Showing plenty of mettle, Tata Steel still has a lot of value

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Jitendra Kumar GuptaMoneycontrol Research

The speed at which Tata Steel is divesting its non-core or loss-making operations of the European business and resolving some of the sticky issues relating to these facilities is worth nothing as this should sooner or later lead to further re-rating of the stock.

Europe – A drag for Tata Steel so far

European operations supply 10 million tonne of steel annually, which is about 42 percent of total group volumes of 24 million tonnes. While the company had huge operations in Europe, most of them were making losses. In FY16, Europe made an operating loss per tonne (EBIDTA per tonne) of USD 12.8 as against ex-Europe Tata Steel operating profit of Rs 7,550 per tonne. Thankfully, with Tata Steel making efforts to restructure European operations, it is losing less and less money.

More than the revenues, Europe’s biggest challenge was to reduce losses and focus on activities that add to overall profitability of the company. For instance, its domestic business makes an EBIDTA of close to Rs 11,000 as against USD 68 EBIDTA made by the European facilities. One obvious solution lies in cutting down or divesting from some of the high-cost operations or loss making facilities to improve the overall profitability.

European restructuring

To achieve this, earlier in May it sold UK-based facilities to private equity player Greybull Capital. That apart, it sold specialty steel business to Liberty House for a consideration of Rs 820 crore and divested its 50 percent stake in JV, Tata Elastron S.A for an amount of Rs 2.72 crore.

Initially, when Tata Steel acquired the European business, it had about five facilities in Europe. Out of that, it has already sold three facilities, with most of them loss-making. Effectively this has brought down the losses. The remaining two facilities, in UK and Netherlands, are considered to be profit-making facilities with exposure to flat steel products. That apart, Tata Steel has also sorted out the issue of past pension liability with a settlement amount of 550 million pounds along with a 33 percent stake in the UK company. Moreover, now onward, the pension will be linked to the market rather than the assured amount employees used to get.

Ever since the acquisition, Tata Steel had taken a hit of close to Rs 31000 crore on account of restructuring and impairments relating to the European assets.

Therefore, the worst looks to be over for the European operation particularly in the light of improving industry environment.

While commenting on the sales, Tata Steel UK CEO Bimlendra Jha said, "With this sale, Tata Steel UK will complete its portfolio restructuring to focus on the strip products supply chain linked to Port Talbot. The sale is also an important step towards developing a more sustainable future for the rest of our UK business,”

Restructuring benefits visible 

Part of the European restructuring benefits are already visible. Despite a 9.5 percent decline in annual sales in FY17, Europe reported Rs 4,705 crore EBITDA as against an EBITDA loss of Rs 513 crore in FY16. For the first time since 2009, Europe reported EBITDA per tonne of USD 103 in the final quarter of FY17 as against a negative EBITDA of USD 18 per tonne in the last quarter of FY16.

This is going to have a huge bearing on the overall financials of the consolidated entity. Even at USD 80 per tonne, the European business would be making an EBITDA of close to Rs 5,200 crore in FY18 as against EBIDTA loss of Rs 513 crore in FY16.

Indian operations: Solid support

This is good news for the Indian operations, which have already seen a recovery in terms of both realisations and volumes. In FY17, domestic business saw its EBITDA per tonne improving to Rs 10,828 from Rs 7,979 per tonne in FY16.

India operations shipped 11 million tonnes of steel as against 9.5 million tonne in FY16. Moreover, India will continue to show volume growth driven by higher domestic demand and ramp up production at Kalinganagar plant.

For the domestic operations, Tata Steel has guided a volume of 12.3-12.4 million tonnes in FY18. Even if European volume growth remains flat, the consolidated entity will be producing close to 26.5-27 million tonnes in FY18, which is an annual volume growth of almost 10-11 percent.

Valuations

Since a large part of the debt of Tata Steel is related to these two remaining facilities in Europe, the debt on overall basis will not come down drastically. However, with improving cash flows, the debt to equity which was at five times in FY16 has eased to three times in FY17 and further expected to come down to 1.9 times in FY18.

During this period, the absolute debt is expected to come down from Rs 88,000 crore in FY16 to Rs 78,000 crore in FY19. Moreover, what is heartening is that the interest coverage ratio will also improve from 0.6 times in FY16 to 2.2 times in FY17 and 2.5 times in FY18.

While revenue growth is certainly looking good, profit growth would be even higher backed by the contribution from the European business. In FY19, the company is expected to make an EBIDTA of around Rs 20,000 crore as against Rs 18,500 crore EBIDTA in FY18 and Rs 16,700 crore EBIDTA made in FY17.

On the basis of FY19, the stock is trading at 6 times enterprise value to EBIDTA and offering a dividend yield of close to 1.5 percent. This is quite reasonable considering the revival in the industry and an end to the losses at its operations in Europe.