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Tisco: In a downturn? - Views on News from Equitymaster
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Tisco: In a downturn?
Jan 23, 2006

Performance Summary
Private sector steel major, Tata Steel has reported subdued performance for the third quarter and nine-month period ended December 2005. With the steel cycle having displayed signs of cooling off since the beginning of the current fiscal, the company’s performance has been adversely affected. Not only has the company registered a decline in its topline in 3QFY06, the bottomline performance has also been bleak. The performance for the nine-month period has not been encouraging as well.

(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net Sales 37,313 36,808 -1.4% 106,343 110,104 3.5%
Expenditure 21,597 22,899 6.0% 60,319 63,797 5.8%
Operating Profit (EBDITA) 15,716 13,909 -11.5% 46,024 46,307 0.6%
EBITDA margin (%) 42.1% 37.8%   43.3% 42.1%  
Other income 338 413 22.1% 1,183 1,904 61.0%
Interest 809 364 -55.0% 1,774 1,013 -42.9%
Depreciation 1,495 2,357 57.6% 4,666 5,818 24.7%
Profit before tax 13,749 11,601 -15.6% 40,768 41,380 1.5%
Extraordinary items (22) (286) 1182.5% (523) (872) 66.7%
Tax 4,822 3,777 -21.7% 14,590 13,276 -9.0%
Profit after Tax/(Loss) 8,905 7,537 -15.4% 25,656 27,233 6.1%
Net profit margin (%) 23.9% 20.5%   24.1% 24.7%  
No. of Shares (m) 554 554   554 554  
Diluted earnings per share*         65.6  
Price to earnings ratio (x)         5.5  
(* trailing 12-month earnings)            

About the company
Tata Steel (Tisco) is India’s largest private sector steel company. The company has the distinction of being one of the lowest cost steel producers in the world at about US$ 200 per tonne for hot rolled coil. The company has a total steel capacity of 4 m tonnes (MT) with another 1 MT coming into play within FY06. Tata Steel also intends to add another 2.4 MT of capacity, which is likely to be completed by FY09 and another 6 MT in phases by FY11. The company has been focusing on increasing contribution from value-added and branded products and derives over one-third of its total revenues from these. Exports form about 14% of its revenues (FY05).

What has driven performance in 3QFY06?
Realisation woes: The poor performance of the company on the topline front has continued during 3QFY06 as well, with net sales registering a decline of 1.4% YoY despite volume sales being higher by 10.5% YoY. Thus, the pressure on topline could be attributed entirely to weak realisations, which were lower by about 10% to 11% YoY. As per the segmental break-up provided by the company, while steel sales (85% of total revenues) were lower by 1% YoY, owing to lower realisations, profits of the steel segment at the PBIT level were lower by 17% YoY. The situation was further aggravated by the near 30% YoY fall in profits of the ferro- alloys and minerals division. This division forms almost 10% of the company’s topline.

It must be noted that steel prices, globally, have been treading lower. The same has been reflected in domestic steel prices, which have fallen by 20% to 30% in the last 8 to 9 months compared to their peak in early FY06 (see chart alongside). The reason for this sharp correction in steel prices has been the excess supply of the metal in international markets with China increasingly meeting its demand from internal capacities. However, considering that a considerable portion of Tata Steel’s sales comes through value added sales, which are less impacted by swinging steel prices and with almost 65% to 70% of its overall sales done through long-term contracts, the company’s financial performance has remained relatively insulated.

Cost break-up
(% of net sales) 3QFY05 3QFY06 9mFY05 9mFY06
Purchase of finished, semi-finished & others 10.5% 4.8% 9.0% 4.8%
Raw materials 13.0% 16.6% 12.4% 14.7%
Staff costs 8.2% 9.1% 9.1% 8.9%
Power 4.7% 5.5% 5.0% 5.4%
Freight 6.4% 7.1% 6.4% 6.8%
Other expenditure 18.5% 21.7% 18.6% 20.0%

Margins on the decline: Operating margins during the quarter were lower by about 430 basis points. While part of this could be attributed to lower steel realisations, there has been a rise across all the operating heads, as can be seen in the table above. A sharp rise was witnessed in raw materials costs, which was seemingly on the back of high input costs like coal. Apart from the rise in staff costs, freight costs also rose, as petro product prices during the quarter remained firm.

Bottomline registers a decline: The poor performance at the operating level percolated down to the bottomline. In fact, despite the 22% YoY growth in other income and a 55% YoY fall in interest expenses, the fall in bottomline was higher than that at the operating level. This was owing to a couple of reasons. One being that depreciation charges were significantly higher during the quarter, up 58% YoY. This is because the company has recognised an amount of Rs 2.1 bn during the quarter towards various charges relating to mining leases owing to certain government regulations. Since, this expenditure has been treated as ‘Development of properties’ under the head fixed assets, the depreciation during the current quarter includes Rs 567 m being amortisation upto December 2005. Secondly, the effect of extraordinary expenses pertaining to the employee separation scheme (ESS) during the quarter has been higher owing to the fact that in 3QFY05, the company had booked Rs 286 m as profit on sale of long-term investments, which cushioned the negative impact of ESS last year. All of this led to the bottomline registering a fall of 15% YoY during 3QFY06.

Performance over the last few quarters…
  1QFY05 2QFY05 3QFY05 4QFY05 1QFY06 2QFY06 3QFY06
Net sales growth (YoY, %) 40.2% 43.1% 41.8% 20.8% 9.5% 3.4% -1.4%
Net profit growth (YoY, %) 179.1% 130.6% 99.1% 44.5% 24.0% 12.5% -15.4%
Operating margins (%) 44.3% 43.6% 42.1% 37.3% 45.8% 42.7% 37.8%

What to expect?
At Rs 357, the stock is trading at a price to earnings multiple of 5.5 times its trailing 12-month earnings. However, it is trading at 2 times price to book value on FY06E basis, which we believe is expensive. The company’s nine-month performance has been somewhat below our expectations and as such, we would be downgrading our numbers, albeit marginally. While the company’s volume sales have been in line with our estimates, the underperformance has come on the realisations front. Thus, as per our valuation band (P/BV), Tisco is richly valued on FY06E basis and fairly valued on FY07 basis. While it is difficult to time the steel cycle downturn, we expect steel prices to remain under pressure as more capacities come on stream.

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