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TATA Steel
Action
TATA Steel is our top pick in the Indian metal space on: 1) stronger y-y earnings
growth in FY13F resulting from a 2.9mn-tonne capacity expansion, scheduled to be
completed by December 2011; 2) the sustainable turnaround of its European
operations; and 3) Rio Tinto’s offer to acquire Riversdale Mining, which should lead
to value discovery for TATA Steel’s Riversdale stake. Maintain BUY.
Catalysts
Improving steel prices, positive news flow on capacity expansion and development
on Riversdale Mining are likely to be key triggers.
Anchor themes
TATA Steel has shown a remarkable turnaround at Corus and a significant
improvement in the profitability of its domestic business. With investment in mining
projects, raw material integration for the company ought to improve significantly. At
the same time, with strong cashflow, leverage should come down as well.
Fundamentals in place
European operations: sustainable turnaround
TATA Steel’s European operations – with their robust performance
driven by focus on core strengths and fixed-cost savings – have
continued to surprise the street. We expect Corus’s EBITDA per tonne
to stabilise in the range of US$60-70/t and that utilisation will be close
to 90%.
With total EBITDA of close to US$1bn, we believe TATA Steel’s
European operations will be able to meet its debt obligations. TATA
Steel has also started reinvesting in the projects to improve efficiency
and augment capacity in Europe. These major points should help to
maintain profitability despite raw-material cost pressures.
Visibility improving on overseas raw material projects
TATA Steel has invested in raw-material projects through stakes in
Riversdale (RIV AU, Not rated) and New Millennium Capital (NML CN,
Not rated). Rio Tinto recently launched a takeover bid for Riversdale
valued at US$3.47bn. We estimate TATA Steel’s stakes in Riversdale
at the offer price will be worth more than US$1.7bn (INR85/share).
However, TATA Steel shares have yet to build any value from the
above, in our view.
With Rio Tinto’s interest in Riversdale, visibility on Riversdale’s
operations should improve, in our view, and the acquisition could offer
potential upside for TATA Steel in terms of project progress.
Raw material integration drives India business
TATA Steel’s India business has continued its robust performance,
driven primarily by captive raw materials. Indian operations have
100% captive iron ore and close to 50% captive coking coal. Since we
expect raw material prices to remain high, we think that the Indian
operations will continue to post strong earnings.
At the same time, with its 2.9mn-tonne expansion scheduled to be
completed by December 2011, TATA Steel should see 33% y-y
earnings growth in FY13F. We see TATA Steel as the only large
Indian name with prospects of strong volume expansion in FY13F.
Drilling down
Significant cashflow after new capacity
should reduce debt concerns
With TATA Steel’s 2.9mn-tonne capacity expansion scheduled to be on line by
December 2011, we believe the operating cashflow from its Indian operations will
increase from INR83bn in FY11F to INR114bn in FY13F. At the same time, capital
expenditure should come down from close to INR55bn in FY11F to INR10bn in FY13F
(largely maintenance capex). Accordingly, we expect total free cashflow to increase
from INR28bn in FY11F to INR105bn in FY13F. As a result, our forecasts show
consolidated cashflow rising to US$2.6bn in FY13F, from US$1.1bn in FY11F. This
should ease TATA Steel’s debt concerns, given that it will help the company to
improve its debt-equity and prepay a significant chunk of debt to reduce leverage.
Fundamentals in place – valuation attractive
TATA Steel’s 2Q FY11 results have reaffirmed our belief in the turnaround of TATA
Steel’s European operations and the sustainability of its Indian operations’ robust
performance. TATA Steel Europe reported EBITDA per tonne of US$56/t in what was
a tough quarter, as it faced: 1) high raw material prices (iron ore prices of US$145-
150/t and coking coal prices at US$225/t); and 2) seasonal weakness on account of
the summer holidays in Europe.
TATA Steel is trading at 8.1x FY12F EPS and 5.1x FY12F cash EPS. We believe this
is at a significant discount to its peers and provides an attractive opportunity. With
TATA Steel’s European operations going strong and its 2.9mn-tonne expansion at
Jamshedpur scheduled to start production in 12 months, we believe it has all the
fundamentals in place for strong performance from hereon. Steel prices have also
started to rise after recent weakness, and capacity utilisation at the European
operations improved to 90% in 3Q FY11, from 87% in 2Q FY11.
We value the stock at INR846
Our sum-of-the-parts based price target of INR846 includes its domestic business at
INR753/share, Corus at INR34/share, its interest in Riversdale Mining at INR44/share
and its South East Asia business at INR15/share.
We value the domestic business at 10x FY12F standalone EPS of INR75.3 and Corus
at 5x FY12F EV/EBITDA. We value TATA Steel’s 24.2% stake in Riversdale Mining
and 35% stake in Riversdale Mining’s Benga project based on the company’s current
market cap of US$2.35bn.
Key risks to our call: 1) weak steel prices; 2) further deterioration in European
economies; and 3) raw material prices rising significantly.
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