TATA STEEL

Beta: 1.25

Institutional Holding: 40.15%

Dividend Yield: 7.5%

P/E: 1.5

M-Cap: Rs 16,000 cr

AFTER the acquisition of Corus in ’07, Tata Steel has become the sixth-largest steel producer in the world. Currently, its total production capacity stands at around 28 million tonnes (mt). The company sells its products across different geographies including Europe, America and Asia. In the long term, the company wants to secure its raw materials (iron ore, coking coal and limestone) requirements. To fulfill this need, the company has acquired mines in different parts of the world, including Mozambique, Ivory Coast and Oman. Currently, its Indian operations are self-sufficient in raw materials, while the European one (Tata Steel UK) depends on external suppliers.

FINANCIALS:

Tata Steel’s Indian and overseas operations, especially Tata Steel UK, have different operating efficiencies. The Indian operations are highly integrated and have an operating margin of more than 40%. On the other hand, the European operations produce high value-added products without any backward integration and have an operating margin of 10-12%. Overall, the company’s consolidated operating margin has improved significantly in the past few quarters. Its consolidated operating margin for the September ’08 quarter stood at 18%, compared to 14% during the year-ago period. The company has taken huge debt to finance its Corus acquisition. Its debt-equity ratio (DER) is close to 1.3 and interest coverage ratio (ICR) is around 8, indicating the company’s ability to service its debt.

GROWTH POTENTIAL:

The company’s growth strategy will be different for various geographies. In India, Tata Steel is on track to expand its capacity in Jamshedpur to around 10 mt and has no plans to cut production. Given the pro-active measures taken by the Indian government to counter the effect of a slowdown, the company may not see significant volume drop in coming quarters. But it will go in for a production cut of around 30% in geographies like Europe, where the impact of the global slowdown is more severe. But the European operations will continue to gain due to an improvement in performance. The company has already achieved around $262 millionon account of this in the current fiscal so far, and has a target of $600 million for FY09, which will roughly account for slightly over one-third of the operating profit of Tata Steel UK.

RISKS:

Tata Steel’s European operations may witness volatility in earnings on account of falling steel and raw material prices. Tata Steel UK has so far managed to pass on the high cost of raw materials to its end customers. However, during a market slowdown, if the sales realisation falls more than the decline in raw material prices, the company’s operating profit will be severely affected. Considering Tata Steel’s high leverage, the overall impact on its consolidated profit may be significant.

TO SUM IT UP:

Tata Steel may not witness high growth during the second half of FY09 due to the sharp fall in steel prices. For valuation purposes, we have assumed a conservative steel price of $450/tonne and lower EBITDA margin (9% for Tata Steel UK and 45% for the Indian operations) for the second half of FY09. The diluted earnings per share (EPS) for FY09 is estimated at around Rs 140, which translates into a forward priceearnings (P/E) multiple of 1.35. At the current price level, the enterprise value (EV) is around three times the estimated EBITDA for FY09. According to Bloomberg data, most international steel producers like Nippon Steel and Posco are currently trading at trailing EV/EBITDA multiples of more than 4. All these factors indicate that Tata Steel is reasonably valued and is a very good bet for risk-loving investors. The stock not only provides price appreciation opportunity, but is also likely to generate handsome dividend returns in future.