'Reduce' ratings on Tata Steel Ltd, Positive on European business: Kotak Institutional Equities

Updated: Feb 17 2014, 16:03pm hrs
Spike in debt disappoints Tata Steel's reported Q3FY14 Ebitda (earnings before interest, taxes, depreciation and amortisation) of Rs 40 bn was broadly in line with positive surprise at TSE (Tata Steel Europe) and disappointment at domestic business. An increase of Rs 58 bn in net debt disappointed; management attributed the increase to the seasonal build-up of inventory. We are positive on European business but are concerned about (i) weak domestic demand, (ii) increasing debt and (iii) an unfavourable risk-reward ratio, especially against the backdrop of the event risk of Shah Commission report. We downgrade the stock to Reduce from Add. TP (target price) increases marginally to Rs 400 from Rs 395 earlier.

Adjusted Ebitda in line with our estimate, TSE shines, India disappoints.

A consolidated Ebitda of Rs 40 bn (+79% y-o-y, +8% q-o-q) was 6% better than our estimate, but included reversal of R2.3 bn of excess electricity charges paid by TSE. Standalone Ebitda of R29.4 bn (+16 % y-o-y, flat q-o-q) missed our estimate by 10% due to (i) lower-than-expected realisation and (ii) higher-than-expected forex loss of R800 m. TSEs Ebitda of R8.6 bn was 110% ahead of our estimate; adjusting for one-off, Ebitda was $101m and Ebitda/ tonne at $32, ahead of our estimate. Net income of R5 bn missed our estimate by 16% due to higher-than-expected tax rate.

Cuts back on India volume guidance but maintains relatively positive outlook for TSE.

Management expects ~8.8m tons of steel deliveries in FY2015 (estimates), down from 9m+ tonne guided earlier. Volume guidance has been drifting down for the India business, though not a surprise considering weak demand. TSE expects 4m tonne of steel deliveries in Q4FY14, translating into FY2014e shipments of 13.8m tonne (+6 % growth). Deliveries at TSE may be a tall ask. High inventories at TSE of 2.6m tonne (70 days) is a touch worrying even as the management attributed this increase to the normal seasonal build-up of inventory.

Net debt increases further, dashing hopes of deleveraging.

Net debt, including hybrid perpetual securities, increased Rs 58 bn q-o-q to R724 bn at end-Dec 2013. Management attributed the increase to the seasonal build-up of inventory and capex of R39 bn in the quarter. Increase in debt has been higher than expected and calls for revision in peak debt number, which we believe would be closer to R755 bn as compared to our earlier estimate of R705 bn.

Downgrade to Reduce after strong run-up and unfavourable risk-reward ratio.

Exhibit 10 summarises key changes to our estimates. We are positive on the prospects of Europe and build in increase in profitability for TSE. However, weak India demand could disappoint. After a strong run-up in the past six months, risk-reward is not favourable. News flow around the Shah Commission report on illegal mining in Odisha is an additional risk (though not a base case while valuing Tata Steel). We downgrade the stock to Reduce from Add with a TP of R400 (R395 earlier).

We assign 6x multiple to the India business and 5x to Europe and others businesses. We assign R54 bn (R56/share) to listed market investments and other investments. We do not assign explicit value to investments in raw material projects, viz. DSO and Bengal coking coal project. We assign marginal value of 0.25x capital invested in Odisha steel plant.

As detailed in our earlier notes, Tata Steel can be a difficult stock to value, noting (i) hugely volatile European operations making forecasts challenging, (ii) a highly leveraged balance sheet with a good portion of EV (enterprise value) accounted for by debt. A small change in Ebitda or debt assumptions has material impact on equity value, (iii) a good appetite for capex, which makes deleveraging unlikely for the next 2-3 years and (iv) investments in a number of non-core areas, strategic raw material projects and other Tata Group companies. Perception of value and valuation of investments changes depending on the steel cycle, which leads to exaggerated movement in stock in either direction. We believe that the risk-reward ratio has turned a bit unfavourable due to a run-up in stock prices. The Shah Commission report on illegal mining is an additional event risk, though we do highlight that Tata Steel (i) is among the most compliant miners and (ii) uses iron ore entirely for captive consumption.