End of European Dream Necessary for Indian Story to Flourish – Just Another Investor

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Hello Readers! First of all, why even do an article/blog on a relatively less exciting company like Tata Steel? Well, the Steel Industry has undergone consolidation over the last few years (thanks to IBC!) and leaves us with three major players in the Industry – State-Owned SAIL, and privately-owned Tata Steel and JSW Steel. We wondered if the consolidation in the industry and the large ticket acquisitions will help the large players in a Post-Covid World and decided to study the industry leaders. Well, with this in background, let us start our discussion on Tata Steel!

Company Overview

  • Established in 1907, Tata Steel is the flagship entity of the Tata Group; the company is promoted by Tata Sons
  • Tata Steel has consolidated capacity of 32 MnTPA as of March 2019
  • Tata Steel has manufacturing units at Jamshedpur (Jharkhand) and Kalinganagar (Odisha) with production capacities of 10 MnTPA and 3 MnTPA, respectively
  • Therefore as of fiscal 2020, the company’s capacity formed around 17% of the country’s overall steel capacity
  • The Indian units meet 100% of its iron ore requirements through captive mines; further, around 27% of its coal requirement are met through captive mines.
  • In Financial Year 2018-19, the Company initiated a 5 MnTPA expansion project at Kalinganagar to enhance its cumulative capacity to 8 MnTPA at the facility
  • The company has further 12 MnTPA of capacity through its European operations

Shareholding Pattern (As of June 2020)

Source: Company Filings

Major Group Companies Information (Fiscal 2020)

Source: Company Filings
  • Tata Steel successfully acquired Bhushan Steel Limited in fiscal 2018-19 through its wholly-owned subsidiary Bamnipal Steel Ltd , which further increased Group company’s capacity by 5.6 MnTPA; the acquired entity was renamed as Tata Steel BSL and merged with Bamnipal Steel
  • The company also acquired Usha Martin Limited (capacity of 1 MnTPA) through its subsidiary Tata Sponge Limited and later renamed the company as Tata Steel Long Products
  • The EBITDA per Ton is the highest for Tata Steel India followed by Tata Steel BSL and Tata Steel Europe

Share of different entities in consolidated revenue and operating profits (Fiscal 2020)

Source: Company Filings
  • The numbers above clearly demonstrate the pain point for the company – the performance of its European subsidiary
  • The European business constituted 31% of the Group company’s revenue in fiscal 2021 but reported an operational loss in fiscal thereby dragging the profitability for the company

Trend in Revenue and Operating Margin

  • The realizations for the steel products dropped substantially globally during fiscal 2015 and fiscal 2016 on account of dumping by Chinese Steel Manufacturers
  • The anti-dumping duty imposed by the Government partially aided the recovery in steel prices
  • The operating margins for the Group company reached its decadal peak of 18.2% in fiscal 2019 before correcting again in fiscal 2020
  • It is important to note that the demand and margins for the company had dropped even before Covid-19 pandemic hit the globe
  • During 9M fiscal 2020, the net profit for the company dropped to INR 27.9 billion compared to INR 68 billion in the year ago period

Balance Sheet continues to remain highly leveraged for the company

Source: Company Filings
  • The Gearing for the company had reached its peak of 2.6X in fiscal 2015, as the company started investing in its Greenfield project at Kalinganagar, Odisha
  • The capex during the year was INR 134.9 billion leading to high net debt
  • The interest coverage for the company dropped below 1 in fiscal 2016 due to plummeting prices of end products leading to steep drop in operating margins during the fiscal
  • In fiscal 2018, the company sold 8,35,37,697 equity shares in Tata Motors and raised INR 3,778 Crore through the transaction; this aided the company in reducing its Gearing from 2.3X in fiscal 2017 to 1.6X in fiscal 2018
  • Despite the strong cash flow from operations generation in fiscal 2019 of around INR 25,300 Crore and strong profitability, the gearing did not improve for the company; the inflows were majorly utilized to fund company’s acquisitions (Bhushan Steel and Usha Martin) alongwith meeting company’s capex requirement
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Funding Profile (As of March 2020)

