Smaller players of Tata Group: Which companies are investors' picks
Tata Group companies have always drawn the attention of investors for their transparent business practices and investor friendliness. And, with the recent appointment of Cyrus Mistry as the successor of Ratan Tata, these companies are again in the limelight.
While media reports have pondered over what this appointment means to the country's oldest business house, much attention has been also paid to the top breadwinners in the conglomerate.
We at the ET Intelligence Group decided to analyse the smaller players in the group to understand what lies ahead for them and to help investors pick and choose the right bets.
The House That Tatas Built
There are over 30 publicly-listed companies in the Tata empire, with market capitalisation ranging from Rs 56 crore (casting and forging company Tayo Rolls) to Rs 2 lakh crore (IT giant TCS). These belong to a slew of sectors including technology, retail, metals, hospitality, chemicals, and engineering.
Together, these companies have a market cap of over Rs 4 lakh crore with the top five players based on their market capitalisation constituting nearly 90% of this. They include TCS, Tata Motors, Tata Steel, Tata Power, and Titan Industries.
While these companies are more often on investors' radar, there are at least 18 companies that have a market cap of less than Rs 3,000 crore and, barring a few exceptions like Voltas and Rallis, are not tracked too often by analysts and investors. Our focus is on these small cap and midcap companies in the group.
Some of them are in the pink of health and look attractive at current valuations. These include Benaras Hotels, Rallis, and Tata Coffee.
On the other hand, some companies like Nelco, Voltas, Tata Teleservices (Maharashtra), and Tinplate are finding it difficult to maintain growth due to various factors such as intense competition, slowing demand from users, and higher raw material costs. Read on to know which to pick and what to skip.
VOLTAS
A household name for air-conditioners and refrigerators, Voltas has reported a significant drop in volumes and margins in the cooling business due to unfavourable weather conditions. Even as competition is stiff, the company is reluctant to compromise on the pricing front in this business segment so as not to damage its brand image. However, if the volumes fail to pick up in coming months, the segment margin may drop further.
Voltas derives the major share of its revenue from the electrical & mechanical projects (EMP) business where it has a strong international presence in the Middle East. The current global turmoil has put pressure on its margins and new orders are hard to come by. Moreover, the company is currently under pressure to complete a couple of projects in Qatar despite concerns of cost overruns. The challenge here is to maintain its reputation as it bids to win some of the major upcoming projects in Qatar in the run-up to the FIFA World Cup in 2022 to be hosted in the country.
TATA TELESERVICES (MAHA)
The telecom arm of the Tata Group has been struggling to report a net profit over the last several years and the task has become even more difficult with falling per user revenue and rising competition.
Together with its sister concern Tata Teleservices, the company had 8.8 crore subscribers at the end of October compared with 9 crore in June. In the last few months, the company has lost customers to competition. In addition, only half of its users are active according to data from the Telecom Regulatory Authority of India.
This is much lower than 80-90% active customers for its bigger peers including Bharti Airtel and Idea Cellular. With stiff competition from larger players, future prospects look gloomy for Tata Teleservices (Maharashtra).
TATA COFFEE
Tata Coffee, a subsidiary of Tata Global Beverages, is an integrated coffee plantation company. The company earns its revenue from production and sale of coffee (cured and instant), tea and pepper and from tourism on plantation estates. It is engaged in the production of specialty and certified coffees for developed, premium-paying markets.
Rallying coffee prices since last year have punctured the operating margins of the company's overseas subsidiaries. However, Tata Coffee as a standalone entity has registered record turnover and earnings during the first half of this fiscal aided by improved performance of the instant coffee division and continued growth logged by its plantations.
The outlook for coffee prices remains bullish with consumption exceeding supply and global inventories at an all-time low. A concrete business association with Starbucks Coffee can trigger further growth for the company.
TATA METALIKS
Tata Metaliks manufactures and sells pig iron. It also provides customers with critical support across their entire business cycle thereby emerging as a one-stop shop for raw materials and end products.
Though its sales have been growing at a moderate pace of 10-12% on average, the company has been reporting losses since the past six quarters on account of a spike in raw material prices. Unlike in the past, pig iron prices have lagged behind coke prices for the last four quarters. This has impacted the company's bottom line.
The company is facing difficulties in sourcing iron ore on account of mining restrictions in the places where it operates. Until the company gains pricing power and overcomes its raw material sourcing hurdles, its profitability will remain under pressure.
