Domestic expansion to enhance margins

While short-term concerns on high input costs and softer steel prices remain, rise in volumes of domestic operations will drive profits over the next two years.

Tata Steel’s better than expected numbers for the March quarter saw its stock rise by almost two per cent on Thursday, more than the 1.1 per cent rise in the Sensex. Even after adjusting for the various one-off items, the consolidated performance was largely ahead of Street estimates. It was led by its European operations, which posted better profits, aided by firm steel prices, cost control and higher utilisation levels.

Here on, analysts say there are risks of steel prices softening and input prices remaining firm. Barring this, over the next two years, the company is expected to witness stable growth in revenues and faster growth in profits. The latter will be aided by increase in volumes from high-margin domestic operations. Thus, most analysts have a buy rating (with price targets ranging Rs 700-750) on the stock, which at Rs 572.60 trades at a reasonable 7.3 times.

PRICE, VOLUME GAINS
Both domestic and international steel prices were up on an average by about 15-18 per cent year-on-year in the March quarter. A better pricing environment, along with higher volumes in the European operations, which was partly due to de-stocking of inventory, helped Tata Steel to report 25.3 per cent growth in revenues in the quarter. While net profits grew 71.5 per cent to Rs 4,176 crore, despite a decline in operating margins by about 250 basis points, the sharp rise was a result of an Rs 2,280-crore gain on account of sale of the UK-based Teesside Cast Products (TCP) operations. Adjusting for this, consolidated net profit was Rs 1,870 crore, lower by 32 per cent year-on-year.

On a sequential basis, though, the operational improvement in European operations and lower consolidated debt has been impressive. In comparison to $88 million in the December 2010 quarter, Tata Steel’s European operations posted an Ebitda (earnings before interest, taxes, depreciation and amortisation) of $217 mn (adjusted for one-off items) in the quarter, on a 22 per cent rise in sales. Proceeds from the TCP sale were used to reduce debt, which helped in lowering net debt from Rs 52,836 crore last year to Rs 46,632 crore as of March. This should help keep interest expenses under check.

GROWTH, CONCERNS
Analysts expect European operations to post strong performance in the June quarter as well. However, the impact of higher raw material costs could reflect from the September quarter, if steel prices soften.

Going ahead, gains on the realisations front are likely to be limited, as analysts do not see further upside for both domestic and international prices. However, Tata Steel will benefit on account of higher volumes once its expansions go on stream. The company is increasing its domestic steel manufacturing capacity by 2.9 million tonnes to 9.7 mt a year. After its completion by December, this will add about eight per cent to consolidated volumes and about Rs 9,000-12,000 crore to consolidated revenue.

FASTER PROFIT GROWTH
In Rs  crore	FY10	Q4FY11	% chg	FY11	FY12E
Net revenue	101,758	33,823	25.3	118,753	124,294
Ebitda	7,407	4,466	5.1	15,996	16,595
Ebitda (%)	7.3	13.2	-	13.5	13.4
Net profit	-2,009	4,176	71.50	8,983	9,908
EPS (Rs )	-4.2	43.5	58.6	69.5	78.3
P/E (x)	NA	-	-	8.1	7.2
EV/Ebitda (x)	12.4	-	-	5.6	5.6
ROE (%)	-2.8	-	-	22.2	18.6
Change is year-on-year   All figures are consolidated      Source: Edelweiss Securities

Notably, the growth in profits would be higher, given that the new capacities will prop up margins. That’s because the domestic business accounts for higher operating margins (thanks to integrated operations), in excess of 30 per cent, as compared to single-digit margins in the European operations. Additionally, the European business, which is running at about 90 per cent capacity utilisation, will benefit from improved availability of captive raw material and absence of loss-making TCP operations from the current year.

The risk to analysts’ estimates is a sharp correction in international and domestic steel prices. For instance, domestic steel HRC prices, currently down about eight per cent from their peak levels to about Rs 35,000 per tonne, could further fall if the demand comes down as a result of slowing in industrial capex and demand in user industries like construction. Likewise, any slowdown in euro zone demand could also impact overall performance.

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