| Tata Steel Ltd (TATA IN) Worst case scenario of a short term ban in Orissa would be a buying opportunity given India & Europe improvement | Overweight Price: Rs425.80 28 Apr 2014 Price Target: Rs550.00 PT End Date: 31 Dec 2014 | |
The Supreme Court (SC) has reserved its interim order on the Orissa iron ore mining case, but is likely to be released over the next few days. Media reports (links attached of reports from ET, FE) suggest that one of the possible outcomes would be a short term ban imposed on mining in Orissa (for a period of ~3 months) and in the meantime Orissa regularizes the mines running on deemed extension.
Implications for the steel industry and broader economy: Any iron ore mining ban in Orissa would hurt the steel industry and by extension the broader economy hard, with the severity increasing with the duration of the ban. Long steel production is likely to be impacted the most.
Implications for TATA: As we have highlighted previously in our research, all of TATA’s iron ore mines in Orissa are working under Environment and Forest clearances and are under deemed extension which started in 2003-05. The SC order in Goa did make deemed extension illegal but only after they had operated for more than 20 years. Even though on the current facts we see little probability of TATA’s mines being asked to shut down, we would admit that predicting court judgments is NOT our strong point. On a worst case scenario of a short term iron ore ban in Orissa (up to 3 months) should not create any material impact on TATA given inventories (Orissa mines account for ~30 % of TATA’s requirements) and beyond that an increase in iron ore cost should be broadly offset by higher selling prices locally.
The impact would be more on sentiment especially given the sharp run up in the stock. However, any correction should be a buying opportunity for 4 simple reasons:
a) Demand cycle in Europe is turning after ~5 years of slump. TATA is operating at ~75% utilization and vs. peak EBITDA of ~$2.5bn would end FY14 at ~$500mn EBITDA and given that European demand is improving and so is pricing power, the up-cycle for TATA Europe earnings has just started
b) India demand cycle is likely at the bottom after 3 years of very weak demand. A cyclical recovery in India is likely to start over the next 12 months, and TATA with SAIL are the only 2 companies who have new capacity to take advantage of any demand improvement.
c) The expected earnings increase over the next 2-3 years (higher volumes even with lower margins would mean higher EBITDA) would come at a time of sharply reducing capex (TATA has been spending on average ~$2-2.5bn over the last 3 years) allowing large cash flow generation and hence net debt increase.
d) Captive iron ore does give TATA India an advantage but is not the only driver for the large profitability gap v/s peers in India. We estimate captive iron ore accounts for ~Rs3000/T of the ~Rs7000/t difference in EBITDA/T between TATA and the next most efficient steel company in India
Given the above reasons, any stock price correction on the new flow of Orissa iron ore mining ban should be a buying opportunity in TATA for investors wanting to play an economic rebound in Europe and India
http://www.financialexpress.
Investment Thesis
TATA remains our top pick despite the stock being up 50%+ since mid-August vs. the SENSEX up 8% over the same period. In our view, expectations of a potential improvement in European metals demand are positive for TATA’s European operations. We believe an improving Europe over the next two years implies further a re-rating of stock. In addition, we believe domestic demand should remain stable with limited new capacity addition from major players. Potential investment sales to de-lever could provide further upside.
Valuation
Our PT of Rs550 is based on FY15 estimates. We use a target multiple for TATA Europe of 6x EV/EBITDA, given the visibility in Europe steel demand. We estimate TATA is trading at a significant discount to MT on headline FY15E estimates (TATA trades at 5.2x FY15 EV/EBITDA vs. MT at 5.8x (using Bloomberg consensus estimates for MT) and the discount widens if we were to adjust for a) the CWIP sitting on the books relating to Orissa and b) the TATA Motors stake. Adjusted for CWIP, TATA trades at 4.2x FY15E EV/EBITDA. In our view, the discount between TATA and MT should narrow, given TATA is also levered to a European recovery.
FY 15 EBITDA (Rs bn)
|
Multiple (x)
|
EV (Rs bn)
| |
Europe
|
6.0
|
45.7
|
274
|
India
|
5.7
|
136.4
|
778
|
Asia
|
5.0
|
9.2
|
46
|
Total EV
|
1,098
| ||
Net Debt
|
615
| ||
CWIP
|
116
| ||
Pension Deficit
|
43
| ||
Derived Equity Value
|
556
| ||
No of Shares (MM)
|
1,013.8
| ||
Target Price (Rs/share)
|
550
|
Source: Company reports and J.P. Morgan estimates. Note: Adjusted for CWIP.
Risks to Rating and Price Target
Key risks (other than macro economic weakness) include a sharp decline in India profitability, weakness in steel price and a decline in European demand.
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