CMC
With a strong presence in the country's IT systems and integration sector for decades, CMC in a way complements the Tata Group's other technology companies. CMC earns half of its revenue by providing systems integration services to the government and private sector clients. It is also a high-margin business for the company with over 30% operating margin before depreciation.
Though the company reported impressive double-digit growth in its profits in the last six years, it was mainly on account of better cost management. Revenue remained more or less stagnant during the period.
The company's stock has lost 26% in the last year. It currently trades at a trailing twelvemonths P/E of 9. The domestic market for systems integration is rapidly developing, but CMC is yet to report any major improvement in its top line. Investors are advised to wait for a few quarters for cues on future growth.
TRF
Material-handling company TRF is but a small fish in the group with market capitalisation of less than Rs 300 crore. As the company's business is directly associated with the growth in the industrial sector, TRF too has been hit by slowing economic growth.
Though the current order backlog of Rs 1,275 crore gives TRF revenue visibility for more than a year, the order book size has been eroding consistently over the past few quarters as new orders have been hard to come by. The company is expected to bag a few orders from clients such as NTPC and Tata Steel in the near term.
Another concern for TRF in the near term is its deteriorating operating margin and return on capital employed (ROCE). The company's consolidated operating margins have dipped from over 10% until a year ago to less than 5% in FY11 while a consolidated ROCE of 6.4%, for FY11 is the lowest in the past four years.
RALLIS INDIA
Rallis India has come a long way from reporting losses in FY03 to becoming the most highly-valued agrochemicals company in India today. The company commands a P/E of above 23, higher than its bigger peers such as Bayer Cropscience and United Phosphorous. In last few years, the company posted a steady improvement in profits regardless of market volatilities. Recently, it acquired Metahelix to expand its presence in the seeds industry.
After growing its net profit at a cumulative annualised growth rate of 36% between FY08 and FY11, the company seems to be facing some headwinds. During the first three quarters of calendar year 2011 its profits grew in single-digit figures.
The company has a bright future with growing demand for crop protection products and better seeds across the world. It is setting up an additional unit in Dahej and is focusing on new products, R&D, registrations and exports to lead future growth.
TRENT
Trent is the retail arm of the group. Unlike many of it peers, Trent has very high operating efficiency. In the retail business, growth generally comes by increasing sales in the same stores and also by increasing the number of stores. This requires large capital expenditure and high working capital for increasing the inventory. To earn good returns on the capital invested, inventory turnover has to be high and debt needs to be in control.
Trent has one of the best inventory turnovers or the least inventory days in the industry, which reflects its efficiency. On average, it takes 60 days to sell inventory compared to 125 days for Pantaloon Retail (India). Trent's balance sheet is also comparatively stronger with a debt to equity of just 0.3. This means, the company has enough room to take loans for further growth.
At a price of Rs 963, the company is trading at a P/E of 46, which appears to be high on a trailing twelve-months basis, but is not as steep when discounted for its future earnings as stores take a couple of years to break even. Given its current expansion phase, investors can consider buying this stock at the current level.
TINPLATE
Tinplate Company of India (TCIL) is the country's largest producer and supplier of tin mill products, which are used in the metal packaging industry. TCIL corners about 35-40% of the domestic market.
Growth in the packaging sector is closely linked to the processed foods and beverage industry, which is expected to grow at 18-20% in 2012. Over the past five years, its sales and profits have grown at a compounded rate of 13% and 14%, respectively.
Though the long-term prospects are promising, the company's profitability has been under pressure on account of high input and borrowing costs. Since the March 2011 quarter, its sales and profits have been falling. In fact, in the September 2011 quarter its net loss almost doubled as it was not able to pass on the rise in raw material prices to consumers. Till this happens, the company's profitability will remain under pressure.
While these companies are more often on investors' radar, there are at least 18 companies that have a market cap of less than Rs 3,000 crore and, barring a few exceptions like Voltas and Rallis, are not tracked too often by analysts and investors. Our focus is on these small cap and midcap companies in the group.
Some of them are in the pink of health and look attractive at current valuations. These include Benaras Hotels, Rallis, and Tata Coffee.
On the other hand, some companies like Nelco, Voltas, Tata Teleservices (Maharashtra), and Tinplate are finding it difficult to maintain growth due to various factors such as intense competition, slowing demand from users, and higher raw material costs. Read on to know which to pick and what to skip.
