Tata Steel’s (TATA) large miss in India results was mostly driven by sharply higher imported iron ore costs (+R12 bn), which should reverse over the next two quarters, and combined with ferro chrome re start should also offset most of the ASP (average selling price) decline, leading to higher Ebitda/tonne even with lower prices. Europe reported a surprisingly large beat at $64/t (after positively over the last few quarters). Net debt increased given working capital and lower India OCF (operating cash flow) and last mile spending on 3mt steel plant.
The stock is trading at 0.85x P/B (price-to-book value) and over the last 11 years only twice has it gone below and has bounced sharply post that. The key thesis of deleveraging remains intact. We cut our Ebitda estimates by 7-13% over FY 15- 17 and our EPS (earnings per share) estimates by 10-49% and reduce our PT (price target) to R590 from R630. Remain OW (overweight).
Sharp miss in India Ebitda/t driven by higher iron ore: Consolidated Ebitda stood at R30.7bn vs JPMe (JP Morgan estimates) of R32.7 bn). Standalone Ebitda stood at R19 bn (-36% q-o-q) v/s JPMe of R24 bn and Ebitda/t at R9295/t (-37% q-o-q). While headline ASP/t declined by 7% q-o-q), we believe this was more driven by a timing issue. Imported iron ore (given the mining ban on captive mines) impacted Ebitda by R12 bn (R5600/t). Going forward, while ASP/t should further decline over the March/June quarter, the iron ore hit would reverse as captive mines and ferro chrome mines have restarted and Ebitda/t should recover to R13k/t. The 3mt steel plant is expected to be commissioned over the next few months as last leg approvals are awaited. We are not concerned about lack of Khodbund iron ore and expect existing mines to ramp up.
Surprisingly strong showing at TATA Europe (TSE): Implied Ebitda/t at $64/t was sharply ahead of estimates and while we do not expect the same to sustain intoQ4, we would highlight that TSE has consistently surprised positively over the last few quarters as the fruits of rationalisation come through. Given the euro’s depreciation, we expect FY16 to remain strong for TSE.
Net debt rises q-o-q given lower OCF, elevated capex, and working capital: We maintain our thesis that net debt should reduce from FY16 onwards as capex reduces and Ebitda increases on higher volumes.
Large underperformance vs. global/regional peers: TATA has materially underperformed global steel peers and is near its multi-year low valuations. From here, we believe the worst is over in terms of India steel margins (which is the cash cow) and as demand improves, the benefits of the $3 bn expansion should flow through.
Why we believe Q3 India Ebitda/t was the bottom: As we had highlighted earlier, given the lack of clarity on the exact impact of imported iron ore, the swing in earnings could be high and that is what happened. India Ebitda was a big miss at R19 bn (-36% q-o-q). Imported iron ore accounted for R12 bn hit (R5,500/t) as the company used 2.5mt of imported iron ore (would further use 1mt in Q4 and the remaining ~1.5mt over the rest of FY16). While headline ASP/t declined by 7% q-o-q (R4,000/t) we would highlight that given TATA’s much higher proportion of value added steels, which generally have contracted pricing, the resets flow through to the spot market with a lag. TATA’s ASP/t had increased by R1,800/t in Q2, even as the markets had softened and hence there is a element of the reset in contracts. We also suspect some mix issues which lead to larger ASP/t decline on a q-o-q basis.
The sharply higher raw material cost/t of R5,500/t broadly accounts for most of the q-o-q decline in Ebitda/t. From here, the iron ore mines have restarted and so have the ferro chrome mines. While blended steel ASP/t should further decline by R1,000-1,500/t, there would be a very large cost/t decline on captive iron ore and hence Q4 Ebitda/t should recover to at least R12,500/t and further improve in FY16 as the full benefits of normalisation kick in.
Tata Steel Europe continues to improve. Given the euro’s depreciation we see further upside in FY16 over FY15 levels. TATA’s net debt increase seen in Q3 should reverse from FY16 onwards as capex reduces sharply, working capital normalises and Ebitda increases on higher volumes.
—JP Morgan
