Infosys 74 19 6 1

Wipro Accenture* 64 49 29 39 7 12 Wipro Infotech

EDS* 58 12 30

Source: Companies, ML Note: Accenture data June 01, EDS Dec 00

Developing The Domestic Market TCS is the largest player in the domestic market, deriving 6% of its revenues from India. While billing rates and margins are typically lower in the domestic market vs the export market (typical discount seen in the

22

Reputed Client Base TCS has about 800 active clients annually, more than twice its closest Indian competitors such as Infosys (INFYF/INFY, C-2-1-7/C-2-1-7, Rs3,623/$61) and Wipro (WIPRF/WIT, C-3-1-7/C-2-1-7, Rs1,690/$35). 19 of the company’s top 25 clients have been with the company for over 5 years. It has a healthy percentage of repeat business at over 70% of revenues, with a reasonable contribution from new clients as well. Close Indian peers have new client contribution at less than 20%. The company has over 20 dedicated development centers (DDCs) TCS’ blue-chip client base includes 7 of the Fortune top 10 clients viz. General Motors, Ford Motor, General Electric, Citibank, IBM, AT&T and Verizon and over 85 Fortune 500 clients. This compares with 67 Fortune 1000 clients at Infosys and 84 at Wipro. A recent important client addition announced this month was of United Utilities Water Plc., UK. This is a US$40m contract over 3 years. United Utilities is UK’s 1st multi-utility group with annual turnover of £1,775m. According to the media, TCS added 84 gross clients between April and July 2001 (counts new business entities under same company/ group individually). This compares with about 50 gross additions by Wipro and Infosys.

Source: Tata Consultancy Services

Year-ending March 01 BFSI * Manufacturing Telecom Retail & Distribution Transportation Others

industry is at 40 to 50%), TCS gains valuable experience in the domestic market by undertaking complex projects. One such project was computerisation of the Reserve Bank of India’s (Central bank) public debt office to provide a real time money market trading and settlement system.

Products – Consolidating Knowledge Base, Leveraging IPRs TCS derives about 6-8% of its revenues from products, implying nearly $50m of product revenues in FY01. Amongst peers Infosys derived about 2.5% of revenues from products in FY01 at about $10m. TCS developed its first product, The Integrated Standard Banking System (ISBS), for the domestic market in the 80s. This product controls over 60% of the market even today. Until recently, TCS’ products were marketed mainly in the domestic market or sold as part of solutions in the global market. Now TCS appear to focus increasingly on commercially leveraging its IPRs, globally as well. Some of its leading products include Mastercraft (one of the world’s few tools of its kind, which help to organize and manage software development systematically, generic as well as custom products), Quartz (a universal, integrated banking package, reflects over 700 person years of development effort, deployed in 8 sites and is rapidly gaining acceptance in global markets), Network Custody and Clearing System (NCS, a custodial services system,

Restructuring In India - The Tata Group – 17 April 2002

deployed on 25 sites for 10 blue-chip clients, reflects 300 person years of development effort) and Cempac (a cement industry focused total management tool) etc. n Financial Metrics

FY01 TCS' FY01 revenue/employee is lower than Indian peers’ such as Infosys ($54,056 in FY01) and Wipro ($45,771 in FY01). This could partly be explained by TCS having a higher percentage of domestic revenues at 6% vs peers’. The employee numbers also include those on products.

n Technology Experience TCS’ has rich experience spans nearly 35 years. Its technology experience ranges from mainframe technology based assignments in the 70s to current day internet-based technologies and core technology services for telecom and technology. This gives TCS the ability to work with and integrate multiple systems, that clients often find themselves saddled with, particularly with increasing M&A in user industries such as banking etc. n Client Base

FY01 EBITDA margin at 36.2% was lower than 42.6% for Infosys and about 40% for Wipro.

TCS has a large, reputed client base. Its repeat business contributes over 70% of revenues. 19 of the company’s top 25 clients have been with the company for over 5 years.

