It is indeed heartening to see a healthy debate going on in the media with respect to the recent privatisation of Pakistan Steel Mills. However, it is equally disturbing to note that several 'vested' parties have been exploiting the situation to mislead the public about the overall Pak Steel privatisation process.
There have been allegations that first of all the privatisation has been undertaken hastily in a non-transparent manner and secondly, a national, strategic asset has been sold at a throwaway price.
I will first tackle the issue of process transparency. After reviewing the matter, it appears that the Privatisation Commission did indeed follow a transparent process for the privatisation of Pak Steel, consistent with the process for other privatisations.
The Pak Steel process started in July 2005 when an international bank was appointed as the Financial Advisor. The appointment of the international bank was the result of a detailed review of technical and financial proposals received from several banks in response to an advertisement by the Privatisation Commission.
The Privatisation Commission started the Pak Steel sale process by inviting Expressions of Interest from interested parties in September 2005. Expressions of Interest advertisements appeared in both local and international press. Parties that submitted an Expression of Interest were issued a Request for Statement of Qualification, which included the qualification criteria approved by the Privatisation Commission Board.
These parties submitted their Statements of Qualification in October 2005, which were reviewed by a committee of government officials and Privatisation Commission Board members. The committee in turn submitted its recommendations with respect to pre-qualification of interested parties to the Privatisation Commission Board for final approval.
All pre-qualified parties were given equal chance to carry out a due diligence of PSMC, which included access to data room and management meetings. The Privatisation Commission carried out concurrent negotiations with all pre-qualified parties on the bidding documents. The final bidding documents were signed off by all the bidders prior to the bidding on March 31st.
There are also allegations that the Reserve Price has not been disclosed and therefore this lack of disclosure signifies that there was an underhand deal between the Government and the successful bidders. Having studied all the recent major privatisations, there is not a single privatisation where the Privatisation Commission disclosed the Reserve Price.
The Reserve Price is always kept confidential and it is announced only if the highest bid received happens to be less than the Reserve Price (as was the case in the privatisation of United Bank Limited). Therefore, this allegation also lacks substance.
Why did the Privatisation Commission issue the Letter of Acceptance to the successful bidder on the same day, immediately after the bidding without first going back to their Board and the Cabinet Committee on Privatisation? Yes, this is a deviation from the Privatisation Commission's standard operating procedure.
The reality is that the Privatisation Commission Board met a day before the bidding to discuss the Reserve Price and the Cabinet Committee on Privatisation met on the morning of the bid date to approve the Reserve Price. Since the Reserve Price had been approved at the highest level as per the Privatisation Commission Ordinance on the day of the bidding, it was rightly decided to give the Privatisation Commission the authority to issue the Letter of Acceptance immediately provided the highest bid was above the Reserve Price.
This approach seems to make a lot of sense and avoids the typical delays in issuance of Letter of Acceptance. I would like to ask the people who are using this as a means of criticising the government to point out the number of instances where the PC Board and the Cabinet Committee on Privatisation have not approved the highest bid that exceeded the Reserve Price. I believe the answer is never.
People have also questioned as to why did the Privatisation Commission allow consortiums to be formed after pre-qualification. This is a flexibility that is given in most privatisations. In all major closed and ongoing privatisations (NRL, PTCL, PPL, PSO) the Privatisation Commission has always given the pre-qualified parties the flexibility to form consortiums subject to the Privatisation Commission's approval. During the privatisation of National Refinery last year, 2 pre-qualified parties (namely Fauji Foundation and Gharibwal Group/Pak Hy-Oils) formed a consortium after pre-qualification to jointly bid.
In the case of Pak Steel, it is important to note that all the members of both the bidder consortiums were parties that were originally pre-qualified by the PC on a stand-alone basis. Therefore, there is absolutely no merit in the allegation that there something shady about the process since Privatisation Commission allowed already pre-qualified parties to form consortiums.
Overall, the privatisation process took around 7 months from the time the Privatisation Commission invited Expressions of Interest, which is in line with other privatisations (both in Pakistan and elsewhere).
Before attempting to address the issue of valuation, it is important to understand what is Pak Steel. Pak Steel is a small, sub-scale integrated steel manufacturing facility with an annual capacity of only 1.1 million tonnes. A 1.1 million tonne plant is considered to be of an uneconomical size and this is why there has been a lot of discussion over the last 2 to 3 years on the need to expand Pak Steel capacity (which would require an investment of almost US $1 billion).
It owns over 19,000 acres of land, which was allocated by the Government of Sindh for the specific purpose of setting up of steel mills and associated downstream industry. Out of these 19,000 acres, only 4,457 acres are being transferred with the company to the successful bidder. All of these 4,457 acres of land are in use by Pak Steel and do not include any unutilised land (in fact some of the bidders believe additional land would be required for an expansion).
