Why Tata Steel's Kalinganagar expansion makes good sense

Growing the more profitable integrated India capacities, after restructuring European operations, will boost its consolidated earnings

Tata Steel’s announcement on capacity enhancements at its Kalinganagar plant shows its renewed domestic focus after streamlining the European operations. The company plans to expand its Kalinganagar (Odisha) steel-making capacities from the current three million tonnes per annum (MTPA) to eight MTPA in four years. 

The move is seen as a positive one, given that Tata Steel enjoys one of the highest profit margins among domestic and global steelmakers. So the expansion of its India capacities through organic route should translate into a substantial increase in its profits too. Moreover, the uptrend in domestic steel cycle should lend support.

Focus on more profitable India biz

Tata Steel has continued growing its domestic capacities in past few years through de-bottlenecking of its Jamshedpur plant and ramping up its new Kalinganagar capacities. Consequently, domestic volumes have continued to grow consistently during the past six quarters (from 2.15 MT in June 2016 quarter to 3.08 MT in September 2017 quarter). Achieving over three MT production run-rate in a quarter with total 13 MT capacities meant that the company required fresh capacities to fuel volume growth going ahead, which is where the expansion plans come into play.

Interestingly, unlike the roughly Rs 25,000 crore the company spent on setting up the initial three MPTA capacity and Kalinganagar, the planned five MTPA capacity is expected to cost Rs 23,500 crore, indicating a much lower capital cost per tonne. Given that the existing Kalinganagar capacity is already profitable and cash flows are strong, the time taken for new capacities, as they come on stream, to contribute to Tata Steel's financials should be shorter.

What's more, rising production and expansion come at a time when domestic steel cycle too has turned favourable and hence, should drive Tata Steel's earnings. The domestic steel players have immensely benefited from realisation front post imposition of Minimum Import Price (MIP) and other government measures since February 2016. With improved realisations, the company has continued reporting EBITDA (earnings before interest, tax, depreciation and amortisation) per tonne of over Rs 10,000 (Rs 10,786 - Rs 13,586) in the last four quarters, which is the best amongst peers. JSW Steel reported EBITDA per tonne of about Rs 7,500 a tonne in September 2017 quarter.

Notably, the domestic operations of the company are also more profitable compared to its European operations. Tata Steel India had reported a profit of $167 per tonne compared to $44 in its European operations in the September quarter.

With European operations now streamlined and turning profitable post resolution of key issues such as UK employee's pension liabilities, and the company going ahead to transfer its European facilities to a joint venture with Thyssenkrupp, the Europe business worries are also sorted out.

All these developments have already turned the street bullish on Tata Steel, which is also reflecting in the strong gains in the stock price.

Among recent ratings, Bank of America Merrill Lynch had initiated coverage on Tata Steel with a Buy and price objective of Rs 890. The brokerage expects nearly 51 per cent annual growth in earnings over FY17-19. Their positive view is premised on improving capacity/volume mix with high-margin India capacity exceeding that in Europe for the first time since the acquisition of Corus in 2007, driving 146/638 basis points expansion in EBITDA margins/return on equity over FY17-19.

The successful resolution of pension deficit issue in Europe would enable management focus to shift back to value-accretive capacity expansion in India with India share potentially rising to about 68 per cent (up 1,650 basis points) of consolidated capacity by FY22 and strategic joint venture with ThyssenKrupp providing an attractive value-creation opportunity, they add.

Most analysts have been reiterating their positive view on steel sector as they see more legs to the steel up-cycle. While domestic consumption is expected to rise driven by infrastructure and housing demand, analysts also see capacity utilisations improving. Analysts at Kotak Institutional Equities expect domestic steel industry's capacity utilisation to improve to close to 90 per cent over next 2-3 years. They also expect domestic steel prices to increase and buoy earnings of Indian steel companies over the next two to three quarters and hence maintained a positive view on Tata Steel (target price of Rs 780) along with JSW Steel and Jindal Steel and Power.

The stock's reaction on Wednesday (down 1.2 per cent) is possibly due to the company's plan to raise up to Rs 12,800 crore through a rights offer, as this is likely to result in an equity dilution of about 15-20 per cent. The street's concern also stems from the company's plan to grow the business inorganically. Reports in the recent past suggest that the company could possibly bid for some of the steel assets of defaulting companies being auctioned by lenders. Since India's other top steelmakers are also eyeing these assets, any aggressive bids to win the deal could have a bearing on consolidated numbers of the companies.