Table 4: Key Financial Metrics

n Domain Expertise

Revenue (US$ m) EBITDA (US$ m) EBITDA margin % No. of employees Revenue/employee (US $)

FY97 220 80 36.4% 9500 23158

FY98 290 120 41.4% 10500 27619

FY99 410 190 46.3% 12100 33884

FY00 490 205 41.8% 14300 34266

FY01 690 250 36.2% 16800 41071

Source: Tata Consultancy Services

9m FY02 During the first 9 months of FY02, TCS has shown YoY rupee revenue growth of 34%, EBITDA expansion of 340 bp. and EBITDA growth of 49%, outperforming industry. Table 5: 9m FY02: Key Financial Numbers EBITDA YoY EBITDA Rs bn Revenue EBITDA PBT Margin % margin change TCS 30.5 10.7 10.4 35.1 340 bp YoY% 34 49 56 19.2 8.1 6.9 42.1 -130 bp Infosys INFTF, C-2-1-7, Rs3709 YoY% 44 39 41 25.0 7.5 7.0 29.8 340 bp Wipro WIPRF, C-3-1-7, Rs1596 YoY% 17.0 32.0 37.0 -270 bp in PBIT 34.8 PBIT Wipro margin of margin of global IT global IT svcs svcs Source: Company, ML Research

Key Highlights Of TCS’ Business Profile n Management TCS is managed under the leadership of its CEO Mr. Ramadorai, a 29-year TCS veteran and a Master in Computer Science from the University of California.

Three decades of experience and lateral recruitment have helped TCS build its domain expertise. Further, TCS has Centers of Excellence which carry out domain specific research aimed at capturing project experience into components and then possibly into brands. TCS is also exploring the option of collaborating with customers to share in owning the IPRs. For e.g. it has a joint IPR with an Australian company for one of the insurance products. n R&D TCS has the largest software R&D center in the country at Pune. It invests over 4% of turnover in R&D (vs less than 1% by Infosys, Wipro and the big 5 and global SIs). In addition it sponsors external R&D and has 11 collaborations with premier technological and educational institutions. TCS also has Centers of Excellence which undertake domain focused research, as discussed above. n Human Capital; Processes TCS invests over 6% of revenues in training and has a training facility to train over 3,000 people at a time. Over 50% of the employees have Master’s or PhD degrees and 60%+ have engineering degrees. Its EVA-linked performance based compensation system rewards merit. The opportunity to work on complex projects is also a motivating factor. Quality processes and methodologies enable TCS to manage very large projects. TCS has 14 centers and over 9,500 SEI-CMM level 5 certified consultants. It was also the world’s first company (four centers) to be certified at People’s Capability Maturity Model (PCMM) Level 4 in Aug. 2001. TCS has won prestigious large contracts such as the project from The Global Straight Through Processing Association (GSTPA) to develop a Transaction Flow Monitor (TFM), won against stiff competition from other global consortia including the big 5. TCS won this project in ‘00, as part of the consortium led by the Swiss Corp. for International Securities Settlement.

23

Restructuring In India - The Tata Group – 17 April 2002 n Inorganic Growth Strategy TCS leverages partnerships and alliances to expand business prospects, where necessary. For e.g. it has a partner in Switzerland, TKS Teknosoft, which helped it develop the Swiss market. It has several alliances with product and technology companies such as Oracle, Microsoft, IBM, Siebel, I2 etc. It also has several joint ventures including the call center with HDFC, Intelenet Global Services in which TCS has a 45% stake, the 49% JV with Singapore Airlines etc. Unlike many Indian vendors such as Infosys, Wipro etc. who have been considering the M&A route to growth, but have yet to kick-off the process, TCS has made tangible progress in implementing its inorganic growth strategy, as seen by the CMC acquisition.

The CMC Acquisition TCS acquired 51% in CMC Ltd. in Oct. 2001. CMC, with revenues of $160m in FY01, brings with it synergies in terms of its wide skill sets across systems integration, hardware/software support services (IS outsourcing related) and strong R&D capabilities in electronics system design. It also has a large well reputed client base including clients in verticals like transportation (London Underground, Changi Airport), and a large share of the domestic market with work done for the Indian government (Indian Railways) etc.

24

India

15 April 2002

Tata Tea Ltd.

