Tata Steel - Still not out of the woods; upgrade to Neutral - Centrum

We believe that Tata Steel is still not out of the woods in terms of operational performance and balance sheet stress but upgrade our rating on the stock to Neutral from Sell on the back of recent sharp underperformance. We see volume traction in domestic operations (CAGR of 9.7% over FY13-15E) backed by aggressive focus on retail marketing efforts post expansion but see margins remaining muted (EBITDA of US$265/t in FY14E) on the back of subdued realizations (lower YoY by 6.5% in FY14E) and lower backward integration on coking coal. We see headwinds continuing in European operations and reduce our consolidated earnings estimates lower. We reduce our target price lower to Rs325. Upgrade to Neutral.

Volume traction from domestic operations backed by aggressive retail focused marketing efforts - TISCO has been able to stabilize its 2.9mtpa expansion at Jamshedpur and we expect volume traction ahead backed by aggressive focus on retail and marketing activities in an otherwise subdued domestic market. We expect finished steel sales volumes of 8.4MT/8.9MT in FY14E/15E at a CAGR of 9.7% over FY13-15E.

Standalone margin expectations remain muted on subdued realizations and lower integration - We see economies of scale benefit due to Brownfield expansion for standalone operations which would reduce per tonne employee and conversion costs but this is expected to be nullified by lower integration on coking coal (~40% captive post expansion) and subdued realizations (FY14E average blended realizations to be lower YoY by 6.5%). We expect standalone EBITDA margin of 28.1%/28.6% in FY14E/15E.

Headwinds for European operations continue - We see headwinds for European operations continuing with i) lacklustre domestic demand from almost all regions of Europe, ii) absence of backward integration, iii) no reduction in fixed costs due to volume pressure and additional burden from carbon legislation and iv) strain on financials on account of large maintenance and sustenance cost (~US$500mn sustenance capex every year). We expect sales volumes of 14 MT each in FY14E/15E at European operations with EBITDA/tonne of US$25/30 respectively. We will keep a close eye on any possible write-down for European assets by the management in its year end review.

Nothing much to write home about from raw material projects - TISCO has undertaken various raw material projects internationally but we do not see any material benefit in the short term on account of very slow progress and limited visibility due to logistics bottlenecks. The company has invested ~US$400-450mn in its DSO and Mozambique project till date.

Earnings revised downwards - We have revised our earnings estimates downwards on account of lower margin expectations in view of subdued demand and excess supply exerting downward pressure on realizations in both domestic and global steel markets. We have revised our EBITDA/tonne estimates lower for domestic operations by 6%/6.9% for FY14E/15E. Lower realizations and additional costs of carbon legislation in Europe have led us to revise our earnings forecast lower for European operations. We also expect higher interest and depreciation costs going ahead and coupled with our lower margin forecast, we have revised our adj-PAT estimates for FY14E/15E by 25.4%/24.5%.

Valuations - downside appears limited - We see downside protection for Tata Steel at current levels after the strong underperformance in the recent past. With domestic operations expected to witness increased earnings on the back of volume growth we expect the stock fall to get arrested. We have revised our earnings estimates lower and shift our valuation base to FY15E from FY14E and reduce our target price to Rs325 (from Rs355 earlier). We upgrade our rating to Neutral from Sell earlier as the stock has gone well below our target price post the recent underperformance.

Source : Equity Bulls

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