VOLTAS
A household name for air-conditioners and refrigerators, Voltas has reported a significant drop in volumes and margins in the cooling business due to unfavourable weather conditions. Even as competition is stiff, the company is reluctant to compromise on the pricing front in this business segment so as not to damage its brand image. However, if the volumes fail to pick up in coming months, the segment margin may drop further.
Voltas derives the major share of its revenue from the electrical & mechanical projects (EMP) business where it has a strong international presence in the Middle East. The current global turmoil has put pressure on its margins and new orders are hard to come by. Moreover, the company is currently under pressure to complete a couple of projects in Qatar despite concerns of cost overruns. The challenge here is to maintain its reputation as it bids to win some of the major upcoming projects in Qatar in the run-up to the FIFA World Cup in 2022 to be hosted in the country.
TATA TELESERVICES (MAHA)
The telecom arm of the Tata Group has been struggling to report a net profit over the last several years and the task has become even more difficult with falling per user revenue and rising competition.
Together with its sister concern Tata Teleservices, the company had 8.8 crore subscribers at the end of October compared with 9 crore in June. In the last few months, the company has lost customers to competition. In addition, only half of its users are active according to data from the Telecom Regulatory Authority of India.
This is much lower than 80-90% active customers for its bigger peers including Bharti Airtel and Idea Cellular. With stiff competition from larger players, future prospects look gloomy for Tata Teleservices (Maharashtra).
TATA COFFEE
Tata Coffee, a subsidiary of Tata Global Beverages, is an integrated coffee plantation company. The company earns its revenue from production and sale of coffee (cured and instant), tea and pepper and from tourism on plantation estates. It is engaged in the production of specialty and certified coffees for developed, premium-paying markets.
Rallying coffee prices since last year have punctured the operating margins of the company's overseas subsidiaries. However, Tata Coffee as a standalone entity has registered record turnover and earnings during the first half of this fiscal aided by improved performance of the instant coffee division and continued growth logged by its plantations.
The outlook for coffee prices remains bullish with consumption exceeding supply and global inventories at an all-time low. A concrete business association with Starbucks Coffee can trigger further growth for the company.
TATA METALIKS
Tata Metaliks manufactures and sells pig iron. It also provides customers with critical support across their entire business cycle thereby emerging as a one-stop shop for raw materials and end products.
Though its sales have been growing at a moderate pace of 10-12% on average, the company has been reporting losses since the past six quarters on account of a spike in raw material prices. Unlike in the past, pig iron prices have lagged behind coke prices for the last four quarters. This has impacted the company's bottom line.
The company is facing difficulties in sourcing iron ore on account of mining restrictions in the places where it operates. Until the company gains pricing power and overcomes its raw material sourcing hurdles, its profitability will remain under pressure.
CMC
With a strong presence in the country's IT systems and integration sector for decades, CMC in a way complements the Tata Group's other technology companies. CMC earns half of its revenue by providing systems integration services to the government and private sector clients. It is also a high-margin business for the company with over 30% operating margin before depreciation.
Though the company reported impressive double-digit growth in its profits in the last six years, it was mainly on account of better cost management. Revenue remained more or less stagnant during the period.
The company's stock has lost 26% in the last year. It currently trades at a trailing twelvemonths P/E of 9. The domestic market for systems integration is rapidly developing, but CMC is yet to report any major improvement in its top line. Investors are advised to wait for a few quarters for cues on future growth.
TRF
Material-handling company TRF is but a small fish in the group with market capitalisation of less than Rs 300 crore. As the company's business is directly associated with the growth in the industrial sector, TRF too has been hit by slowing economic growth.
Though the current order backlog of Rs 1,275 crore gives TRF revenue visibility for more than a year, the order book size has been eroding consistently over the past few quarters as new orders have been hard to come by. The company is expected to bag a few orders from clients such as NTPC and Tata Steel in the near term.
Another concern for TRF in the near term is its deteriorating operating margin and return on capital employed (ROCE). The company's consolidated operating margins have dipped from over 10% until a year ago to less than 5% in FY11 while a consolidated ROCE of 6.4%, for FY11 is the lowest in the past four years.