Vandana Luthra (91 22) 232 8670 [email protected]

Moving Into International Arena – Opportunities And Risks Reason for Report: Company Overview

Highlights: The Tetley acquisition catapulted Tata Tea from the second largest branded tea marketer in India to the second largest tea multinational in the world with combined sales of over US$600m. The deal should offer significant synergies – Tetley gets access to Tata Tea’s gardens and production base and the latter gets Tetley’s premium brands and global distribution network. Tea prices are on a structural downturn with supply exceeding demand. In such a scenario, Tetley’s technical expertise should enable Tata Tea to upgrade its product portfolio and thus improve its competitive position. While Tata Tea’s restructuring initiative – moving from plantations to branded tea to now, global branded tea through Tetley – are exciting, the strategy does entail risks. Key challenges are to retain Tetley’s management team and improve cash flows to pay down the high cost debt, as the Tetley balance sheet is highly leveraged. Hence returns would accrue only on a longer-term horizon. Tetley was acquired for £271m (equity: £70m, debt: £201m) by a special purpose vehicle, Tata Tea GB. In FY01, Tata Tea GB made a loss of £13.7m including goodwill write-off of £12m. Tata Tea’s current exposure in Tata GB is Rs5bn, 57% of its net worth. This could rise should Tata GB need cash to pay down debt. In a worse case, Tetley’s bankers do not have recourse to Tata Tea’s balance sheet.

• • • • • •

Historic PE Band

Historic EV/EBITDA Band

700

45000

600

40000 35000

500

30000

400

25000

300 25x 20x 15x

200 100

20000

20x

15000

15x

10000

10x

5000

0

DSP Merrill Lynch Limited Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc. Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Apr-02

Dec-01

Apr-01

Aug-01

Dec-00

Apr-00

Aug-00

Dec-99

Apr-99

Aug-99

Dec-98

Apr-98

Aug-98

Dec-97

Apr-97

Aug-97

Apr-02

Dec-01

Apr-01

Aug-01

Dec-00

Apr-00

Source: Trends; Company Date

Aug-00

Dec-99

Apr-99

Aug-99

Dec-98

Apr-98

Aug-98

Dec-97

Apr-97

0

Aug-97

Consumer

•

Source: Trends; Company Date

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.

25

Restructuring In India - The Tata Group – 17 April 2002

Company Background Tata Tea is India’s second largest marketer of packet tea – FY01 tea volumes were 74m kg, sales and net profit was Rs8.2bn and Rs1bn respectively. Tata Tea owns 54 tea producing estates with approximately 25,700 hectares under tea cultivation across India. Branded teas account for 85% of Tata Tea’s total volumes. Tetley is the world’s second largest branded tea company – CY2000 sales were £246m and losses, £13.7m. Tetley blends, packs and distributes tea products (mainly tea bags) in the UK, Canada, Australia, USA and a number of European countries.

Restructuring Initiative Tata Tea’s recent acquisition of Tetley, world’s second largest tea company, is an example of Tata group emerging as a more vibrant player in an industry which otherwise offers falling growth rates. The deal should bring significant synergies – Tata Tea’s large production base can potentially feed into Tetley’s global distribution network. Over the last few years, Tata Tea has been gradually moving from plantations to branded teas. Exiting commodity (spices, etc.) trading and focusing on core branded teas appeared to be a successful strategy with the company establishing around 20% market share, (the second largest with turnover of Rs7.5bn), in the last two decades. The next step was to insulate the company from the vagaries of commodity prices and improve profitability of the business. The Tetley acquisition intends to achieve this objective, albeit gradually. The acquisition should help to expand Tata Tea’s export markets and provides access to Tetley’s extensive worldwide distribution network, thus creating an Indian multinational. n Factors Driving Tetley Acquisition While the acquisition will likely bring returns only in the long run, we present here management’s vision behind the acquisition. •

•

Value Addition Is Now Key

In a scenario of supply exceeding demand, the key for tea companies is to improve per unit realizations. This can be done by cost cutting and stronger brand portfolio. The former has limited potential in a highly labor intensive plantation business. Stronger brand portfolio is a better alternative. Tata Tea is trying to do just this with the acquisition of Tetley. The acquisition provides the company with a mix of plantation and brands. Plantations give regular access to specific types of tea, critical for maintaining blend quality and very importantly, to get the freshest teas. At the other end of the spectrum, Tetley strengthens Tata Tea’s existing brand portfolio. •

Stronger Brand Portfolio

Branded teas account for more than three-fourths of Tata Tea’s turnover. However, these are largely mid to lowerend brands facing stiff competition from smaller unorganized players. Falling commodity prices further exacerbates this problem. Hence a stronger portfolio was the key to improving market share and profitability in an otherwise relatively low-margin and fiercely competitive tea market. However building new brands is a time consuming and expensive exercise and the problem is further magnified when you add R&D costs. The Tetley acquisition should enable Tata Tea to overcome these issues to some extent. The premium-end of the market is less susceptible to commodity price changes and can improve profitability of the overall portfolio. Tata Tea should also benefit from Tetley’s technical expertise in value-added tea products such as instant, ice and herbal teas, all of which offer higher margin potential.

