1. Reduce rating on Tata Steel: Sale of UK asset may lessen cash burn considerably

Reduce rating on Tata Steel: Sale of UK asset may lessen cash burn considerably

Tata Steel may sell its UK operations including the Port Talbot plant as earnings turnaround appears difficult and operations will require material funding.

By: | Updated: April 4, 2016 2:42 AM

Tata Steel may sell its UK operations including the Port Talbot plant as earnings turnaround appears difficult and operations will require material funding. The UK operations are loss-making at the Ebitda level and also require large sustenance capex—cash burn is high. The asset sale will reduce Europe cash burn materially. Given the large losses in UK and difficult turnaround, we do not expect any meaningful debt reduction, if a sale occurs. We raise our target price to 250 (220 earlier), but maintain REDUCE rating.

Tata Steel Europe to explore full or part divestment of UK operations

Tata Steel may sell its UK operations in full or part after its board in a strategic review of operations decided to explore all options of restructuring including divestment. UK operations include two major plants—Port Talbot (liquid steel capacity 4.9 mtpa) and Scunthorpe (capacity 4.5 mtpa) and a smaller, Rotherham operations (capacity 0.8 mtpa). Tata Steel had earlier stated its intention to sell Scunthorpe operations (long product division) and the deal is being negotiated with Greybull Capital. The board’s decision essentially puts other plants in UK including Port Talbot on the divestment list as well. The company stated that it reviewed the proposed restructuring of Port Talbot operations, but global overcapacity and high manufacturing costs in the UKmake restructuring difficult.

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Sale of UK operations will reduce cash burn; we expect no meaningful debt reduction

The sale of UK operations will reduce the cash burn in Europe considerably. The high cash burn in Tata Steel’s Europe operations ($0.7 bn/$1 bn in FY2014/15) is majorly due to Ebitda losses in UK operations and additional capex for maintenance projects. In FY2014/15, Tata Steel’s UK operations incurred Ebitda losses of $89m/$274m.

In addition, we estimate that the company incurred a capex of $280m/$230m in UK in FY2014/15; cash burn in UK, excluding interest cost, was ~$370m/$500m in FY2014/15. We estimate the FY2016e losses in UK to be even higher than in FY2015 due to weak steel markets. The turnaround of UK operations will be a tall task even for a strategic buyer and may reflect in very low valuations, if a sale occurs. We do not rule out shutdowns or closures in case there is no deal.

Netherlands operations profitable on a standalone basis

On ex-UK basis, Tata Steel Europe will be mostly restricted to Ijmuiden, Netherlands—a comparatively better and profitable operation in the European steel industry; it earned Ebitda of

$499m/$680m in FY2014/15. However, we still expect cash burn of $200m-$300m in Europe post interest and capex. We assume the sale/closure of UK operations will start in 2HFY17 and raise our Ebitda estimate by 0-2% for FY2017-18e to factor in lower Ebitda losses in UK. We raise our TP to R250 (R220 earlier), but retain Reduce rating. Expensive valuations at 7X FY2017e Ebitda, even after accounting for duty/MIP support to earnings, underpin our cautious stance.

High cash burn in Europe—respite likely from asset sale

We note that Ebitda of $465m reported as per TSE’s accounts is lower than Ebitda reported as per consolidated accounts ($690m) due to accounting adjustments, including different treatment of pension costs.

TSE’s negative free cash flow of $1.03 bn had a large impact of (i) $274m of Ebitda loss in UK, and (ii) ~$230m capex in UK operations. While the break-up within UK between Scunthorpe and Port Talbot is not disclosed, we highlight that Scunthorpe accounts for about 44% of steelmaking capacity in the UK for TSE. We expect no meaningful debt reduction from the UK asset sale, though it reduces cash burn.

Changes in our estimates

We increase our FY2017-18e Ebitda estimate by 0-2% to factor in the gradual closure of UK operations from mid FY2017. We cut our Europe steel delivery estimates to 9.8 m tonnes/6.3m tonnes in FY2017/18e from 12m tonnes (in both the years). We build in Ebitda/tonne of $44/ton in FY2017e assuming some volumes from UK operations will still be produced. In FY2018e, we build in $85/tonne of Ebitda to account for only Netherlands earnings. Our TSE Ebitda increases by 13/18% for FY2017/ 18e to R29 bn/R37 bn. The entire increase does not flow down to our consolidated Ebitda estimate due to changes in SE Asia and other subsidiaries’ Ebitda estimates.

Our EPS estimate for FY2017-18E increases by 52-56% to R22/R37. The higher increase in EPS estimate is led by lower depreciation charge due to the sale of UK operations. We also cut our capex estimate for FY2017/18e to R44 bn/R40 bn from R50 bn (each) earlier, to factor in lower spends in Europe on maintenance projects now.

Strong FY2015 earnings in Netherlands—largely led by higher spreads

Ebitda margins in Netherlands operations improved to 10.6% ($108/ton) from 7.1% ($79/ton) due to higher spreads in FY2015. Margins will have likely declined in FY2016. Steel spreads improved in CY2014 due to the sharp fall in raw material prices while steel prices declined with a lag. Our exhibit (above) compares Tata Steel Europe’s Ebitda/ton with Arcelor’s Europe Ebitda/ton. The lower TSE Ebitda is largely due to weak earnings at the UK operations.

 

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