RALLIS INDIA
Rallis India has come a long way from reporting losses in FY03 to becoming the most highly-valued agrochemicals company in India today. The company commands a P/E of above 23, higher than its bigger peers such as Bayer Cropscience and United Phosphorous. In last few years, the company posted a steady improvement in profits regardless of market volatilities. Recently, it acquired Metahelix to expand its presence in the seeds industry.
After growing its net profit at a cumulative annualised growth rate of 36% between FY08 and FY11, the company seems to be facing some headwinds. During the first three quarters of calendar year 2011 its profits grew in single-digit figures.
The company has a bright future with growing demand for crop protection products and better seeds across the world. It is setting up an additional unit in Dahej and is focusing on new products, R&D, registrations and exports to lead future growth.
TRENT
Trent is the retail arm of the group. Unlike many of it peers, Trent has very high operating efficiency. In the retail business, growth generally comes by increasing sales in the same stores and also by increasing the number of stores. This requires large capital expenditure and high working capital for increasing the inventory. To earn good returns on the capital invested, inventory turnover has to be high and debt needs to be in control.
Trent has one of the best inventory turnovers or the least inventory days in the industry, which reflects its efficiency. On average, it takes 60 days to sell inventory compared to 125 days for Pantaloon Retail (India). Trent's balance sheet is also comparatively stronger with a debt to equity of just 0.3. This means, the company has enough room to take loans for further growth.
At a price of Rs 963, the company is trading at a P/E of 46, which appears to be high on a trailing twelve-months basis, but is not as steep when discounted for its future earnings as stores take a couple of years to break even. Given its current expansion phase, investors can consider buying this stock at the current level.
TINPLATE
Tinplate Company of India (TCIL) is the country's largest producer and supplier of tin mill products, which are used in the metal packaging industry. TCIL corners about 35-40% of the domestic market.
Growth in the packaging sector is closely linked to the processed foods and beverage industry, which is expected to grow at 18-20% in 2012. Over the past five years, its sales and profits have grown at a compounded rate of 13% and 14%, respectively.
Though the long-term prospects are promising, the company's profitability has been under pressure on account of high input and borrowing costs. Since the March 2011 quarter, its sales and profits have been falling. In fact, in the September 2011 quarter its net loss almost doubled as it was not able to pass on the rise in raw material prices to consumers. Till this happens, the company's profitability will remain under pressure.
AUTOMOTIVE STAMPINGS
Formerly known as JBM Tools, ASAL is part of the Tata AutoComp (TACO) group, the country's leading automotive components conglomerate. The company is engaged into the production of a wide range of sheet metal components for passenger and commercial vehicles and tractors.
ASAL has posted a drop in sales and profit since last two quarters. It raised Rs 29.5 crore through a rights issue in July this year. The company's stock has depreciated since last year, underperforming the broader market indices.
TATA ELXSI
Bangalore-based Tata Elxsi is a niche player in the technical design segment. It offers embedded product design and industrial design solutions. It also provides animation and visual effects services and systems integration. Despite increasing opportunities across most of the business segments, Tata
Elxsi has not been able to register impressive growth over the last four years.
The company's revenue has not budged much from the Rs 400-crore level while profits at the operating and net level have declined during the period. The erratic change in its sales and profits reflects the lumpy nature of its business.
Tata Elxsi's stock has lost 26% in the last one year. Its trailing twelve months P/E works out to be 18.8, which is on the higher side when compared to the P/E range of 6-10 for IT companies of similar size. The premium valuation could be attributed to its exposure to the fast-growing animation industry. However, the company's performance so far does not instill confidence. Investors need to wait until there is some stability in its growth trajectory.
ORIENTAL HOTELS
Oriental Hotels is an associate company of Indian Hotels Company - one of the largest hotel chains in the country. Indian Hotels Company offers technical assistance to Oriental Hotels, which has the Reddy group of Chennai as its chief owners. One of the flagship brands of the company is Taj Coramandel.
Besides this, the company also runs other hotel units such as Fisherman's Cove, Vivanta by Taj and Gateway Hotels. Over the years the company has demonstrated impressive financial performance. Its operating margin is the best in the small-sized hotels segment.
Even in the present situation of weak business, the company has an operating margin of around 28%. With the completion of rebranding and expansion of Indian Hotels Company in coming quarters, the company would see an increased flow of revenues.
At present, the company is fairly valued. Its stock is commanding a P/E of 16. Its current stock price is at a 34% discount to its price a year ago. Investors are advised to buy into the stock with a horizon of one year.