Structural Changes: Supply Exceeds Demand

Historically, supply and demand of tea has been in Tata Tea’s favor: over the last decade demand grew at 3% p.a. whereas production grew at around 2.2% p.a. Going forward, management expects supply to exceed demand and hence, structurally, tea prices will likely remain depressed. Factors operating on the supply side – Domestic supply is a function of exports and production. Exports have been falling owing to greater competition from lower cost producers, Kenya and Sri Lanka. Concurrently domestic production has been rising with a number of smaller plantations focusing less on quality. This leads to a vicious cycle of lower prices and smaller players further focusing on volumes to maintain the profitability of their plantations.

26

Factors operating on the demand side – Tea appears to be losing glamour. Perhaps more marketing aggression from cola manufacturers and growing coffee culture have impacted tea demand. While tea still remains the staple drink of the masses given that it is the most affordable beverage, urban markets have more alternatives available today and hence the falling tea demand.

Key Challenges While the acquisition of Tetley catapulted Tata Tea from the second largest branded tea marketer in India to the second largest tea multinational in the world, it also worsened the risk profile of the company. The key risks relate to management capabilities and an over stretched balance sheet. Strategically the company is moving in the right direction – selling branded teas worldwide and not just in India, however the key challenge is to earn a return from the Tetley acquisition. Management expects this to take some years.

Restructuring In India - The Tata Group – 17 April 2002

The key challenges for the group are: •

Table 2: Balance Sheet

Highly Geared Balance Sheet

Tetley was a highly leveraged buyout. The total acquisition cost of £271m was financed through £70m equity and £201m debt. A special purpose vehicle, Tata Tea GB, was created for the acquisition. At the time of acquisition, Tata Tea GB was held 100% by Tata Tea. Since then the Tata group has picked up 1.4% stake and Tata Tea’s stake is now 98.6%. Tata GB’s current debt equity ratio is 1.8:1 and debt repayment schedule extends over the next 7-8 years. With interest cover of merely 1.2x (as of end Dec2000), management’s key objective is to increase cash flows and reduce debt. As of end Dec 2000, Tata GB’s net loss was £0.5m. Tata Tea’s total exposure in Tata GB is Rs5bn, 57% of its total net worth. While Tetley is a leading brand in a number of countries, the key risk is whether the Tata group needs to infuse further cash. The additional £30m investment this year in Tata GB (£20m by the group and £10m by Tata Tea) brings this risk to the fore. Management has indicated further investments in Tata GB are unlikely. In a worse case, Tetley’s bankers will not have recourse to Tata Tea’s balance sheet •

Management Capabilities

The Tetley acquisition, places enormous pressure on management capabilities. Skill sets differ between a company operating in a local market and one that is operating in diverse markets. The relationship between the companies appears harmonious given that there has not been any major exodus of Tetley employees. For the acquisition to be successful, the underlying aim, i.e. to leverage Tetley’s global marketing expertise and Tata Tea’s strong experience in tea production, must be met. Table 1: Earnings Model Year to 31 March Net turnover Operating profit Operating profit margin Depreciation EBIT Interest Other income Profit before tax Tax Net profit Growth Net margin

1998 8698.7 1566.0 18.0% 146.6 1419.4 238.8 261.1 1441.6 420.0 1021.6 74.3% 11.7%

1999 8742.3 1935.5 22.1% 176.7 1758.8 180.7 269.5 1847.6 560.0 1287.6 26.0% 14.7%

2000 9124.6 1392.9 15.3% 186.5 1206.4 176.1 620.3 1650.7 405.0 1245.7 -3.3% 13.7%

2001 8228.8 1047.4 12.7% 203.7 843.6 250.4 682.8 1276.1 274.0 1002.1 -19.6% 12.2%

Year to 31 March Share capital - Equity Reserves Net worth Debt Total liabilities

1998 486.2 3304.0 3790.2 2867.4 6657.6

1999 486.2 3997.9 4484.1 2400.2 6884.3

2000 562.2 7740.2 8302.4 2697.5 10999.8

2001 562.2 8189.0 8751.2 2390.3 11141.5

Net fixed assets Investments Total current assets -Inventories -Debtors -Other assets -Cash & bank Total current liabilities Net current assets Total assets

