Tata’s Board has approved: (i) 5 million ton KPO phase II expansion and (ii) rights issuance of up to Rs 128 bn. KPO phase II expansion was largely anticipated and capex cost is reasonable, but volume growth will be far in the future. The size of potential equity issuance is surprisingly large. While it may reduce gearing and provide headroom to bid for stressed assets, it could be EPS dilutive near term and hence could weigh on stock price. Maintain Underperform.

KPO phase II expansion announced

Tata plans to expand KPO capacity from 3 million tons to 8 million tons by FY22. This includes expansion of raw material, upstream and downstream facilities including cold rolling mill. Proposed capex is Rs 235 bn, which would be funded through a mix of debt/equity (mix not disclosed).

Volume growth to be largely back ended

KPO Phase II expansion will lift Tata’s India capacity by 38% to 18 million tons. However, the project would take 4 years for completion (longer than expected). Given time for ramp-up, volume growth from the project should be far in the future.

Capex cost reasonable

Phase II brownfield capex at $734/ton (incl. Downstream CRM) appears reasonable compared to phase I ($1300/ton greenfield) but higher vs. JSW Dolvi phase II ($460/ton). Phase I capex included enabling infra for 3 million tons expansion. Overall capex/ton for KPO (phase I and 2) will be $950/ton in line with broad benchmark greenfield capex cost. We estimate the project could potentially generate ROIC of 11% (assumes Ebitda/t of Rs 11,500/t).

Board approved rights issuance of up to Rs 128 bn

Tata may consider issuance of equity and equity linked instruments to fund organic, inorganic expansions and also to deleverage. Potential $2 bn of equity issuance at CMP could lead to 18.6% equity dilution, 5% EPS dilution. It could reduce net gearing to 1.4x (2.2x 2Q). Notwithstanding phase II capex, potential capital raise appears large given that existing standalone India operations ex-KPO II could generate average FCF of Rs 65-70 bn p.a. We think Tata is looking to reduce gearing so that it has greater headroom to bid for stressed assets.

Valuation/Risks

Steel prices/spreads have surprised positively and while markets appear to be extrapolating these, we think current spreads/steel prices could moderate leading to potential earnings downgrades. At 7.4x FY19e Ebitda, risk reward appears negative. Our PT of Rs 536 is based on SOTP valuation. Upside risks: Higher prices, higher TSE margins. Downside risks: Lower steel prices, higher BS stress.

Company Description

Tata Steel is among the large steel producers globally with steel capacity of 29.5 million tons. It has operations primarily in India (9.7 million tons) and in Europe (17.8 million tons). It is in the process of expanding capacity at India by 3 million tons through greenfield expansion at Odisha. The company’s India operation is largely integrated as it has 100% captive iron ore and sources around 40% of its coking coal requirement through captive mines.