TAYO ROLLS
Jamshedpur-based Tayo Rolls (formerly Tata Yodogawa) is a subsidiary of Tata Steel involved in the manufacture of cast rolls, forged rolls, special castings & pig iron. Tayo is a company with mounting losses each quarter. Continued delay in commissioning and ramp up of a new project coupled with the temporary suspension of pig iron operations had affected the profitability of the company causing severe cashflow problems.
The revenue of the company has also stagnated at Rs 128 crore since the last two fiscals. The company's stock has fallen since March this year, underperforming the broader market indices.
The roll industry is largely dependent on the steel industry. The current downtrend in the steel industry has compelled steel plants to have better inventory control management, due to which orders have been deferred resulting in poor offtake for companies like Tayo. The business of the company is likely to pick up once prospects for the steel industry improve.
NELCO
Once a flagship technology company of the Tata group engaged in high-end telecommunications, Nelco's operations today are limited to remote telemetry and managed network solutions. The company's stock performance has been poor over the last year following lacklustre business outlook.
Though the company's revenue grew at a moderate pace in the last five years, profits have dwindled. Revenue grew at a five-year compounded annual growth rate (CAGR) of 8.2% till September 2010, but the company failed to report consistent profits during the period. It reported an operating loss in each of the two years ended September 2011.
The company's core business of remote telemetry solutions has been facing competition from smaller vendors. The division's revenue shrank by nearly one-third in FY11. The other division that delivers network solutions also failed to grow during the year.
Nelco's stock fell by 58% over the last year. Given the bleak future prospects, it looks difficult for the stock to provide meaningful returns in the long run.
BENARES HOTELS
Robust financial performance, near zero debt, good dividend-paying record and advantage of location are major investment triggers for the stock of Benares Hotels.
The company trades at a P/E of 11 times, which is relatively low. The company's presence in Varanasi, one of the main pilgrimage destinations in India, ensures a continuous flow of travellers.
For years, the company has been recording a net profit margin in the range of 15-20%. This is far better than larger players like Royal Orchid Hotel and Kamat Hotels, which have a net profit margin of 10% and 1%, respectively. Given these factors, the stock looks promising for long-term investors.
MOUNT EVEREST MINERAL
The company sells bottled natural mineral water under the brand named 'Himalayan'. Tata Global Beverages owns 40% stake in Mount Everest Mineral Water (MEMW).
MEMW is a loss-making company logging annual sales of Rs 20-22 crore since the last five fiscals. The company has entered into a joint venture with Nourishco Beverages, a company promoted by Tata Global Beverages and PepsiCo India Holdings for branding and manufacturing Himalayan Natural Mineral Water. Since February 2011, MEMW has been in the process of transferring sales and distribution of its product. This arrangement is expected to drive market reach and volumes of brand Himalayan, aided by wider market access of the premium network of Pepsico India Holdings.
The company's stock has depreciated during the last nine months following poor financial performance. The company's business prospects hinge on the success of its joint venture with Pepsi and Tata Global Beverages.
It has been an eventful few weeks, culminating in the EU summit on Friday. The continued volatility in markets has tested the nerves of many an investor, and during times such as these it is important to look at the big picture trends and pay close attention to the views of market veterans. One such veteran, Jeremy Grantham, who runs the well known value fund manager GMO, published his "shortest quarterly letter ever" during the past week , which has some interesting observations on global markets. To summarise:
-His forecast of "seven lean years" of 2 1/2 years ago is being realised with a continuance of the large debt overhang, drop in asset values and general financial incompetence.
-In particular, the US and developed world is experiencing a permanent slowdown in GDP growth as result of slowing population growth, an aging profile and growing entitlements leaving inadequate resources for growth, together with a declining savings ate.
-In addition, an inadequate infrastructure, declining standards of education and ineffectiveness of government has made the US less competitive than other developed and some developing countries.
-Growth has also been held back by the growing inequality in the US leading to growing feeling of injustice, a weakening of social cohesiveness and a fall in the work ethic.
-Lack of income growth for the middle class has made demand more susceptible to changes in confidence and the willingness to take on more debt.
-The most critical long-term issues of depleting resources, a comprehensive energy policy and global warming have not been addressed in a serious manner.
-Looking ahead over the next year, the likelihood of bad outcomes are not as high as in 2008, but the possibility of extremely bad and long-lasting problems is as high as it has ever been.
