Tata Steel's FPO: Good pricing

An improving industry environment and benefits from the company’s capacity expansion and backward integration should lead to higher profits in the coming years.

Tata Steel has seen a turnaround in its operations in the last one year. Notably, given the various developments, both internally and externally, the fortunes of Tata Steel appear to be changing for the better. While steel prices are higher and demand is picking up globally, the company's timely capacity expansion, deleveraging of the balance sheet and moves to secure part of its raw material needs should help improve its profitability in the coming years. Estimates suggest the company will clock a consolidated net profit of about Rs 6,500 crore and Rs 7,630 crore in 2010-11 and 2011-12, respectively, compared to a loss of Rs 2,015 crore in 2009-10.

Meanwhile, part of the costs related to the company’s initiatives will be funded through its ongoing follow-on public offer (FPO) of Rs 3,477 crore, which opened/closes on January 19/21. And, given the company’s future prospects, subscribing to the offer should yield healthy returns in the medium term.

Timely expansion
About Rs 1,875 crore from the FPO proceeds will be used for expansion of the company’s domestic steel producing capacity by 2.9 million tonne (MT) to 9.7 MT. Post the completion of the expansion, which is expected by December 2011, the company should add 8 per cent to its volumes (consolidated capacity including its European operation stands at 27 MT) and about Rs 9,000 crore to consolidated revenues assuming 80 per cent capacity utilisation and current steel prices at about Rs 39,000 per tonne. More importantly, the impact will be huge on its consolidated net profits. The company reported a consolidated net margin of 6.8 per cent in the first half of 2010-11 due to lower margins at its non-integrated European operations, which account for over 60 per cent of revenues. But Tata Steel’s India operations (where the new capacity is being set up) enjoy over 25 per cent net margins. If the same is assumed for new capacity, it will translate into net profits of Rs 2,500-3,000 crore, which is about 38-46 per cent of its 2010-11 estimated consolidated net profit of Rs 6,457 crore. This is also a reason that over the next year the growth will come largely from new capacities as its European operations (already running at 80 per cent utilisation) and existing Indian operations (at almost full utilisation) are running at near optimum levels.

Improving scenario efficiencies

The expansion has been timely and the company will be able to leverage the strong domestic steel demand, which is expected to grow about 14 per cent in 2011 as against the 5.7 per cent growth in the European Union (27 countries). Also, given that steel prices in both its key markets, Europe and India, have recovered by about 13-20 per cent in the last one year, expect Tata Steel’s operating margins to improve further (see graph). In the long run, the margins would also get a boost from the company’s efforts (coking coal project in Riversdale and DSO iron ore in New Millennium) towards securing raw material supply for its non-integrated international operations. Operational gains apart, the company also stands to gain from the deleveraging of its balance sheet in the coming years. The company will use Rs 1,090 crore from the FPO proceeds to pay its debt, which in addition to other initiatives like issue of warrants to promoters and issuance of FCCBs (foreign currency convertible bonds), will bring down its debt-equity ratio from over two times in 2009-10 to less than one by the end of 2011-12. Backed by all these improvements, the company’s consolidated net profit could grow from Rs 6,457 crore in 2010-11 to Rs 10,000 crore in 2012-13.(Click for graph)

Valuations
Tata Steel’s stock closed at Rs 639.80 on Wednesday, which is about 4.9 per cent higher than the FPO upper band of Rs 610. At the offer price, the stock is valued at about nine times the 2011-12 earnings and 5.3 times its enterprise value to operating profit, which is reasonable, and offers decent headroom for appreciation. Even if an enterprise value of five times of the estimated 2012-13 operating profit is taken, the per share value works out to Rs 823, which is within the analysts’ 12-month price targets that range Rs 750-830. On the flip side, among key factors that will have a bearing on the company’s fortunes – which investors will have to monitor – are steel prices and steel demand in international markets, especially the European Union.