Source: Company Presentation

  • The funding profile for the company is well diversified with 48% of its borrowings being carried out from domestic market and rest from overseas markets
  • As of March 31, 2019, around 66% of company’s long-term borrowings were unsecured; further bonds and debentures constituted around 37% of the company’s debt profile
  • Therefore, the company has perhaps over-stretched its leverage as suggested by the high % of unsecured borrowings, which obviously comes at a higher cost of capital
  • Further, the company may require to raise further funds through NCDs going forward for repayment of long-term debt especially on account of muted cash flow generation due to Covid-19
  • The company approved fund-raise of around INR 6,700 Crore during March 2020 – April 2020 through unsecured NCDs at coupon rate of around 7.75%
  • In April 2020, S&P Global Ratings downgraded the foreign currency rating from BB- to B+ sighting weaker operating environment due to Covid-19
  • Over the next two years, the company has around INR 3,000 Crore of debt maturing; as of March 31, 2020 the company had around INR 10,900 Crore in short-term investments and Cash equivalents

Trend in ROE and ROCE

  • After dismal returns during fiscal 2015 to fiscal 2017, the company saw some revival from fiscal 2018 onwards
  • The company had exceptional gain of INR 13,850.7 Crore in fiscal 2018 arising on modification of benefit structure for members of the new pension scheme for employees of Tata Steel Europe; this led to spike in profitability and ROE for company during the fiscal

Trend in Working Capital Cycle

Source: Company Filings

Trend in EPS and Dividend Per Share

Source: Company Filings

  • Despite the high debt on its balance sheet, the company has been a consistent dividend payer
  • Infact even in its loss-making period during fiscal 2015 to fiscal 2017, the company has announced dividends
  • There is nothing in the company’s dividend distribution policy which mandates compulsory dividend payment every fiscal; for more details, please refer to Tata Steel – Dividend Distribution Policy

Trend in Free Cash Flow to Firm and Capex for the Group

Source: Company Filing

  • The drop in margins during fiscal 2015 to 2017, coupled with high capex due to greenfield expansion at Kalinganagar facility led to low Free Cash Flow during the last five years
  • The capex has gradually tapered off post around INR 23,500 Crore of capex during fiscal 2015 and fiscal 2016, but continued to remain relatively high at around INR 9,500 Crore in fiscal 2020
  • Owing to Covid-19 Pandemic situation, the company has decided to cut its capex in fiscal 2021 by around 50%; the same will obviously help company to conserve cash

Tata Steel Europe – The White Elephant Drags on….

  • Tata Steel acquired Corus Steel Plc in 2007 at whooping $12 billion to become the world’s fifth largest Steel Manufacturer
  • During the acquisition, the steel capacity of the Indian arm was 4 mtpa and Corus Steel was 18mtpa
  • However, soon after the acquisition Global Financial Crisis followed which severely dented the prospects of the European arm
  • The borrowings for the European arm continued to pile up as the losses increased for the company
  • The liquid steel production for Tata Steel Europe dropped from 20.1 million tonnes in 2007-08 to 10.3 million tonnes in 2018-19

The continued lackluster performance of Tata Steel Europe

Source: Company Filings; Note: Fiscal 2020 PAT for Tata Steel Europe is not available; however the same will likely be in negative considering the Q3 fiscal 2020 trend

  • The profitability of Tata Steel Europe has always been under pressure due to the imports of cheap Chinese products in European region
  • Further, the higher interest cost for the company due to piling debt makes positive cash flow generation further difficult for the business
  • It is important to note that unlike Indian operations, the European operations are not vertically integrated; the company has strong dependence on third parties for raw materials
  • The spike in profitability in fiscal 2018 was on account of modification of benefit structure for members of the new pension scheme for employees of Tata Steel Europe
  • During fiscal 2018, the company also sold assets its specialty Steels Business held through Tata Steel UK – an indirect subsidiary of Tata Steel Europe; however, there was no meaningful cash flow generation through transaction
  • Tata Steel Group has failed in its efforts to sell of the European assets and therefore continues to carry its burden on its balance sheet
  • Tata Steel Europe closed its Orb Electrical Steels business in the UK in fiscal 2020
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Tata Steel India – Stronger than its Parent

  • The performance of Tata Steel India (Standalone company) has been much stronger than the Group Company

Sales Growth and Operating Margin significantly stronger for company’s standalone operations

Source: Company Filings

  • The revenue for Tata Steel India (“TSI”) has grown at around 8% CAGR during fiscal 2015 to fiscal 2020, as compared to almost nil growth for Tata Steel Group
  • Even during fiscal 2015 and fiscal 2016, when the steel industry was going through a steep downturn, TSI reported strong margins and substantially higher than the Tata Steel Group
  • Backward integration of manufacturing processes through captive mining of iron ore (100%) and coal (~27%) makes TSI one of most efficient steel manufacturer in the country