Over 14,500 acres of land (at the main plant site as well as the entire township/steel town together with bungalows in Lahore, Islamabad and city office in Karachi) is being transferred back to the Government.
The Government and the Privatisation Commission have had the foresight to realise that strategic buyers will not pay any value for excess land holdings and have therefore ensured that only that land which is required for the core operations of Pak Steel is transferred with the company to the successful bidder.
Therefore, allegations that successful bidders will sell the land are baseless since there is no surplus land. Equally important to note is that the pre-qualification process of the Privatisation Commission disqualified a number of parties who were believed to be interested in only Pak Steel's land.
Pak Steel's improved financial performance over the last few years has essentially been driven by the unprecedented increase in international steel prices and margins as the steel industry has globally hit a historic peak. Despite the improved financial performance, the core operating issues faced by Pak Steel remain.
Another reason for Pak Steel's improved profitability is the subsidy given by the Government to Pak Steel in the shape of mark up waiver on GOP guaranteed loans. The Government undertook restructuring in 1999-2000, picking up Pak Steel's debt liabilities.
Despite the restructuring the Government of Pakistan still subsidises Pak Steel balance sheet, as the Ministry of Finance directly funds the interest cost on the Rs 7.767 billion, subordinated loan. Cumulative savings to Pak Steel in this regard are estimated in excess of Rs 4.5 billion. Additionally the company also enjoys Rs 825 million of interest free debt on its books, which is owed directly to the Government of Pakistan.
Pak Steel requires significant capital investment immediately if it is to operate at 100% capacity utilisation on safe and sustainable basis. Pak Steel has never achieved full capacity in its entire history. The technology used at Pak Steel is outdated and inefficient. Over the last 20 years, the company has failed to invest in upgrading and maintaining its facilities. As a result, most areas of the mill are in dire need of repairs.
The Coke Oven Battery Plant has broken down and its Hot Strip Mill is functioning well below potential. It has been reported that Pak Steel's capacity utilisation during the first six months of 2005-06 was less than 50% and the company probably made an operating loss which the Pak Steel management covered though one time income generated from sale of scrap.
The state of affairs at Pak Steel can be further gauged from the fact that in June 2005 the company had Rs 11 billion in cash and bank balances which have reduced to around Rs 7 billion only presently. Please note this cash has been used to finance day to day operating needs rather than undertake much needed capital repairs.
All cash on Pak Steel's books as of the day of privatisation will be paid back to the Government. Pak Steel management had commissioned an international consultant by the name of Corus in 2004 to carry out a technical audit of its operations and facilities.
The report by Corus was extremely critical of Pak Steel's operations and identified many areas of weakness that needed immediate attention at substantial cost. It is estimated that Pak Steel will require over US $75 million investment in the immediate term just to repair its coke ovens and undertake other critical repairs (without any increase in capacity).
Several vested parties have pointed out that since the value of 4,457 acres of land alone is over Rs 12 billion and that in addition Pak Steel has raw material and finished goods inventory of over Rs 9 billion, the plant and machinery has therefore been valued at only Rs 6 billion.
If the objective of privatising Pak Steel is to shut down Pak Steel, dismantle the plant and undertake an asset sale, then yes possibly the Privatisation Commission's valuation approach needs to be questioned. Only in such a situation would it be pertinent to look at the value of land and other assets separately.
If such an approach is adopted, then one would also need to take into account all its direct and contingent liabilities and obligations as well. The whole discussion has been around the value of assets but there has been no mention of its liabilities and other financial obligations.
More importantly, this approach would require that the social, economic and other financial costs associated with closing the down the steel mill (displacement of 13,000 workers, loss of domestic production and increased reliance on imports for finished goods, closure of the only metallurgical institute in the country, cost of dismantling the plant, environmental clean up etc) are also factored in.
The reality is that the Privatisation Commission is privatising Pak Steel on a going concern basis. The standard valuation methodology used world over is Discounted Cash Flows. This methodology does not look at the value of the assets separately but instead values the worth of the business, which is essentially measured by its cash generating ability.
It has been reported in the press that Pak Steel earned an after tax profit of Rs 6.7 billion in 2004-05 and that it would take the new owners only 4 years to recover their investment. The reality is that the steel sector globally is an extremely cyclical industry.
The recent improvement in PSMC's profitability has been driven by increasing steel prices and improving margins. The steel cycle is now turning as evident by falling international prices. China which is probably the largest consumer of steel was until recent a net imported of steel. With significant investment in steel capacity in China over the last few years, China has now become a net exporter and as result, this has started to push down international steel prices and hence margins.
Therefore, it is not appropriate to look at profitability in only one year but instead over a longer period to determine any company's true worth. Pak Steel's average after tax profit over a 5-year period is only Rs 2.6 billion.
Pak Steel's profitability going forward is also expected to be negatively impacted by the incentive package that has been announced for the workers and officers. In addition to an upfront, one time charge, there will also be a recurring expense as a result of this incentive package.