-Yet the S&P 500 index has performed relatively well (compared to other global markets), driven by high profit margins and low inflation levels. Historically, these two factors are significant in determining P/E levels of the market and point towards levels which should be 20% higher if it were not for the numerous negatives facing the market.
-The S&P 500 index is unlikely to come down to its fair value of 975-1000 until profit margins decline. However, profit margins will eventually come down towards historical averages , dragging the market down with them.
-All major equity bubbles have broken below trend line values and stayed below them for years – the US in 1929 and 1965, Japan in 1989 – but the current market did not even reach the trend line in 2002 and took only 3 months to recover to the trend line in 2009. This is unprecedented and has been a result of the excessive stimulation of markets by Greenspan and Bernanke.
-Based on their study of the 10 biggest market bubbles (pre-2000) they calculate that it typically takes 14 years to recover the old trend line. With investors being conditioned to expect quick recoveries, an old fashioned downturn without the support of the Fed (whose arsenal is vastly depleted) could lead to a major decline in markets at some point.
-Following the market downturn in July, they found international developed equities , emerging markets and US high quality stocks to be relatively cheap with an expected 7% real return over 7 years. Despite the cheapness they remained a bit underweight due to the numerous negatives.
Recommendations:
-Avoid lower quality US stocks and remain near normal weighting in global equities.
-Have a bias towards safety.
-Avoid long term bonds and have enough cash on hand (and not be short-term greedy).
-Gradually build exposure to resources in the ground on a 10-year horizon. However, resources are likely to have further declines in prices due to a slowdown in China and better weather.
An insightful piece as usual - while pointing out the big issues facing the market, it does suggest maintaining core weightings in sectors such as US high quality, international developed equities, emerging market equities and commodities. At the same time, keep a reasonable amount of cash on hand to increase exposure on further market downturns. So stay the course, and try not to be incentivised to engage in either panic selling on downturns nor trying to pick the bottom to increase long exposure (as you are likely to be underexposed when the market begins to turn around). However, some amount of portfolio rebalancing when markets have big surges on the upside (to reduce long exposure) and on the downside (to increase long exposure) would be prudent.
The EU summit was an important event in that it set a long-term goal in terms of eventual fiscal union. This is a big positive as it does meet a key requirement for market stability – i.e. setting a long-term vision for the Eurozone. This opens the way for the ECB to play a more supportive role in the government bond markets , ranging from increasing its regular bond purchases in the secondary bond markets to quantitative easing (but a big bazooka announcement is unlikely unless market conditions warrant it). However, the actual path towards final stability is likely to be rocky as the finer details and processes are worked out over the coming months. Unfortunately, this implies continued volatility but, at the same time, the removal of a 2008 type meltdown scenario.
Have provided a chart below (from Soc Gen) which illustrates the relationship between the price of gold and the US monetary base over the last 90 years. This is the fundamental case for holding gold as part of diversified asset portfolio – as central banks across the world enter into further easing , gold is likely to continue to rise. So continue to buy on pullbacks!
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European Union leaders agreed on new fiscal rules enshrining tougher budget discipline on Thursday, an EU official said, after the European Central Bank doused hopes of dramatic action on its part to arrest the euro area's debt crisis.
The 27 EU leaders, meeting in Brussels, agreed on automatic sanctions for euro zone deficit offenders unless three-quarters of states vote against the move, and approved a new fiscal rule on balanced budgets to be written into national constitutions.
"There is a deal between leaders on the new fiscal compact," an EU official told reporters after four hours of talks.
However, they were still debating how to strengthen their future permanent rescue fund and whether to give it a banking licence, and had not yet broached the vexed question of whether the new pact requires major changes to the EU treaty.
European Council President Herman Van Rompuy, the summit chairman, wants all 27 EU states to agree to the rule changes via a minor adjustment to a treaty protocol that could be implemented quickly without requiring full ratification. But German Chancellor Angela Merkel demanded a fully fledged treaty change to give the measures extra weight.
"The Germans are obsessed with how we are going to do things, saying we have to change the treaty. They are totally obsessed. That's why it can get difficult," an EU diplomat said.
ECB President Mario Draghi earlier spooked financial markets by discouraging expectations that the bank would massively step up buying of government bonds if EU leaders agreed on moves towards closer fiscal union.