Balance Sheet substantially stronger for standalone company

Source: Company Filings

Trend in ROE and ROCE

Source: Company Filings

  • The standalone entity has never reported negative returns for the company unlike its parent company
  • The Indian operations of the company therefore has been able to deal with market volatility and cycles in much more prudent manner as compared to its European operations

Strong Cash Flows for Tata Steel India

Source: Company Filing; Note: The Capex for Fiscal 2020 is the best estimate basis discussion in company concall

  • The cash flows from Tata Steel India has been a bright spot as discussed above and continues to support Group performance
  • The free cash flow generated from Tata Steel India is therefore just about sufficient to fund the interest expenses (~INR 84 billion) at the Group Level
  • In fiscal 2021 and fiscal 2022, the company will have to substantially cut down on capex in-order to offset the margin contraction; as it is likely that the European operations will register a loss, the interest at Group company level will have to be majorly funded by Tata Steel India, Tata Steel BSL and Tata Steel Long Products (supported through inter-corporate deposits and other related party transactions)
  • Therefore, restructuring of European Operations is very critical for the company, without which the Group company will continue to limp
  • Please note that we have not even discussed about the principal repayments of INR 3,000 Crore due for next two years; therefore, the company has rightly decided to raise further INT 6,700 Crore in-order to ensure sufficient liquidity for the firm

Headwinds for the company

  • The performance of European operations continues to be a major drag for the company
  • Further, in the current scenario the company may find it very difficult to dispose any of its global assets or get the right value for the asset
  • The already weak demand scenario in Europe will be further accentuated due to Covid-19 pandemic
  • The long-term debt for the company is unlikely to drop for the company over next two fiscals, as the margins will remain under pressure due to demand destruction on account of Covid-19; therefore the high interest cost will be a drag on profitability
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Tailwinds for the Company

  • The dropping interest rates in the economy bodes well for debt-heavy companies such as Tata Steel; however, the same cannot be seen as a positive and only prevents further strain on the balance sheet
  • The oversupply situation in China will partially ease due to closing down of outdated Induction Furnace capacities of upto 100 mtpa enforced by Chinese Government; also, the Government has been pro-active in imposing anti-dumping duties on Chinese products
  • The consolidation in the industry may reduce the pricing pressure for leading players in domestic operations
  • Further, the Covid-19 Pandemic may lead to further pressure on the non-integrated players in the industry and lead to distressed sale of assets
  • The possible equity dilution in Port Talbot Steelworks through a 50% stake sale to UK Government may result in cash inflow of around INR 8,600 Crore which will be a big boost to the company; however, the same is currently under negotiations

Consolidation in the Industry to benefit last men standing

  • As of fiscal 2020, the top 3 players in the industry constitute around 46% market share in the industry
  • Post fiscal 2015, many players in the industry were witnessing operational stress on account of high leverage; this led to players gradually operating at lower manufacturing capacities thereby providing support to prices.
  • Despite some of the major companies in the industry such as Bhushan Steel, Essar Steel, etc. undergoing insolvency proceedings, the other major players in the industry witnessed improvement in their operating margins from fiscal 2015 onwards.
  • The lower capacity in the domestic industry coupled with drop in Chinese output provided pricing support to the players

Peer Comparison

Source: Company Filings; Note: P/E and P/B for Tata Steel (Standalone) are not the right indicators as the price also includes risks & performance of consolidated company

  • The margins of Tata Steel (Standalone) have been the best in the industry; however, it is significantly lower on consolidated basis
  • The Gearing for Tata Steel (Standalone) is also better than its peers; however, the same may also be on account of company doing certain acquisition through its associate’s balance sheet

To Conclude….

  • The long-term demand for the industry would remain robust in post Covid world given the low consumption of steel in the industry and growth potential in various downstream sectors
  • The future prospects of the company will depend on two major factors: the recovery in Tata Steel India operations post Covid and how the company manages to arrest losses and restructure its European operations
  • Our bet is on successful restructuring over next two years born out of necessity due to Covid-19 Pandemic followed by a growth period (profit-wise) for the company
  • At 9.8X fiscal 2020 consolidated earnings and 0.54X book, an investor willing to take moderate to high risk may look to invest in the company
  • The upside potential for the stock is substantial incase the company is able to effectively restructure its European operations. Which Side are you on?

HAPPY INVESTING!



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Saurabh Prabhu
Stock Market. Cricket. F1 Enthusiast. Private Equity Professional . Ex- Crisil.
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