Pak Steel has many litigation/claims cases against it, which have a combined value of over Rs 3.5 billion. These include claims lodged by contractors, suppliers, customers and employees. It is common for investors to reflect in their valuations the impact of such contingencies/future claims.
Therefore, the Discounted Cash Flow methodology looks at the future profitability of the business over a period of time (taking into account the forecasted prices and margins) and also factors in the investments required going forward and the changes in working capital (the inventory is part of a company's working capital requirements and is essential for continued operations).
The highest bid of Rs 16.80 per share, translating into Rs 28 billion for 100% of the company therefore reflects the worth of Pak Steel on a going concern basis and a competitive bidding process has resulted in this highest bid.
I would like to take this opportunity to illustrate that the Rs 28 billion or US $482 million for 100% of the company received by the government appears to be a reasonable value.
Assuming that the successful bidder is able to undertake the necessary repair and is able to introduce efficiencies, which result in a 50% increase in profitability on average.
Therefore the average annual after tax profit of Rs 2.6 billion will increase to Rs 3.9 billion (or US $65 million). Assuming a US dollar based cost of equity of 15% (taking into account risk free rate, country risk premium and equity market risk premium) and a US inflation factor of 3%, one arrives at a present value of US $558 million of future cash flows before capital expenditure.
From this, one would need to subtract around US $75 million of critical investment required to ensure Pak Steel operates at full capacity on a safe and sustainable basis. This would result in a value of US $482 million or Rs 28 billion for 100% of the company.
Overall, it is a misconception that the value received by the Government for 75% equity stake in Pak Steel is well below its "true worth". The value received by the Government represents Pak Steel true worth and is through a competitive bidding process, which takes into account (i) the fact that the mill is based on old Soviet era technology (commissioned in 1981-1984) which is now outdated and inefficient and (ii) the extremely poor state of Pak Steel's facilities that need urgent critical repairs at substantial cost to the successful bidder.
Concerns have also been voiced that the privatisation of Pak Steel to a consortium of Magnitogorsk Iron & Steel Works and Al Tuwairqi Group will create a private monopoly. This concern, like other allegations, is completely baseless. Tuwairqi Group is setting up a 1 million tonnes per annum DRI technology plant with an installed capacity of 1mtpa in close proximity of PSMC.
The proposed project of Tuwairqi Steel Mills is being set-up in an Export Processing Zone and will primarily be an export-oriented plant. In case Tuwairqi plant for any reason wants to sell its products in the domestic Pakistani market, it will have to pay all the duties and import charges levied on imported products.
In effect Tuwairqi plant production, from a domestic sales perspective will be treated as imports, which would make Tuwairqi plant no more competitive then any other imported products. The steel sector in Pakistan is completely deregulated and imports are allowed without any restrictions.
The concern over the creation of a monopoly in Pakistan with the privatisation of Pak Steel does not have any merit. It is important to note that such concerns may be valid where a company operates as a dominant player in a protected environment, which is not the case as far as Pak Steel is concerned. Currently traders and other steel industry players are free to import at international prices.
Also on the issue of private monopoly, the overall market in the 2004 was estimated at 4.2mt, which is expected to have grown to over 5.0mtpa given the current construction boom in the country. Pak Steel presently caters to less than 25% of the total steel demand with the rest met through imports. Assuming a demand growth of 10% per annum, the steel market in Pakistan will be at over 6.0mtpa in the year 2008 by the time the Tuwairqi plant will come into commercial operations.
Pak Steel together with Tuwairqi plant will not have significant market power. It is also important to note that Tuwairqi plant and PSMC will be catering to different segments within the steel sector. Tuwairqi plant will start operations with making sponge iron and will later on upgrade to produce billets (which will require additional investment).
Therefore, the product range of Tuwairqi plant will be restricted only to billets, while Pak Steel has the capability to manufacture both flat and long products. Billets account for only around 35-40% of PSMC's total production. Furthermore it is expected that Pak Steel going forward will increasingly focus on higher value added flat products.
In conclusion, all allegations appear to be false and without merit. Credit should be given to the Government of Pakistan and the Privatisation Commission for undertaking such a difficult privatisation. Pak Steel is a classic case of why no government should be involved in running businesses. Pak Steel, which is considered to be a national asset of strategic importance, is in extremely poor state and is plagued by inefficiencies, corruption and overstaffing.
Let us all pray that this privatisation turns out to be a success for Pakistan and that the new owners of Pak Steel make the much needed investments in the mill to bring about efficiencies, improve product quality and expand capacity to serve the need of our country and for the benefit of all stakeholders.
It is encouraging to read in both the local and international press statements by the successful bidders that they intend to invest US $800 to 1,000 million in Pak Steel over the short to medium term to increase its capacity by almost 200% to 3 million tonnes per annum.