As soon as the draft summit agreement leaked, a senior German official rejected key measures including letting the future rescue fund, the European Stability Mechanism, operate as a bank, borrowing from the ECB, and a long-term goal of issuing common euro zone bonds.
Draghi said the bloc's existing bailout facility should remain the main tool to fight bond market contagion, despite its clear limits. It was illegal for the ECB or national central banks to lend money to the IMF to buy euro zone bonds, he said, appearing to veto one firefighting option under consideration.
The ECB did take unprecedented action to support Europe's cash-starved banks with three-year liquidity and cut interest rates back to a record low 1.0 percent to counter a forecast recession brought on by widespread austerity measures.
The euro and world shares briefly rallied on news of the draft summit conclusions, only to fall back on the German rejection. Investors are increasingly convinced only the ECB has the power to protect the euro zone, and were disappointed by Draghi's caution on bond-buying.
"One step forward, two steps back," said Alan Clarke, UK and euro zone economist at Scotia Capital. "The euro zone leaders might as well not bother. Pack their bags, go home, enjoy the weekend and do their Christmas shopping."
French President Nicolas Sarkozy dramatised the danger facing the 17-nation single currency area hours before their eighth crisis summit of the year in a speech to European conservative leaders in the French port city of Marseille.
"Never has the risk of Europe exploding been so big," he said. "If there is no deal on Friday there will be no second chance."
France and Germany used the Marseille meeting to lobby for their plan to amend the European Union treaty to toughen budget discipline, which they want to have ready by March. But several countries are sceptical of full-blown treaty change.
Merkel said on arrival in Brussels: "The euro has lost credibility and this must be won back. We will make clear that we will accept more binding rules."
The new ECB chief said his remark last week that "other elements" might follow if euro zone leaders agreed to seal tougher new budget rules had been overinterpreted as hinting the bank could step up bond purchases.
"I was surprised by the implicit meaning that was given," Draghi said, without offering an alternative interpretation.
The ECB cut its main rate by a quarter-point and flagged a strong chance of recession next year. Draghi admitted the central bankers had been divided even on that decision.
The plight of Europe's banks was also thrown into sharp relief. The European Banking Authority told them to increase their capital by a total of 114.7 billion euros, significantly more than predicted two months ago.
A Reuters poll of economists found that while 33 out of 57 believe the euro zone will probably survive in its current form, 38 of those questioned expected this week's summit would fail to deliver a decisive solution to the debt crisis.
DIVISIONS
Before Draghi spoke, one euro zone source said negotiators were close to agreement for their central banks to lend 150 billion euros to the IMF for firefighting operations.
Although the ECB chief ruled out the IMF buying euro zone bonds, that left the option of lending directly to governments as it more customarily does, although Italy for one has insisted it needs no such assistance.
The EU remains divided over the need for treaty change. Van Rompuy is urging leaders to avoid a laborious full overhaul that could take up to two years and face uncertain ratification.
He wants them instead to slip stricter budget enforcement through in a protocol to existing treaties, a suggestion which infuriated Merkel.
If all 27 EU states do not support more fiscal union by adapting the existing Lisbon treaty, which took eight years to negotiate, then Sarkozy and Merkel want the 17 euro zone countries to go ahead alone with more integration.
Swedish Prime Minister Fredrik Reinfeldt, speaking for a non-euro state, said: "We want to stick with the 27 concept of course because all of us are members of the European Union and we want to have our influence. We want to keep the European project together."
However, he said there was no support in Sweden for treaty change as of now.
The Franco-German plan would slap automatic penalties on countries that overshoot deficit targets and make countries anchor a balanced budget rule in their constitutions.
"General government budgets shall in principle be balanced. Member states may incur deficits only to take into account the budgetary impact of the economic cycle or in case of exceptional economic circumstances," the draft summit conclusions said.
The sanctions could be stopped only if three quarters of euro zone countries are against them.
Not all euro zone countries are comfortable with all the French and German proposals, with Finland opposed to their call for majority votes on major policy decisions.
U.S. Treasury Secretary Timothy Geithner, ending a visit to Europe to urge decisive action with talks with new Italian Prime Minister Mario Monti, said it was essential for European leaders to strengthen their financial firewall to give economic reforms a chance to work.
Monti is pushing through economic reforms after the euro zone's third biggest economy found itself sucked to the centre of the debt crisis.