2528.1 1778.4 4017.8 1103.6 838.6 1722.3 353.3 1666.7 2351.1 6657.6

2292.6 2311.1 4265.4 1590.8 826.7 1341.5 506.4 1984.9 2280.5 6884.2

2918.7 1995.6 8393.6 1912.1 829.6 5517.7 134.2 2308.0 6085.6 10999.8

3113.6 6219.1 3833.8 1414.5 606.7 1727.9 84.7 2025.0 1808.8 11141.5

1998 1,441.6 -329.0 1,112.7 146.6 -309.1 9,50.2 -432.9 64.6 -368.3 0.0

1999 1,847.6 -558.7 1,288.9 176.7 168.8 1,634.5 58.8 -532.7 -473.9 0.0

-45.1 -347.6 -392.8 189.1 164.2 353.3

-467.3 -540.2 -1,007.4 153.1 353.3 506.5

2000 1,650.7 -366.3 1,284.3 186.5 -4,172.5 -2,701.6 -812.6 315.5 -497.1 76.0 3,046.8 297.3 -593.7 2,826.4 -372.3 506.4 134.1

2001 1,276.1 -282.8 993.3 203.7 4,228.6 5,425.7 -398.6 -4,223.5 -4,622.1 0.0 4.4 -307.2 -550.2 -853.0 -49.4 134.2 84.8

Source: Tata Tea

Table 3: Cash Flow Statement Year to 31 March Profit before tax Tax paid Profit after tax Depreciation Changes in working cap Cash from operations Capex (Inc) / dec in investments Cash from investing Increase in share capital Increase in reserves Chg in debt Dividend (inc tax) paid Cash from financing Total cash flow Opening cash Closing cash Source: Tata Tea

Source: Tata Tea

27

Restructuring In India - The Tata Group – 17 April 2002

Cost Breakdown FY01 4

Turnover Breakdown

Chart 2: India Tea Price Trend

2

5

Rs/ Kg 85

1999

2000

2001

80

1

75 70

3

2

65

1

60

1 Raw materials 2 Packing 3 Manufacturing & others 4 Personal 5 Advertising & selling Source: Tata Tea

% 23.0 8.0 37.0

% 85.0 15.0

1 Branded 2 Loose

Source: Tata Tea

28

50 45 40 Jan

23.0 9.0

Feb

Mar

Apr

May

Jun

Source: Tea Auction Data, J Thomas & Co. Source: Tata Tea, Industry Sources

Table 4: Tea Turnover Breakdown Volumes (mn kg) % YoY Realisation (Rs. kg) % YoY % of Total Turnover

55

FY98 71.4 92.7 76.1%

FY99 72.2 1.1% 114.9 24.0% 94.9%

FY00 78.5 8.7% 109.5 -4.7% 94.2%

FY01 74.0 -5.7% 107.3 -2.0% 96.4%

Jul

Aug

Sep

Oct

Nov

Dec

India

15 April 2002

The Indian Hotel Company

Bharat Parekh (91 22) 232 8656 [email protected]

Restructuring For A Better Tomorrow Reason for Report: Company Overview

Highlights:

Chart 1: PE Band

Chart 2: EV/ EBITDA

1000 900 800 700 600 500 400 300 200 100 0

32 27 22 17

Source: Company Data

DSP Merrill Lynch Limited Produced in conjunction with DSP Merrill Lynch Limited an affiliate of Merrill Lynch & Co., Inc.Merrill Lynch & Co. Global Securities Research & Economics Group Global Fundamental Equity Research Department

