Tata Steel FPO Analysis

Fortunes tied to European recovery

Domestically the company is on a strong footing. But European operations remain vulnerable to fluctuations in raw material prices and volatile European economies

Tata Steel is one of the world's largest steel companies with a steel production capacity of approximately 27.2 million tonnes per annum (mtpa). According to World Steel Association (WSA), the company was the seventh largest steel company in the world in terms of crude steel production volume in 2009. The company has operations in 26 countries and a commercial presence in more than 50 countries. As of March 31, 2010, the company had approximately 81,000 employees.



Tata Steel was established as India's first integrated steel company in 1907 by Jamsedji N. Tata, the founder of the Tata Group, and is currently one of the flagship companies of the Tata Group. The company is present across the entire value chain of steel manufacturing including producing and distributing finished products as well as mining and processing iron ore and coal for its steel production. The company's operations are primarily focused in India, Europe and other countries in Asia Pacific. In financial year ending 2010 (FY 2010), the company's operations in Europe and India represented 62.9% and 28.8%, respectively, of its total steel production volume. Of the net sales, 46.4% came from Europe, 26.2% from India, 14.9% from rest of Asia and 12.5% from Rest of the World in FY 2010.

The European operations are standalone, without captive iron ore and coal mines. But the company is partly addressing this issue. It acquired 35% stake in a coal project owned by Riversdale Mining. It also has 24% stake in Riversdale Mining. In December 2007, the company entered into a joint venture with Societe Pour Le Developpement Mnier De Cote D'Ivoire (SODEMI) for an 85% stake in the development of an iron ore mine. SODEMI has the remaining 15% stake. In September 2010, the Tata Steel group acquired 80% interest in a Canadian Iron ore project from New Millennium Capital Corporation (NMI) and 100% off-take rights of the project, besides acquiring about 27% of the common shares of NMI. The Canadian Ore project is likely to commence iron ore production in 2012.

The company has grown significantly in recent years with its steel production capacity increasing from approximately 5.0 mtpa in FY 2006 to 27.2 mtpa currently. This growth was due to the company's acquisition in April 2007 of Corus Group plc (Corus) with a total steel production capacity of 18.4 mtpa (including 10.7 mtpa in the United Kingdom and 7.7 mtpa in the Netherlands). The company has a 6.8-mtpa steel production plant in Jamshedpur and a variety of finishing plants. The company's Indian operations also include captive iron ore and coal mines. The remaining 2.0 mtpa of its steel production capacity is located in Singapore and Thailand. The company plans to further increase its Indian steel production capacity by an additional 2.9 mtpa through brown-field expansion of the Jamshedpur facility.

The company is also developing a 6.0-mtpa green-field steel plant in Orissa and a 5.0-mtpa green-field steel plant in Chhattisgarh and is in the initial planning phase for the construction of a 3.0-mtpa green-field steel plant in Karnataka. The company expects to produce a mix of flat and long products through green-field expansions.

The company offers a broad range of steel products including a portfolio of high value-added downstream products such as hot rolled coils, sections, plates and wires. The company is also a large producer of ferro chrome in India. The company's main markets for its products are Europe and India, which accounted for approximately 72.6% of the company's net sales in FY 2010, with the remaining sales primarily taking place in other markets in Asia and in North America. The company's customers primarily comprise the construction, automotive, aerospace, consumer goods and material handling and general engineering industries.

The company is coming with a follow on public offer of 5.7 crore shares of Rs 10 each at a price band of Rs 594 to Rs 610 per share. The amount raised will be about Rs 3385.8 to Rs 3477 crore at the lower and upper band. Of this, Rs 1875 crore will be to part finance Rs 16372 crore expansion at Jamshedpur, Rs 1090 crore for payment of redemption amounts on maturity of certain redeemable non-convertible debentures issued by the company on a private placement basis due on May 07,2011; and the rest for general corporate purposes.

