Tata Steel: Global woes

Weakening demand and lower realisations in its international operations will mean continuing pressure on Tata Steel’s financials.

The last time Tata Steel reported a fall in revenues and a significant drop in net profits was in 2001 and 2002. This was mainly on account of a global recession and falling steel prices, resulting in lower demand for steel and significant erosion in margins. The turnaround came in 2003 as it reported higher sales and net profits. It seems to have come full circle once again.

Recently, the company’s rating was downgraded by Moody’s Investors Service. This time, the concerns are more on account of its international operations and worsening global steel outlook, resulting in deterioration in the company’s financial conditions. “The operating parameters like EBIDTA margins are decelerating quickly.

Also, its high debt of $13-14 billion is a concern in light of very little visibility over future cash flow on account of a sharp fall in steel demand and prices,” says Ivan Palacios, assistant vice president – analyst, Moody’s Singapore. So, will it do an encore?

Overseas worries

During Q3FY09, Tata Steel reported a 42.5 per cent drop in consolidated net profit to Rs 810 crore, which was better than analysts’ expectations of a loss. The outperformance, to an extent, was also on account of hedging gains (in Corus, UK) reported in Q3. With concerns over international operations not expected to ease anytime soon, analysts believe that the performance in FY10 will be hit significantly.

Today, the biggest challenge for Tata Steel is its international operations. The company currently has total crude steel capacity of about 30 million tonnes. Since over 70 per cent is accounted for by its operations in Europe and South East Asia, these regions have a significant bearing on consolidated financials of the company.

For instance, during the first nine months of FY09, the EBDITA margins for the consolidated entity stood at 15 per cent, which is much lesser than 43 per cent margins enjoyed by Tata Steel’s domestic operations (standalone). During this period, its UK-based subsidiary Corus has seen a continuous fall in its EBDITA per tonne viz. from $117 in Q1FY09 to $83 in Q3FY09.

This is largely on account of higher input cost and falling realisations. Corus sells about 70 per cent of its products in the spot market, which had to take the brunt of falling steel prices and thus, the impact on realisations. On the other hand, its limited ability to contain the cost (majority of inputs like iron ore nd coking coal are procured from the market on long-term contract basis) took its toll on profitability.

The outlook for Tata Steel’s operations in Thailand, too, is not exciting. The company suffered an estimated operating loss of $75 million in Q3 ($103 million profit in first six months) in the region.

Deteriorating demand

Margins apart, sales volume too have been hit. In comparison to India, the demand destruction in international markets such as Europe has been higher. During Q3FY09, while domestic revenues were down by 14 per cent, its international volumes were lower by 25 per cent thanks to lower demand and a production cut of about 30 per cent announced by Corus.

Corus is mainly into the flat products used in industrial and automobile sector. The demand for these products has fallen by about 40-50 per cent in European markets, resulting in a dip in volumes from 6.2 million tonnes in Q1FY09 to 4.3 million tonne in Q3FY09. Going forward, with demand expected to remain weak, volumes could be impacted by 30-40 per cent over the next few quarters.

What to expect

Even as volumes in international operations are likely to dip, there is a possibility of margins stabilising. Corus is taking steps to cut its cost (by about Rs 4,500-5,000 crore) including reducing workforce, cuts in production, bringing down power costs among others, which should help lower expenditure going ahead. It also plans to sell (fully or partly) its interest in select operations (cast products and aluminium), which would further help control costs.

Also, about 60 per cent of its long-term raw material contracts are due for renegotiation between January and April 2009. Given that iron ore and coal prices have fallen by 40-50 per cent, the new contract rates should also be lower. With these initiatives, the margins for Corus should gradually look up from Q1FY10 onwards.
 

LOSING STRENGTH
in Rs crore	FY09E	FY10E
Tata steel (mnt)	4.90	5.90
Corus (mnt)	17.30	16.00
Others (mnt)	0.50	0.80
Total (mnt)	22.70	22.70
Avg realisation (Rs/tonne)	55000	44000
Consl. sales	124850	99880
Consl. Net profit	8700	3800
Consl. EPS (Rs)	105.97	46.29
PE (x)	1.47	3.37
mnt: million tonne, E: analyst estimates

However, in FY10, volumes are expected to be lower by about 30 per cent to about 14.5-15 million tonne as compared to 18-20 million tonne in FY08. Given the high share of international business, it is not surprising that many analysts expect FY10 consolidated revenues and profits to fall significantly.

Domestic cushion

Meanwhile, Tata Steel is expecting higher growth in the domestic business driven by favourable product mix towards long products, primarily led by investments in the infrastructure and construction sectors. Tata Steel had added new capacities of two million tonnes during 1HFY2009; with this, the product portfolio is now equally balanced towards the long and flat products.

So far, in each of the months of January and February 2009, the company sold 500,000 tonne (total 1 million tonne), which suggests that it is on track to achieve its Q4 volume target of 1.5 million tonne (5.1 million tonne for FY09 compared to 4.8 million tonne in FY08).

This represents a growth of 37 per cent over Q3FY09. In this light, and given that domestic operations earn margins of 40-45 per cent, Tata Steel should manage to report a marginal rise in absolute operating profits as compared to Q3FY09. This should provide some cushion to weak performance in international operations.

Conclusion

The outlook for the domestic business is relatively stable given the cost competitiveness and integrated operations. However, the international business continues to be a cause of worry as there are no clear signs of demand and prices stabilising at current levels.

Little wonder, analysts are expecting consolidated net profit to decline by about 15-20 per cent in FY09 and by about 50 per cent in FY10. At Rs 157, the stock is available at a PE of 3 based on estimated consolidated FY10 earnings of Rs 50, and may remain under pressure in the near- to medium-term. For those looking at a 2-3 years perspective, consider buying in small lots on declines.