I am looking at Tata Steel as two companies:- Tata Steel standalone and rest of the company. Roughly speaking, Indian operations (or more specifically Tata Steel) account for around 25% of the revenues of the consolidated company.
1. Tata Steel Standalone:
Business Logic:
Tata Steel has a production capacity of 6.8 Million tonnes per annum which is being augmented by a brownfield project in Jamshedpur (2.9 Million ton). The additional capacity is to be commissioned from this financial year. In addition to that, its Odisha plant will have a capacity of 3 Million ton, however that will be commissioned somewhere in 2014 or so. Capacity utilization at Jamshedpur plant during the last two years has been more than 100%.
Tata Steel has a strategy to become self sufficient in terms of raw materials and has been acquiring coal and iron ore mines across the globe - Mozambique and Canada are case in point. However, coking coal prices have been an issue in the Steel industry (Tata Steel has captive capacity of only 50% as far as coal is concerned and 100% in case of iron ore).
Steel prices (demand) might dip in Indian market due to inflationary pressures and rate hikes by RBI. However, on a longer term the, steel scenario in Indian market remains solid.
Tata Steel has been one of the low cost producers of Steel across globe and has an EBITDA margin of the range of 35-40%. These operational efficiencies might come in handy in the current periods.
Valuation:
Tata Steel currently commands a P/E ratio of 5.74 compared to that of 10.08 of SAIL, 5.55 of SAIL and 8.98 of Bhushan. The EV/EBITDA multiple of Tata Steel is 5.18 compared to 5.81 of SAIL, 4.75 of JSW Steel and 10.97 of Bhushan Steel. Thus, Tata Steel seems to be valued at par with the peers in Indian market.
However, market seems to have discounted the growth in the production capacity which is expected to has its impact starting this financial year.
I have done a DCF analysis with following inputs (these are very moderate assumptions, somewhat bearish only):
i) Revenue growth rate of 20% over next three years (this is due to the growth in production capacity, average growth rate for past four years has been 12.7% covering a period of recession) and then slowing down to 12.7% by year 6
ii) EBITDA margin to be 30% (company average is 38.1%) for first three years (even in FY11 Q2 EBITDA margin has been around 30%) and increasing to company average of 38.1% in next three years
iii) Investment as a percentage of sales being 20% for first three years and 15% for the next three
iv) Beta of the stock = 1.2, Risk Free = 10%, MRP = 10%
v) Terminal EV/EBITDA of 5.5 (equal to peers)
The fair price of stock comes out to be Rs 484.4 per share. It should be kept in mind that this is the value of only the Indian Steel operations of the company.
2. Tata Steel Europe:
European operations suffer from the problems of:
i) High pension liability - it is more than net assets of the company. Tata Steel Europe follows IFRS and thus doesn't recognize the pension liabilities on the balance sheet or any change in the same in P&L. The off balance sheet liability of Tata Steel Europe due to pensions is Rs 1,13,762.22 Crores, which is about thrice its assets. The only silver lining in this case is that it is a long term liability and might not materialize in near future and hopefully by its maturity TSE is able to turnaround its business.
ii) Non improving, rather deteriorating economic scenario in Europe.
TSE is tackling this problem by:
i) Cost cutting and mothballing / selling its non-profitable divisions
ii) Vertical integration to secure the supply of raw materials
iii) Trying to rationalize the pension plan
Growth Drivers:
i) Capacity expansion
ii) Increased focus on raw material security
iii) Anything positive from European operations and other Asian operations (not covered in this analysis) is a bonus
Risks:
i) Pension liability in Europe
ii) Increasing interest rates and raw material prices in India
iii) Contingent liabilities of around Rs 12,000 Crore (however, probability of these materializing seems remote)
Exit:
Even after assuming the European and other Asian operations to be of zero value, Tata Steel is undervalued. The exit price in the short duration is Rs 500 per share. It will, however, depend on the performance of European division. Anything positive out of the division and share price can attain new heights.
Nice post and use of SOTP approach. Good to see the real life use of DCF, though as you said, we know how these reports are made :p Also, you could have factored the synergy aspect in
ReplyDeleteAn accounting clarification,IFRS does need recognizing pension liability on balance sheet. Maybe you are referring to the restated Indian GAAP accounts for Tata Steel Europe?
I think using DCF can be useful if we take very conservative assumptions and still find that the stock is undervalued.
ReplyDeleteThanks for the clarification regarding accounting. In the consolidated balance they don't show pension liability. May be because of some other accounting practice.