Apr-02

Aug-01

Dec-00

Apr-00

Aug-99

2 Apr-98

Apr-02

Aug-01

Apr-00

Dec-00

Aug-99

Apr-98

Dec-98

Aug-97

Apr-96

Dec-96

Aug-95

Apr-94

5X

7 Dec-98

15X

12

Aug-97

25X

Apr-96

•

Dec-96

•

Aug-95

•

Dec-94

•

Dec-94

Leisure

•

Led by change in management in September 1997, The Indian Hotels Company (IHCL) has had a significant strategy shift with focus on the value-added side of the hospitality business vs physical expansion and also implemented a restructuring plan which includes: Shift from an asset-heavy to asset-light strategy with focus on asset control via JV/ management contracts. This helps IHCL expand the Taj brand’s reach and capture market share without putting undue burden on the company's balance sheet. E.g. Taj GVK, IHCL’s 25.5% JV in Hyderabad. IHCL has also restructured global operations in the US and Sri Lanka. In the US, it sold off all properties that did not fit its premium image. Owing to debt restructuring in Sri Lanka, the group reduced its global debt by over US$18m. IHCL also reduced staff by 18% in FY01, sold assets worth Rs140m to emerge as a lean organisation and is focusing on renovating leading properties to enhance revenues. Over the next year, IHCL plans to further improve asset utilization by selling-off surplus land worth Rs1bn. IHCL has also decided to restructure its property portfolio to focus on its premium image, which would also free-up cash. RevPARs (revenue per available room) are on a structural downturn led by global/ domestic events and excessive rooms supply in key cities accounting for over 80% of IHCL’s profits. The key challenge for IHCL would be to balance its global growth ambitions and shareholders' returns, which have deteriorated in the medium term.

Apr-94

•

EV/EBITDA

Source: Company Data

Merrill Lynch, as a full-service firm, has or may have business relationships, including investment banking relationships, with the companies in this report.

29

Restructuring In India - The Tata Group – 17 April 2002

Restructuring Initiatives The Indian Hotels Company (IHCL) cruised through management change in September 1997. Since then the company has adopted the following four key restructuring initiatives under the new IHCL management led by Mr. R. K. Krishna Kumar: •

Shifting towards an ‘asset-light’ model focused on hospitality vs real estate-driven earlier.

•

Restructuring global operations to reduce group/ IHCL debt

•

Reducing staff, selling surplus assets and renovating lead properties

•

Likely restructuring of its property portfolio to fit its premium image. This would also release cash.

but also improved bargaining power of the group, which resulted in obtaining a RevPAR premium of 1.17 (for Taj Krishna) and added to IHCL’s bottomline. (Note: RevPAR premium = RevPAR of the company / RevPAR of the competitive set; RevPAR of >1 = greater market share than company’s fair share.) Table 1: Taj Properties In Hyderabad Hotel Taj Krishna Taj Residency Taj Banjara Grand Kakatia Total

Company Taj GVK Taj GVK Taj GVK ITC

Rooms 261 140 118 180 699

Source: Company

RevPARs (revenue per available room - are calculated as occupancy rate multiplied by ARR and is a better indicator to assess the operating performance of the hotel) in the Indian hotel sector have been on a structural downturn led by the tough local scenario resulting from:

Consequent to its 25.5% strategic stake and management contract deal with all the 3 hotels of Taj GVK, IHCL captures the upsides relating to the hotel business in the city of Hyderabad without adding any new property to its balance sheet.

•

Domestic political/ economic uncertainties

•

Deteriorating law & order situation in select pockets

•

Regional tensions in the Indian sub-continent

Similarly, IHCL has also adopted an asset-light approach in the city of Ahmedabad in India and, likewise, to enter Dubai through Taj Palace, where it has taken the management contract route of market expansion.

•

Global recession & events such as 9/11 has led to slow growth in foreign tourist inflows.

n Restructure Global Operations To Reduce

Significant oversupply of rooms in key Indian cities, which accounts for over 80% of IHCL’s profits.

Another important measure adopted by IHCL is to restructure global operations. Taj had a presence in the US through 5 hotels – one in New York (Lexington), one in Chicago (Executive Plaza) and three in Washington. In 1999, the Taj group sold all its properties in the US that did not fit with its premium image. While Lexington hotel was sold for approx. US$105m, the Executive Plaza sold for around US$50m. The company received only around US$1m from the hotels in Washington, as they were under liquidation. The proceeds of the sale were used to reduce the debt burden of Taj HK, its subsidiary St James Court, UK and IHCL. As a result, of this restructuring, IHCL reduced the consolidated debt of the group.

