JSW Steel - JSW Ispat Merger
Neutral
Target Price: Rs732
CMP: Rs694
Upside: 5.5%
Aggressive move in an adverse environment, downgrade to Neutral as valuations set to suffer
JSW Steel has announced the merger of its associate JSW Ispat with itself at a share swap ratio of 1:72 resulting in an equity dilution of 8.3% and creating the largest steel company in India by capacity (14.3 mtpa). We see the merger as impacting negatively on the merged entity in the short term on account of lower margin profile of the merged entity (drop of 160bps in FY14E), high debt levels (to increase by ~Rs78bn in FY14E) putting a strain on balance sheet, no immediate further equity infusion from JFE steel and absence of operational raw material assets in the portfolio. For FY14E, we see proforma EPS for the merged entity reducing 17.5% despite increase in EBITDA by 15.6% on account of lower margin, higher interest costs and equity dilution. We downgrade the stock to neutral from Buy with a target price of Rs732.
m Merger to create scale and synergies in the long run: We expect scale and synergies in the long run on account of geographical diversification of the group, superior technological capabilities, low conversion costs, competitive marketing team with strong retail franchise network and huge scope of low capex based Brownfield expansion at both Ispat’s Dolvi plant and JSW steel’s Vijaynagar plant in the future. But with operational raw material assets the missing link, short to medium term difficulties in running operations would remain.
m Lower overall margin profile (160bps drop), raw material sourcing remains a key concern: We see consolidated margin drop of 160bps for the merged entity in FY14E as compared to the existing consolidated entity of JSW steel. Though mining activity restart has been given a go ahead in Karnataka, with no operational raw material assets in the merged portfolio, we see raw material sourcing a key concern for the group from a long term and sustainable point of view. We expect group volumes to suffer in the short to medium term due to raw material sourcing difficulties and margins will remain under stress due to higher overall raw material costs neutralizing the positive impact of low conversion cost profile.
m Debt levels to shoot up and stretch balance sheet: We see increase in debt of ~Rs78bn by FY14E (~33% of JSW steel’s existing consolidated debt) for the merged entity which would stretch the balance sheet (debt:equity of 1.5x) in the absence of further equity infusion. Higher overall interest cost for the group also remains a key negative even though the management is targeting reduction in interest costs for JSW-Ispat by ~200bps.
m Tax efficiencies seen from deferred tax asset of JSW Ispat and formation of wholly owned subsidiary for downstream units: Deferred tax asset of ~Rs21bn of JSW Ispat would have a positive effect on the group with lower tax outgo for the next few years. The company has also indicated consolidation of downstream units under a wholly owned subsidiary which would result in tax efficiencies and better margins on a superior product basket.
m Valuations – To take a knock: We see a drop in our earlier valuations and target price for the stock due to additional debt burden, higher equity base due to 8.3% dilution and lesser proportionate increase in EBITDA due to lower margin profile of JSW Ispat. We value the merged entity at 5.5x FY14E EV/EBITDA to arrive at a target price of Rs732. Downgrade to neutral from buy.
m Lower overall margin profile (160bps drop), raw material sourcing remains a key concern: We see consolidated margin drop of 160bps for the merged entity in FY14E as compared to the existing consolidated entity of JSW steel. Though mining activity restart has been given a go ahead in Karnataka, with no operational raw material assets in the merged portfolio, we see raw material sourcing a key concern for the group from a long term and sustainable point of view. We expect group volumes to suffer in the short to medium term due to raw material sourcing difficulties and margins will remain under stress due to higher overall raw material costs neutralizing the positive impact of low conversion cost profile.
m Debt levels to shoot up and stretch balance sheet: We see increase in debt of ~Rs78bn by FY14E (~33% of JSW steel’s existing consolidated debt) for the merged entity which would stretch the balance sheet (debt:equity of 1.5x) in the absence of further equity infusion. Higher overall interest cost for the group also remains a key negative even though the management is targeting reduction in interest costs for JSW-Ispat by ~200bps.
m Tax efficiencies seen from deferred tax asset of JSW Ispat and formation of wholly owned subsidiary for downstream units: Deferred tax asset of ~Rs21bn of JSW Ispat would have a positive effect on the group with lower tax outgo for the next few years. The company has also indicated consolidation of downstream units under a wholly owned subsidiary which would result in tax efficiencies and better margins on a superior product basket.
m Valuations – To take a knock: We see a drop in our earlier valuations and target price for the stock due to additional debt burden, higher equity base due to 8.3% dilution and lesser proportionate increase in EBITDA due to lower margin profile of JSW Ispat. We value the merged entity at 5.5x FY14E EV/EBITDA to arrive at a target price of Rs732. Downgrade to neutral from buy.
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