Tata Steel: Buy

Investors with a long-term perspective can buy the stock of steel major Tata Steel. The stock has gained 42 per cent since our buy recommendation in August 2013.

But at ₹403, the stock is still reasonable at 0.8 times the company’s estimated consolidated book value per share for 2015-16, below its five-year average valuation of 1.3 times.

Tata Steel, which has operations spanning India, Europe and South-East Asia, has been expanding its high-margin Indian business and restructuring the less lucrative, though improved, European business.

The Indian business, the major contributor to profits, accounts for 28 per cent of the consolidated revenues. For the half-year ended September 2014, standalone (India business) net profit was ₹4,744 crore as against consolidated profit of ₹1,592 crore. With raw material sourced largely from captive iron ore and coal mines, margins (25 per cent at the operating level) are healthy.

While this is not the best of times on the demand front, the scenario should change for the better once economic growth picks up. Tata Steel’s capacity expansions should therefore hold it in good stead.

The 3 million tonnes per annum (mtpa) expansion at the Jamshedpur plant has increased the installed capacity to 9.7 mtpa. This will rise further after the commissioning of the first 3 mtpa phase of the 6 mtpa Kalinganagar plant in Odisha, by 2014-15. While rising steel imports from countries such as China pose a threat to domestic steel companies, Tata Steel has managed to do well.

For the half-year ended September 2014, its domestic sales volume grew 4.2 per cent year-on-year, aided by healthy growth in sales to the auto sector (up 23 per cent) and the branded products, retail and solutions segment (up 10 per cent). This even though steel consumption in India grew 0.5 per cent during April- October 2014. These segments comprise about 50 per cent of the total sales.

The upcoming Kalinganagar plant, which will produce high-value flat steel products, will cater to the increasing demand from sectors such as automobiles, further boosting sales. Cost effectiveness will give these products an advantage over the high-grade automotive steel products which are now being largely imported.

Closure of some of the company’s iron ore mines in Odisha and Jharkhand that were operating under deemed extension has affected supply, forcing the company to import. According to Tata Steel, it has been operating its mines with all statutory clearances and had applied for renewal of leases well before their expiry. Mining lease renewals, some of which are already under consideration, are therefore expected sooner than later. The fall in captive iron ore supply should therefore be only temporary.

About 60 per cent of Tata Steel’s revenue comes from the European operations or the erstwhile Corus acquired by Tata Steel in 2007.

After a torrid run until 2012-2013 in the aftermath of the 2008 global financial crisis, and massive asset write-offs, things have turned for the better. After a 54 per cent fall in operating profit per tonne of steel (EBIDTA/tonne) to ₹585 in 2012-13, the EBIDTA/tonne more than tripled to ₹2,170 in 2013-14. With the momentum continuing, the EBIDTA/tonne is up 44 per cent to ₹2,939 for the half year-ended September 2014, compared with the same period last year.

This is despite subdued steel prices in Europe – a function of weak demand and rising steel imports, particularly from China. Though Tata Steel Europe’s sales volumes declined a tad in the half year-ended September 2014, falling prices of iron ore and coking coal aided profitability.

While the steel demand outlook for Europe hardly inspires confidence, the company is better placed to ride out this phase too. It has got leaner by closing down selective operations at certain facilities and pruning workforce. In this context, the recent proposal to sell off the company’s long products division bodes well, given that the demand outlook from the construction sector (that uses long steel) is the weakest among user industries. Prospects for the steel strips division, with the auto sector as a key user industry, are however brighter.

Apart from this, Tata Steel’s recent refinancing of $7 billion of international debt, comprising three-fourths of the company’s consolidated debt, should help bring down its finance cost.

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