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Tata Steel: Feeling the heat
Oct 26, 2005

Performance Summary
Tata Steel (Tisco) announced its September quarter results today. The results this time around have been mixed, considering the muted topline growth during the quarter and also the pressure on operating margins. Weak steel prices have adversely affected the performance of the company. However, a significantly lower tax outgo has helped prop up the bottomline during the quarter, also leading to improved net profit margins.

(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Net Sales 37,384 38,651 3.4% 69,030 73,296 6.2%
Expenditure 21,095 22,135 4.9% 38,721 40,898 5.6%
Operating Profit (EBDITA) 16,289 16,516 1.4% 30,309 32,398 6.9%
EBITDA margin (%) 43.6% 42.7%   43.9% 44.2%  
Other income 570 1,188 108.3% 845 1,491 76.5%
Interest 475 307 -35.3% 964 649 -32.7%
Depreciation 1,595 1,755 10.1% 3,170 3,462 9.2%
Profit before tax 14,790 15,642 5.8% 27,019 29,779 10.2%
Extraordinary items (258) (290) 12.5% (501) (586) 17.0%
Tax 5,237 4,898 -6.5% 9,768 9,498 -2.8%
Profit after Tax/(Loss) 9,296 10,454 12.5% 16,751 19,695 17.6%
Net profit margin (%) 24.9% 27.0%   24.3% 26.9%  
No. of Shares (m) 554 554   554 554  
Diluted earnings per share*   75.5     71.1  
Price to earnings ratio (x)   4.6     4.9  
(* annualised)            

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 coils. The company has a total steel capacity of 4 m tonnes (MT), with another 1 MT coming into play within FY06. The company 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. Tisco 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 2QFY06?
Realisation woes: Tisco bounced back smartly from its poor volumes performance during the previous quarter. It must be noted that the company’s production and volume sales had both declined during 1QFY06. However, in 2QFY06, while the production was higher by 14% YoY, steel sales were higher by 16% YoY. But this did not get entirely reflected in the topline, which rose by a much lower 3% YoY in 2QFY06, as weak steel prices took their toll. As per the segmental break-up provided by the company, the average steel realisations for the company were lower by about 8% YoY. Further, a sharp 21% YoY revenue fall in its ferro alloys and minerals division dented the topline performance further. This division contributed almost 10% of the company’s topline and 12% of the company’s PBIT in 2QFY05, which has fallen to 8% and 7% respectively in the quarter under consideration. PBIT margins for this segment fell by almost 10% YoY (1,000 basis points).

It must be noted that steel prices, globally, have been on the descent and the same has been reflected almost immediately in domestic steel prices, which have fallen by 20% to 25% in FY06 till date. The reason for this sharp correction in steel prices has been the lower offtake of steel globally, because of which there was steel inventory build-up in 1HCY06. Moreover, anticipation of a further fall in steel prices led to further deferment of steel offtake, which pressurised steel prices even more, turning into a vicious circle. However, considering that a considerable portion of Tisco’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 volatility in steel prices has not affected the company’s performance significantly.

Cost break-up
(% of net sales) 2QFY05 2QFY06 1HFY05 1HFY06
Purchase of finished, semi-finished & others 7.6% 3.7% 8.3% 4.8%
Raw materials 11.5% 13.3% 12.2% 13.7%
Staff costs 9.3% 8.8% 9.6% 8.8%
Power 4.8% 4.9% 5.2% 5.3%
Freight 6.4% 6.2% 6.3% 6.7%
Other expenditure 18.3% 18.9% 18.6% 19.2%

Record high operating margins: After achieving record high operating margins during the previous quarter, these have come down marginally in 2QFY06 (see chart below). On a YoY basis, operating margins are lower by 90 basis points. Nonetheless, these are still very strong. Barring raw materials, most of the operating expenses have either remained stable or have declined marginally, which is encouraging. In the case of raw materials, with coal prices continuing to remain firm, raw material expenses as % of net sales have increased by 180 basis points (see table above). It must be noted that Tisco imports about 30% to 35% of its coal requirements and coal prices internationally have been on an upswing. However, as indicated by the management during the previous quarter, there has been some reduction in imported coal, as the company managed to meet a larger share of its requirement from indigenous sources.

Lower tax outgo helps bottomline: While the operating profits of the company during the quarter rose a meager 1% YoY, more than doubling of other income, a 35% fall in interest income and a lower tax outgo (31% of pre-tax profit in 2QFY06 compared to 35% in 2QFY05) helped raise the bottomline by 13% YoY. Thus, while the operating margins have registered a fall, net profit margins have actually witnessed an increase of 210 basis points.

What to expect?
At Rs 347, the stock is trading at a price to earnings multiple of 10 times our FY08 estimates and at a price to book value (P/BV) of 1.4x. As per our valuation band (P/BV) and considering the current state of the steel cycle, we believe that Tisco is fully valued. While it is difficult to time the steel cycle downturn, we reckon that steel prices would spiral to lower levels in the medium-term, as greater capacity (read supply) comes on stream. While the company’s 1HFY06 performance has been in line with our estimates, and as such we would not be making any major changes to our full year estimates, we believe that though Tisco’s valuations look appealing, investors must understand that steel being a cyclical industry is prone to severe downturns. In fact, we believe that the current weak steel pricing scenario is a part of the larger correction to come in steel prices.

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