Strengths

The standalone Indian entity Tata Steel is one of the low cost integrated producers of steel, thanks to captive iron ore and coal mines. The company obtained all of its iron ore requirements and approximately 49% of its coal requirements for Indian operations from its own captive mines in FY 2010. At a time when the global iron ore and coal prices are racing ahead, the captive mines keep Tata Steel's input costs low and facilitates higher margins.

The acquisition of Corus lifted Tata Steel in the global steel market. There are synergy benefits that can accrue as the former focuses on value added steel and the latter is one of the low cost producers of crude steel in the world. But even before synergy benefits could be acquired, the slump in the global economy occurred in 2008, and though steel market has improved significantly since they are yet to reach pre-crisis level. As the global steel market is recovering and as India is witnessing strong demand growth, there is scope for further improvement in combined entity's operating and financial profile.

Over the past few years, the company has enriched its product mix with increase in the share of value added steel, including supplies to auto sector, and increase in the sale of branded products. The company plans to continue to expand its downstream operations with the objective of improving its product mix and generating increased and more stable margins.

Weaknesses

In FY 2010, Europe represented 62.9% of the company's steel production. The share of Europe in the company's net sales stood at 46.4% in FY 2010. As Europe is the company's largest market, its business could be materially and adversely affected if economic conditions in Europe deteriorate.

The company purchases all of its iron ore and coal requirements for its European operations from third parties and in FY 2008, 2009 and 2010, the cost of such purchases accounted for 33%, 29% and 39%, respectively, of the total raw material and energy costs of the company's European operations. In the current context of rising iron ore and coal prices, the profitability of overseas operations may be affected, if the company fails to pass on the rise in costs especially when recovery in Europe is weak.

Starting in 2010, certain suppliers of iron ore and metallurgical coal have moved to quarterly fixed-price schemes from annual fixed prices. Quarterly contracted prices of raw materials have added to earnings volatility of the company's European Operations.

Steel making is a raw materials intensive process. Each tonne of finished steel involves transportation of four tonnes of materials. Logistics cost in India is higher than international benchmarks.

Inflation in India is hovering around double digits and is a cause for concern. Tighter monetary policy and restrictive fiscal policy to contain fiscal deficit, may impact the resurgence in domestic steel demand. Higher inflation also leads to government obstacles in raising steel prices.

Delays in environmental clearances and renewal of mining leases could lead to uncertainty with regard to raw material linkages and delay fresh capacity becoming operational. Also, The Mines and Minerals (Regulation and Development and Regulation) Bill, 2010, requires mining companies to share 26% of its profit with local inhabitants and would base the award of mining blocks in the future on an auction basis. This could diminish partially the benefit of captive iron ore and coal mines.

The steel industry is cyclical in nature, sensitive to general economic environment conditions. Also, according to the Ministry of Steel's Annual Report 2009-10, approximately 220 memorandums of understanding were signed by various state governments for a total planned capacities if approximately 276 mpta. If capacity additions accelerate beyond domestic demand, the players may have to export surplus quantities. As domestic competition intensify, this could affect the margins of the Indian operations.

Valuation

Consolidated EPS for the twelve months ended September 2010 of Tata Steel works out to Rs 69.9. At the price band of Rs 594 to Rs 610, P/E works out to 8.5 to 8.7 times. India's largest steel company SAIL is trading 11.1 times while leading private sector steel producer JSW Steel is trading at 13.2 times their earnings for the twelve months ended September 2010 (as per published consolidated figures, which exclude Ispat Industries) .

Tata Steel closed at Rs 632.45 on 18 January 2011. Its 30-day, 60-day and 90-day average share price is Rs 654.75, Rs 633.96 and Rs 633.82 per share. So the offer price band is quite near its recent market prices. The beta for Tata Steel vs the BSE Sensex is 1.5, which indicates that the scrip is highly sensitive to market fluctuations.