Tata Steel

Investors may consider holding on to their Tata Steel shares. Uncertainties at its acquired European operations have been the key challenge for this profitable integrated low-cost steel producer, whose Indian and South East operations continue to remain one of the best bets in the steel industry. The stock trades at an EV/Tonne of about Rs 35,000. This is at discount to several Indian peers such as SAIL but at a slight premium to global peers such as Arcelor Mittal. While the European operations have shown early signs of revival, the key risk to Tata Steel's prospects arise from a delayed private demand recovery, especially once idling capacity is reinstated.

TATA STEEL INDIA

Indian steel price trends usually track global trends, remaining at asmall premium due to tight demand-supply.

With clear signs of recovery, the Indian economy has witnessed very healthy demand growth for almost all steel users — automobiles, electronics, industrial machinery. With steel supply expected to fall short of demand, the last two years have seen a slew of expansion plans by global and Indian majors. Tata Steel plans to ramp up capacities to 10 million tonnes from the current 7 million, with a greater percentage being flat products, which have better margins as a result of potential value addition. Automobile sales, which have seen a strong acceleration in volumes, even with some moderation, may provide Tata Steel with tremendous opportunities to capitalise on.

Emerging opportunities such as packaging, construction solutions and high-end flat products should see Tata Steel well poised to piggy-back on the well established Corus product line and research. Tata Steel's domestic operating margins have hovered around the 40 per cent mark and sales volumes grew 10 per cent between FY06 and FY09.

Realisations, in line with international steel prices, grew between 10 and 25 per cent over the same period. Profits after tax grew at an average of 13 per cent. With capacity being ramped up by up to 50 per cent by FY11, this should reflect on the standalone top line.

TATA STEEL: EUROPEAN STORY

Corus Steel, a wholly-owned subsidiary of Tata Steel, has a capacity of around 20-21 million tonnes of steel per annum accounting for roughly 10 per cent of European capacity and 65 per cent of Tata Steel's revenues in FY09. At the time of Tata Steel's acquisition, Corus had just returned to marginal profitability, after several years of sustained losses as a result of a high cost structure and legacy costs.

The scope for value addition and higher margins in the European markets, research and expertise in packaging, construction, automobiles and engineering grade steel are among the major reasons why Tata Steel acquired Corus. Though Corus by virtue of its huge capacity and wide product line is exposed to a variety of sectors all of them have been severely affected by the recession across Europe.

Tata Steel's European operations have seen very rough seas over the last four quarters taking a double hit from lower realisations and volumes.

The first half of FY10 saw revenue collapse by 51 per cent compared with the same period last year and a cumulative EBIDTA loss of close to Rs 2,500 crore. Lower raw material costs seem to have had minimal effect on the red bottom line. Efforts to streamline Corus' high cost structure include downsizing, mothballing plants and buying mines to secure raw material assets in an effort to hedge against commodity price fluctuations, the last of which is expected to take effect in 2012.

However, until these measures take effect, prospects for Corus may remain quite vulnerable to whether the recovery pans out. European commercial automobile sales are down 30-60 per cent in 2009, with sales sliding for 18 months in a row. But weighed against this, passenger automobiles, thanks to tax rebates and other incentives, have shown some early signs of growth in the last few months in contrast to the brutal drops witnessed earlier this year. Real-estate, industrial machinery and other sectors appear to have already bottomed out and some have managed single-digit growth. However, the numbers remain quite fragile as evidenced by the unexpected drop in German industrial output by 1.8 per cent in October.

Seen in this backdrop, Corus' plans to reinstate idling capacity does carry the risk of ‘oversupply'. The operations have, however, seen an improvement in capacity utilisation from the 50 per cent to about 75 per cent in the latest quarter. The second risk to the outlook arises from the uncertainty about private demand picking up once the stimulus-induced demand tapers off.

If private demand from infrastructure, real-estate, capital expenditure, automobiles and other sectors does not pick up, carrying forward the momentum provided by stimulus measures, steel producers could find themselves in the unenviable position of dealing with higher fixed costs and a renewed correction in realisations. Global steel prices, which are currently 40-50 per cent off their peak prices of mid-2008, have had a flat 2009 due to lack of demand in the second half of 2008 being balanced out by huge production cuts.

Debt repayments

Tata Steel, which in retrospect did pay a high price for Corus, now carries a net debt position of $9.8 billion, down from $11 billion at the end of FY09. Several efforts have been taken to repay portions of the debt by raising funds through a GDR issue and shoring up the balance sheet by raising capital.

Other measures include deferring conversion of debt instruments on more convenient terms. The company has planned to repay another $180 million by end of this fiscal year. The dilutive effect for current shareholders, of equity expansion to pay back debt, is one of the downsides of this steel bet.

In the near term, steel realisations are likely to remain depressed, given the lumpy nature of Chinese demand and still shaky growth in developed nations. The latter makes volume growth an uncertainty.

However, what makes Tata Steel an interesting bet for long-term investors is its geographic profile, product mix and operational efficiency which in the long run are likely to serve investors well, even during downturns in the steel cycle.

via BL