•

n Shift Towards An ‘Asset-Light’ Model Focused

On Hospitality The new IHCL management, after assuming office in 1997, has been implementing strategies to shift from an asset-heavy to an asset-light business model, which focuses on asset acquisition through JV/ management contracts. The company believes expansion through JVs/ management contracts would help IHCL expand the Taj brand’s reach and capture market share without putting undue burden on the company's balance sheet. For example: Taj had a luxury five-star hotel (Taj Banjara), in the fast upcoming city of Hyderabad with luxury hotel demand led by the IT sector. Taj Banjara had a 17% market share in the city. Considering the potential of the city, IHCL saw an opportunity in the expanding capacity in Hyderabad. However, without spending too much on capex, Taj formed a 25.5:74.5 JV with the GVK hotel group called Taj GVK. The GVK group had two (then called Krishna Oberoi & Holiday Inn Krishna) of the city’s four five-star hotels. IHCL retained the management contract for all 3 hotels, which would add to its bottomline. This deal not only increased the Taj brand’s market share in the city of Hyderabad from 17% to 74% as shown below

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Consolidated Debt

Further, IHCL restructured its operations in Sri Lanka by restructuring its US$38m debt, which ballooned due to currency depreciation. Due to debt restructuring in Sri Lanka, the group reduced its global debt by over US$18m led by a one-time settlement with banks. n Reduced Staff, Sold Surplus Assets And

Renovated Lead Properties IHCL reduced staff in 2H FY01 by 1,244 (18%) from a 7,000-strong workforce through VRS at a cost of Rs496m. As a result, labor cost fell to 19.9% in FY01 from 20.7% in FY00. The full benefit of VRS would be reflected in the FY02 numbers.

Restructuring In India - The Tata Group – 17 April 2002

IHCL also sold assets/ land worth Rs140m last year to improve capital turnover. Another stage of IHCL’s restructuring has been to return to the basics and focus on its lead properties. As a result, IHCL initiated significant renovation of key properties in the metros — Taj Mahal, Mumbai, Taj Palace, New Delhi and Taj Bengal, Calcutta. This has resulted in a rise in market share and RevPAR premiums in the respective cities as shown below. Table 2: Citiwise Details

City New Delhi Mumbai Note: Data for April-Nov.

Revenue Mkt. Share FY01 FY02 21.6 23.46 43.11 46.65

RevPAR Premium FY01 FY02 1.05 1.16 0.91 0.99

Source: Company

n A Re-look at Property/ Land Portfolio To improve capital efficiency over the next year, IHCL plans to further improve asset utilization by selling-off surplus land worth Rs1bn, which it owns near the Mumbai airport. IHCL is also currently reviewing its property portfolio and might restructure this to meet its premium image. This should free-up cash for deployment into the premium segment. However, actual implementation of this plan remains contingent upon execution of sale. n Inter Firm Comparison Given the uncertain macro environment, the financials of IHCL as also that of the entire hotel industry, has deteriorated. However, we find that IHCL stands out with its relatively better performance vs competition in FY02.

Already IHCL has an RoE of 12.5% for FY01. The RoE has consistently fallen from 38% in FY95 to 12.5% in FY01. Considering the sector scenario in India and IHCL’s global growth ambitions, we believe the key challenge ahead for IHCL is to strike the right balance between its growth strategies and shareholders' returns, which have been under pressure in the last seven years. Table 4: Earnings Statement Y/E Mar, Rs m Available rooms(per day) Occupied rooms (per day) ARR (Rs) Income Rooms Food & beverages Misc. operating income Total operational income Other income Total income Expenditure Staff costs Food & beverages consume Fuel, power, light Supplies, services, repairs Sales & administration Operating profit Depreciation Interest Less: exp. capitalised to FA Profit before tax Tax Profit after tax EPS (Rs) CFPS (Rs) DPS (Rs)

FY98 2568 1500.3 5953.7

FY99 2618 1491.3 5507.2

FY2000 2762 1623.7 5231.9

FY2001 2705 1644.2 5022.6

3260.4 2243.9 446.8 5951.1 288.0 6239.1

2998.8 2385.9 508.4 5893.1 340.4 6233.5

3013.8 2512.5 508.4 6034.7 271.2 6305.9

3343.9 2921.0 610.1 6875.0 288.4 7163.4

993.4 803.7 470.8 532.7 1237.2 1913.3 324.2 251.9 14.4 1639.6 260.0 1379.6 30.6 37.8 8.5

1114.4 839.9 469.9 446.5 1266.3 1756.1 338.4 231.7 15.0 1541.4 350.0 1191.4 26.4 33.9 8.5

1252.2 763.2 497.2 522.3 1435.2 1568.0 376.9 155.4 3.8 1307.3 175.0 1132.3 25.0 33.4 8.5

