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Tata steel: Margins under pressure! - Views on News from Equitymaster

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Tata steel: Margins under pressure!
Nov 1, 2006

Performance summary
Tata Steel, one of the most cost efficient producers of steel in the world, announced mixed results for the second quarter FY07. On a consolidated basis, topline and bottomline have grown by 17.5% YoY and 2.2% YoY respectively. While operating margins that declined by 390 basis points YoY (3.9%) were affected by lower prices and spiraling raw material costs, net profits would have declined but for higher other income. The topline growth (7.8% YoY) was staid on a standalone basis owing to lower realisations and drop in export turnover.

Consolidated financial snapshot
(Rs m) 2QFY06 2QFY07 Change 1HY06 1HY07 Change
Net sales 51,121 60,083 17.5% 99,728 117,724 18.0%
Expenditure 33,384 41,579 24.5% 65,150 81,806 25.6%
Operating profit (EBITDA) 17,736 18,504 4.3% 34,578 35,918 3.9%
EBITDA margin 34.7% 30.8%   34.7% 30.5%  
Other income 1,076 1,681 56.3% 1,387 2,473 78.2%
Interest 381 726 90.8% 809 1,280 58.1%
Depreciation 1,972 2,460 24.8% 3,874 4,842 25.0%
Profit before tax/(loss) 16,460 16,999 3.3% 31,282 32,269 3.2%
Tax 5,046 5,181 2.7% 9,793 10,123 3.4%
Extraordinary items 288 444 54.2% 592 632 6.8%
Profit after tax/(loss) 11,126 11,375 2.2% 20,898 21,515 3.0%
Net margin 21.76% 18.9% - 21.0% 18.3%  
No of shares (m)     553 580    
Diluted EPS (Rs)*         67.3  
P/E (times)         7.28  
*trailing twelve month earnings            

What is the company's business?
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 5 m tonnes (MT), and 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.

What has driven performance in 2QFY07?
Low volume growth and realisation impact topline:
With demand for automobiles continuing to remain robust in 2QFY07, Tisco continued to gain (it has a 37% market share in the Indian auto segment). This is partly reflected in the company's topline in the same period. On a consolidated basis topline has grown by 17.5% YoY on the back of growth in segmental revenues. Topline of the company comprises revenues from steel, ferro alloys and minerals and others (tubes and bearings division, recently opened mid-sized retail steel outlet, etc) Though revenue growth of the steel business was dull at 5.8% YoY, ferro alloys and metals that enjoy better margins saw a revenue growth of 17.4%, while revenue growth of other operations was robust at 24% YoY. On a standalone basis, while steel production was higher by 4% YoY, volume sales were marginally higher by 0.4% YoY. The topline growth was lower on account of softening of metal prices and drop in exports revenue (declined by 13% YoY).

Cost break up (% of sales) 2QFY06 2QFY07
Stock adjustments 2.3% -2.69%
Purchase of finished and semi finished products 18.3% 23.70%
Raw materials consumed 10.6% 13.56%
Staff cost 8.2% 7.73%
Purchase of power 4.4% 5.40%
Freight and handling 5.8% 5.49%
Other expenditure 15.7% 16.00%
Total cost 65.3% 69.20%

Weak metal price and rising costs shrink margins: Following the softening of steel prices in the global markets over the last few quarters, Tisco’s margins are under pressure. Moreover raw material costs further eroded margins on account of high input costs like coal. Freight costs also rose, as petroleum product prices during the quarter remained firm. On a consolidated basis, operating margins grew by 4.3% YoY while net profit grew marginally by 2.2% YoY on account of increased interest outgo. Net profits would have declined by 3.6% YoY but sustained as other income grew by 56.3%. Standalone operating profit margins were lower by 180 basis points YoY (1.8%), reflecting pressure of higher input costs and weak metal prices. But the bottomline grew by 5.4% YoY on account of higher other income.

Over the last few quarters: Over the last few quarters, company’s performance was volatile in line with volatile steel prices. It must be noted that steel prices, globally, have been trading lower. The same has been reflected in domestic steel prices. 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. This resulted in decline in margins on YoY basis, but sequentially the margins have improved marginally with volume growth.

Over the last few quarters 2Q06 3Q06 4Q06 1Q07 2Q07
EBITDA margin 34.7% 30.2% 25.0% 30.2% 30.8%
Net margin 21.8% 16.8% 14.4% 17.6% 18.9%

What to expect?
At Rs 490, the stock is trading at a price to earnings multiple of 7.3 times its trailing twelve month earnings. While the company expects steel demand in India to grow at over 8% in the calendar year 2006, Chinese demand is projected to grow at 13% YoY. Having said that, the company's acquisitions in Singapore and Thailand are likely to help it diversify revenue base and strengthen its global reach in the coming years. Corus acquisition will help company further spread its wings globally. Apart from access to new markets, it will have access to sophisticated technology and expertise in higher end markets. The concerns are with regards to servicing acquisition costs, and how well they will be incorporated in the balance sheet. Also, Corus’s costs of production are higher, so it will impact Tisco‘s operations initially. We expect steel prices to remain under pressure as more capacities come on stream. Though the global sector is going through consolidation phase, it is still highly fragmented. While uncertainties especially relating to the Corus acquisition abound, we believe over the long-term, only those players with access to cheap raw material and labour are likely to survive. Given company’s track record, we are positive on the long-term prospects of the company.

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