Portfolio

Tata Steel: Buy

Adarsh Gopalakrishnan | Updated on March 12, 2018 Published on September 10, 2011

Indian operations will remain the key to volume growth and consolidated margin expansion in the long run.



When steel prices turn volatile, Tata Steel's Indian operations have a distinct edge. They are highly efficient, enjoy high margins due to product mix and have captive mines. Capacity-additions underway in the Indian market will lift Tata Steel's consolidated margins. Tata Steel's stock trades at Rs 476, discounting the trailing 12-month earnings by 6.4 times and is cheap compared to domestic peers such as SAIL (10.7 times) and JSW Steel (seven times). On an enterprise value basis, Tata Steel at 5.5 times FY-11 EBDITA (earnings before interest, depreciation and taxes) trades at a discount to global peers such as Arcelor Mittal, POSCO and Nippon Steel.

DOMESTIC ADVANTAGE

Tata Steel operates in three geographies: Europe, India and South-East Asia. The Indian operations enjoy two advantages: One, making steel using captive mines is currently far more profitable than the model based on buying raw materials from external miners. Two, Indian markets offer far greater potential on steel demand and are more resilient in terms of demand than the UK, the Netherlands and South-East Asian markets. Despite lower growth in several consumer segments and lacklustre infrastructure spending, Indian steel production grew by five per cent in the first seven months of 2011.

During the first quarter of the ongoing fiscal, Tata Steel's net sales rose by 22 per cent to Rs 33,000 crore on the back of higher realisations and marginally higher deliveries. EBIDTA, excluding ‘other income', dipped marginally to Rs 4,400 crore due to higher raw material costs. But they still fared better than domestic and international steel makers.

This number may have been worse if it were not for the Indian operations, whose EBIDTA increased six per cent to Rs 3,100 crore. Indian operations chipped in with 70 per cent of consolidated profits, even as it produced less than a third of the company's steel.

This was topped off by healthy realisations. In the quarter ended June 2011, Tata Steel's Indian operations earned Rs 20,000 in operating profits per tonne of steel compared to Rs 3,500 from its European operations. This tear-away advantage is difficult to overstate and remains the key catalyst for Tata Steel's stock over the next five years.

EXPANSION IN INDIA

The company's Jamshedpur unit is in the process of upping its annual steel production capacity from 6.8 million tpa to 9.7 million tpa, benefits of which are expected to kick-in from FY-13. Captive mines will take care of the entire iron ore requirement for this expansion and half the coking coal requirement. A three-million tpa flat-products plant in Orissa is also to be commissioned by 2014. The company is in the process of tying up iron ore reserves and coal mines for this plant. The Indian operations will remain the key to volume growth and consolidated margin expansion in the long-run.

WORK IN EUROPE

All said about its Indian operations, the company will continue to have a very significant portion of its consolidated capacity in Europe. While volume growth in this market is hard to come by, margin improvements do appear likely.

The company's iron ore and coking coal mines in Mozambique and Canada are expected to be commissioned over the next two years. The initial output should insulate between 15-20 per cent of the raw material requirements for the European operations. Other efforts to improve margins include chipping away at costs through operational improvements such as recycling waste gas from the furnace and renovating one of the UK blast furnaces.

DEBT AND HOLDINGS

The debt assumed by Tata Steel for its Corus acquisition has been a concern for investors in the stock. However, a series of asset sales (Teesside, Riversdale, Tata Refractories, Southern Steel Berhad) have bolstered the company's cash and current investments to Rs 20,000 crore by June 2011 (compared to Rs 8,700 crore last year). The company's net debt: equity ratio is now around 1.2. Interest coverage in FY-2011 stood at 3.6 times. While more borrowing is likely for the company's Orissa plant, domestic brownfield capacity-additions are likely to boost operational cash flows and aid the company's ability to service debt. The company's investment book includes holdings such as Tata Motors (stake valued at Rs 2,300 crore), Tata Sponge and Tinplate Company.

RISKS

Increasing steel capacity in flat products may lead to a crowded market with pressure on realisations in the near term. However, industry-topping margins and tie-ups to improve product variants should serve Tata Steel well. The company's European operations continue to face macroeconomic challenges resulting in volatile steel volumes and realisations and higher borrowing costs.

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