Tata Steel

Investors can consider buying the Tata Steel stock trading at Rs 594, which is a price-earnings multiple of eight times its standalone earnings and about five times its likely consolidated earnings for FY-09 . The company’s integrated operations, access to captive raw material sources, high operating efficiency and wide geographical footprint are the key advantages.

Capacity expansion plans and strategic moves to secure raw material sources in a strong demand environment, augur well for volume growth and stability in profit margins. A global footprint enables Tata Steel to gain from growth opportunities and better pricing power in markets outside India.
Business overview

On a standalone basis, Tata Steel derives 84 per cent of revenues from its steel division and the rest from products such as tubes, ferro alloys and minerals.

It now has capacity to produce five million tonnes (MT) of steel, which is slated to increase to 6.8 MT, as new capacities are commissioned by end-September 2008.

Tata Steel has set a target to achieve a capacity of 100 MT by 2015, through an equal balance of greenfield and acquired capacities. Greenfield expansions are to be carried out through integrated steel plants of 12 mtpa in Jharkhand, 5 mtpa in Chhattisgarh and 6 mtpa in Orissa. Forays into the titanium dioxide business in Tuticorin and Tirunelveli (Tamil Nadu), ferro-chrome plant in South Africa and setting up of a deep-sea port in Dhamra (coastal Orissa) are also on the anvil.
Inorganic growth

Tata Steel has aggressively pursued an inorganic growth strategy to add capacity. Overseas acquisitions have added to capacity in a big way — including Corus (20 MT), Natsteel (2 MT) and Tata Steel (Thailand), earlier Millennium Steel (1.7 MT). Tata Steel has been investing in those countries where the markets, coupled with the consumption of steel, have been growing. Its recent joint venture pact with Vietnam Steel Corporation and Vietnam Cement Industries Corporation to establish a complex in the Ha Tinh province in Vietnam may allow entry into a market, where consumption and imports have risen rapidly. Recent talks to sell the aluminium smelters of Corus show that moves have already been initiated to reduce Corus’ cost structure and peg up its profitability levels in line with the parent company.

Backward integration through captive sources of raw material place Tata Steel among the lowest cost producers of steel, globally. On the domestic front, the company sources 100 per cent of iron ore and 60 per cent of coking coal requirements from captive sources, largely insulating it from the hike in input costs. On the finished products front, over 70 per cent of the steel is marketed through negotiated long-term contracts.

This reduces the vulnerability of profit margins to the short-term changes in input costs as well as market prices of steel. These factors have resulted in earnings before interest, tax and depreciation and amortisation (EBITDA) margins of more than 40 per cent on the company’s standalone operations, with the company actually improving margins in the June quarter.

Tata Steel’s overseas operations are more exposed to raw material cost increases, as the acquired Corus facilities rely more on external sources of raw materials such as iron ore and coal.

Even the raw material security of standalone Tata Steel may come down to 40 per cent in the next three-five years with the expansion of the Jamshedpur plant and the Orissa facility going on stream. To address this, Tata Steel has identified raw material resources in the US, Africa and Australia for acquisition to ensure that around 50 per cent of the requirement for Corus is met through captive sources.

Strategic investments have been made abroad for various raw materials — low ash coal (Australia), coking coal (Mozambique), iron ore (Ivory Coast) and limestone (Oman). Presence in several overseas markets through its foreign subsidiaries, however, allows the company to benefit from rising global steel prices. Even if domestic prices continue to be held down by policy pressures, the company may be able to pass on input increases in its overseas operations.
Financials

The company managed a five-year compounded annual growth rate (CAGR) of 17.6 per cent in net sales and 35.8 per cent in profits. Operating profit margins rose from 2002-03 to 2004-05, declined marginally in 2005-06 and climbed back to 42.7 per cent in 2007-08. There was a substantial increase in the company’s size after the acquisition of Corus, with the net sales increasing from Rs. 25,212 crore (2006-07) to Rs. 1,31,535 crore (2007-08). By the close of April 2008, financing for the Corus acquisition was completed with bridge funding contracted for the acquisition replaced by a mix of debt, equity and internal accruals and the non-recourse funding syndicated during the year.

The company’s first quarter performance was strong with a 46 per cent increase in sales and 22 per cent rise in net profit. Segment-wise results show a 38 per cent increase in revenue in the steel division, while the ferro alloys and minerals division registered an increase of 163 per cent.
Risks and challenges

While demand prospects remain strong, the key challenges to Tata Steel’s earnings outlook arise from softer trends in global steel prices, any further policy intervention to curb domestic steel prices and the currency and other risks arising from significant overseas operations.

Domestic steel producers were asked to hold their price line for three months beginning May, and have again acquiesced to hold it for the time being, from the first week of August. Moreover, the Government recently asked the steel companies to cut prices in view of the softening global steel prices. Tata Steel too has held prices; but the impact of this freeze on its margins may not be big, given that only 30 per cent of its sales is pegged to open market prices.

Though the demand for steel, as for other commodities, may moderate if global economic growth slows (with India and China also reporting a slowdown), the price outlook for steel over the medium term is still quite bright, given the sizeable demand-supply gap. This will persist as the expansion projects now underway will take time to become operational.