1371.9 830.0 608.1 547.7 1651.9 1865.4 451.6 311.5 17.5 1408.2 205.0 1203.2 26.5 36.4 10.0

Source: Company Data

Table 3: YTD Performance In FY02 Particulars (Rsm) Sales EBITDA PBT (Operations) PAT

IHCL % Change 4362.8 -3.0 913.9 -19.7 368.1 -52.0 138 -74.3

EIH % Change 2759 -20.4 254 -63.2 211.2 -65.3 128.6 -72.4

Source: Company Data

n Key Challenges We believe that IHCL will have to balance its global growth ambition and shareholders' returns, which have deteriorated in the medium term. IHCL once again appears to be looking to expand globally with a presence in key gateway cities of the world, to drive traffic from these centers into India. While this strategy might yield positive results in the long term, we expect medium term pressure on the leveraged IHCL balance sheet.

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Restructuring In India - The Tata Group – 17 April 2002

Revenue Analysis (3Q FY02) Table 5: Balance Sheet Y/e Mar, Rs m Liabilities Shareholders’ funds Share capital Reserves & surplus Loans & advances Unsecured loans Shop security deposits Current liabilities Total liabilities Assets Fixed assets Gross block Capital work in progress Less: depreciation Investments Current assets Stock of stores & supplies Stock of food & beverage Sundry debtors Interest accrued on Inv. Cash & and balances Loans & advances Total assets Source: Company Data

By Category FY98

FY99

FY2000

FY2001

8128.0 451.2 7676.8 1626.7 987.3 346.4 1547.5 11648.6

8894.7 451.2 8443.5 1427.4 623.3 356.8 1635.8 12314.7

9577.0 452.2 9124.8 4042.1 1722.0 281.1 1722.7 15622.9

9615.6 454.2 9161.4 5476.3 1660.8 76.8 1872.3 17041.0

4145.7 5506.3 308.5 1669.1 2180.9 1773.8 45.6 157.7 809.1 0.0 761.4 3548.1 11648.5

4667.7 6102.4 554.3 1989.0 2590.9 1301.4 86.5 143.2 846.4 0.0 225.3 3754.5 12314.5

6068.6 8054.4 365.7 2351.5 3377.5 1297.3 92.3 100.5 834.1 0.2 270.2 4878.5 15622.9

6639.3 8798.9 605.2 2764.8 4221.3 1406.3 96.5 84.2 985.1 0.1 240.4 4771.1 17041.0

3

By SBUs

4 4 1

3 2

1 2 3 4

Rooms F&B Mgmt. fees Other

1 2

46% 39% 4% 11%

75% 12% 10% 3%

1 2 3 4

Luxury Business Leisure Corporate

Source: Company Data

Table 6: Cash Flow Statement Y/e Mar, Rs m Net profit Add: depreciation Gross/ operating cash flow Increase in FA Increase in CWIP Increase in inventories of F&B Increase in stores & supplies Increase in debtors Incr. in other CA (loans & adv) Increase in S. creditors Increase in other current liab. Increase in provisions Increase in working capital Free cash flow Increase in secured loans Increase in unsecured loans Increase in share capital Increase in security deposits Increase in investments Dividend paid Others Net cash flow Opening balance (cash) Increase/decrease in cash Closing balance (cash)

FY98 1379.6 324.2 1703.8 684.5 129.3 18.9 9.1 2.7 349.6 -50.5 32.6 -0.6 398.8 491.2 -154.6 -356.0 0.0 286.2 32.9 421.8 -15.0 -202.9 964.1 -202.9 761.2

FY99 1191.4 338.4 1529.8 596.1 245.8 -14.5 40.9 37.3 206.4 -74.6 86.1 72.9 185.7 502.2 164.8 -364.0 0.0 10.4 410.0 421.8

FY2000 1132.3 376.9 1509.2 1952.0 -188.6 -42.7 5.8 -12.3 1124.0 80.8 448.5 -58.9 604.4 -858.6 1516.0 1098.7 1.0 -75.7 786.6 425.7

FY2001 1203.2 451.6 1654.8 744.5 239.5 -16.3 4.2 151.0 -107.4 72.0 74.3 -0.5 -114.3 785.1 1495.4 -61.2 2.0 -204.3 843.8 42.2

-518.5 761.4 -518.5 242.9

469.1 225.3 469.1 694.4

1131.0 270.2 1131.0 1401.2

Source: Company Data

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