Capacity expansion in the higher-margin Indian market and access to captive raw material will benefit the company.

Investors with a long-term perspective can buy the stock of steel major Tata Steel. The company which operates in India, Europe and Southeast Asia has been dragged by the poor performance of its European business, which was acquired in 2007. In recent times though, Tata Steel Europe has staged a comeback thanks to cost-cutting and operations restructuring.

Despite a recent rebound in stock price, at the current price of Rs 274, the stock discounts its consolidated book value by around 0.8 times. This is at the lower end of its valuation band over the last five years (0.5 to 2.7 times).

A patient investor can benefit from a likely but gradual turnaround in the company’s fortunes in Europe and its expansion in the high-potential Indian market. A weak rupee also favours Tata Steel — its captive mines shield it to a good extent from higher cost of imported raw material. With imported steel turning costlier, domestic steelmakers such as Tata Steel stand to gain.

Europe on a better footing

Tata Steel’s poor performance in Europe over the past few years impacted the company’s consolidated profit. Heavy debt taken to finance the $13.7 billion acquisition of Corus in 2007 and the weakness in the European economy in the aftermath of the global recession proved a big drag. In a tacit acknowledgement that the investment has not lived up to expectation, Tata Steel booked an impairment charge of Rs. 8,356 crore in the March 2013 quarter.

But there seem to be signs of hope. Performance in the European operations which account for 58 per cent of the group turnover has got better over the last half-year, with significant improvement in the recent June quarter. Operating profit at Tata Steel Europe was up 26 per cent — both on a sequential quarter basis and from the year-ago period. Key to this have been structural changes such as supply chain improvements and the introduction of differentiated products. The company has also pruned its manufacturing and overhead costs. This helped it tide over a difficult demand environment and weak prices.

A leaner business should hold Tata Steel Europe in good stead. On the demand front too, there is positive news. Macroeconomic lead indicators have started suggesting an improvement in growth in the company’s major markets such as Europe and the US. According to the World Steel Association, global steel demand is expected to grow at 2.9 per cent in 2013 and at 3.2 per cent in 2014, up from 1.2 per cent in 2012. This should lend support to steel prices.

On the raw material front, even as coking coal prices declined considerably since the second half of 2011, iron ore prices have remained high. Tata Steel is investing in overseas coal and iron ore projects. Increased supplies from the Benga coal project in Mozambique and the Direct Shipping iron ore project in Canada will aid the European operations. The company is entitled to 40 per cent off-take from the Benga project. The Direct Once fully commissioned, the shipping project in Canada will produce 6 mtpa of iron ore. These initiatives should aid the margins of Tata Steel Europe in the long-run.

Good prospects in India

The operating environment for the company’s Indian business (28 per cent of revenues), which is profit-making but bogged down by subdued demand, is expected to improve.

The World Steel Association predicts steel consumption in the country to grow 7 per cent in 2014, up from 6 per cent in 2013 and 2.5 per cent in 2012. Over the medium term, steel demand in the country should get a boost from the planned $1 trillion (Rs 60 lakh crore) investment on infrastructure up to 2017. Recently the Government approved infrastructure projects totalling 1.83 lakh crore.

India has been a net importer of steel since 2007-08. With the recent depreciation in the rupee making imports costlier, local producers stand to benefit from capacity expansions. This is especially true for Tata Steel which has captive mines in India thereby protecting it from the adverse impact of rising cost of imported raw material.

Tata Steel is expanding its production capacity in India even as it undertakes restructuring in Europe. Last fiscal, the company raised its crude steel capacity from 6.8 mtpa to 9.7 mtpa.

With the commissioning of the first phase of the 6 mtpa Kalinganagar project in Odisha, the total production capacity will go up to 12.7 mtpa. Notwithstanding ongoing economic challenges which are crimping offtake, steel demand in the country in the long run is expected to be robust.

In this context, the recent shelving of projects by global steel majors — Posco and ArcelorMittal — in India, totalling 18 million tonnes per annum (mtpa), benefits domestic players.

A big factor in favour of Tata Steel is its captive raw material base. This helps it meet all of its iron ore requirement and 60 per cent of coking coal requirement. Integrated operations give the company an advantage over most other domestic players. While coal prices have declined 14 per cent, the rupee has shed 20 per cent, year to date. Tata Steel, however, is only partially exposed given its limited dependence on imports.

Financial position

Tata Steel’s revenues in 2012-13 grew just 1.4 per cent, in contrast with the growth rates of 12 per cent and 16 per cent in the previous years. The lower growth last fiscal was due to subdued demand and prices both in India and globally. This is expected to reverse in the coming year.

In the latest June quarter, the company’s revenue fell (due to lower realisations), but its expenses fell faster, resulting in operating profit growth of 8 per cent.

In 2012-13, the company’s consolidated loss was Rs 7,058 crore as against profit of Rs 5,390 crore in 2011-12. The loss was due to the impairment charge related to the European operations. Excluding the impairment charge, the company would have posted a profit of around Rs 1,300 crore.

With Tata Steel’s consolidated debt increasing 10 per cent year-on-year to Rs 54,972 crore ($8.3 billion) as on March 2013, the debt to equity has risen to 1.6 times. The interest coverage ratio is at 2.3 times.

Risks

A sharp slowdown in China, the world’s largest producer and consumer of steel could bear on Tata Steel’s prospects by reducing global steel demand and exerting downward pressure on prices.

(This article was published on August 31, 2013)
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