Tata Steel: A Prime Beneficiary of India’s Infra Stimulus Despite UK headwinds

Tata Steel (NS:TISC) may scale around 128 by Mar’24 and 167 by Mar’25 Tata Steel is an Indian MNC, part of the diversified Tata conglomerate, and 2nd largest iron-and-steel producer in India. Formerly known as Tata Iron and Steel Company Limited (TISCO), Tata Steel is among the top steel-producing companies globally with an installed crude steel capacity of 34 MTA. It is one of the world's most geographically diversified steel producers, with operations and commercial presence across the world in almost 26 countries, with key operations in India, the Netherlands, and the U.K. Its largest plant (10 MTPA) is located in Jamshedpur, India. Tata Steel is the 2nd largest steel company in India (measured by domestic production) with a capacity of around 20 MTA after PSU Steel Authority of India Ltd. (NS:SAIL). Tata Steel is also on the way to adding another 5 MTA Greenfield expansions in the state of Odisha. Tata Steel, along with SAIL and Jindal Steel and Power Ltd. (JSPL), is the only three Indian steel companies that have captive iron-ore mines, which gives these companies price advantages. Tata Steel is one of the few steel companies that are fully integrated – from mining to the manufacturing and marketing of finished products.

Overall, almost 57% of Tata Steel's sales are domestic (India), 36% in Europe, 6% in South-East Asia, and 1% in the rest of the world. The manufacturing of steel products (HR coil, CR coil, coated sheets, merchant steel, machine wires, and structural products) constitutes almost 94%, while other (tubes, refractory, pigments, and investment activities) contribute around 6%. The Indian product portfolio is divided into four segments – Automotive and Special Products; Industrial Products, Projects, and Exports; Branded Products and Retail; and Services and Solutions. The Company supplies hot-rolled, cold-rolled, galvanized, branded solution offerings, and more.

Tata Steel is engaged in the business of steelmaking, including raw material and finishing operations. Its products include hot-rolled (HR), cold-rolled (CR), coated coils and sheets, coated steel coils and sheets, precision tubes, tire bead wires, spring wires, bearings, galvanized iron (GI), wires, agricultural and garden tools, conveyance tubes. Its segments include Agriculture, Automotive, Steel, Construction, Consumer Goods, Energy, Power, Engineering, and Material Handling. The Company operates under the brand's Tata Agrico/ Agriculture, Construction & Hand Tools, Tata Astrum, Tata Bearings, Tata Ferro Alloys and Minerals Division, Tata Steel Industrial By-products Management Division (IBMD), Tata Pipes, Tata Precision, and others.

Tata Steel is one of the largest steel producers in Europe with a crude steel production capacity of over 12.4 MTA. It established its presence in the European continent after acquiring Corus in 2007. The manufacturing facilities in Europe comprise primary steel-making facilities in the Netherlands and the U.K., with downstream operations in the Netherlands, the U.K., Germany, France, Belgium, Sweden, and Turkey. The European operations produce a wide range of high-quality quality strip steel products for demanding markets such as construction, automotive, packaging, and engineering.

Tata Steel's operations in South-East Asia, with 2.2 MTA capacity, began in 2004 with the acquisition of NatSteel, Singapore. The operations are run by NatSteel Holdings Pte Ltd., a wholly-owned subsidiary of Tata Steel. The Company's flagship facility in Singapore is one of the largest single downstream rebar fabrication operations in the world. This plant is the only local steel mill with an integrated upstream and downstream operation, where steel is manufactured through recycling scrap, and fabricated according to customers’ needs.

In 2015, Tata Steel acquired a majority stake in Thailand-based steelmaker Millennium Steel, which strengthened its South-East Asian operations, is the largest and most diverse long steel manufacturer in Thailand using recyclable steel scrap as raw material. The product range includes High Tensile Rebars, ready to use Cut & Bend products, light structural, and specialty wire rods for making Tire cords, Tire beads, Wire Ropes, and stick electrodes. The company has a pan-Thailand distribution network and regularly exports steel to Laos, Cambodia, Indonesia, Malaysia, India, and Bangladesh.

Highlights of Q3FY23 report card: Tata Steel (Consolidated-INR 100 Cr. =1B) · Overall terrible report card

· Operating revenue INR 570.84B vs 598.78B sequentially (-6.53%) and 607.83B yearly (-6.09%) · Operating expense INR 530.36B vs 538.17B sequentially (-1.45%) and 448.89B yearly (+18.15%) · EBITDA INR 40.48B vs 60.60B sequentially (-33.21%) and 158.94B yearly (-74.53%) · Net interest paid INR 17.68B vs 15.19B sequentially (+16.38%) and 15.32B yearly (+15.36%) · Core operating profit (EBTDA=EBITDA-INTT) INR 22.80B vs 45.41B sequentially (-49.80%) and 143.61B (-84.12%) · Equity share capital INR 12.21B vs 12.21B sequentially (unchanged) and 12.21B yearly (almost unchanged) · Core operating EPS (EBTDA/Share) INR 1.87 vs 3.72 sequentially (-49.80%) and 11.76 yearly (-84.12%) · EBITDA margin 7.09% vs 10.12% sequentially (-3.03%) and 26.15% yearly (-19.06%) · EBTDA margin 3.99% vs 7.58% sequentially (-3.59%) and 23.63% yearly (-19.63%) · Interest/EBITDA 43.68% vs 25.07% sequentially (+18.61%) and 9.64% yearly (+34.03%) · Deliveries 7.15 MT vs 7.23 MT sequentially (-1.11%) and 7.01 MT yearly (+2.00%) · EBTDA/TON INR 3196.71 vs 6367.36 sequentially (-49.80%) and 19617.08 yearly (-83.70%) Highlights of Q3FY23 report card: Tata Steel (Standalone-INR 100 Cr. =1B)

· Core operating EPS (EBTDA/Share) INR 3.34 vs 3.18 sequentially (+5.16%) and 9.43 yearly (-64.54%) · Deliveries 4.59 MT vs 4.76 MT sequentially (-3.57%) and 4.25 MT yearly (+8.00%) · EBTDA/TON INR 9080.98 vs 8877.20 sequentially (+2.30%) and 26326.20 yearly (-65.51%) · EBTDA margin 13.41% vs 12.05% sequentially (+1.36%) and 36.05% (-22.64%) Highlights of the investor presentation, management commentaries, and Q&A (analyst concall): Q3FY23 · Overall, terrible performances due to lower steel prices (globally), lower spreads/realizations amid various macro headwinds, higher borrowing costs, tepid Chinese demand (ZERO COVID policy), and the imposition of domestic export duty (15% till mid-November) · Although RM (raw materials/input) costs also fell, the overall spread dropped sharply · Indian prices are now stabilizing at lower levels, while demand is also expected to come back amid robust underlying demand from auto, housing, and various infra-related construction sector · TSI is in a position to continue value-accretive growth in India along with an organic/inorganic expansion strategy to serve growing demand from various government-related infra projects · TSI aims to be net carbon zero by 2045 · TSE is also working on a transition to green steel both in Netherlands and U.K. · Aiming to double iron ore mining from around 30 MTA to 60-65 MTA and crude steel production from 21 MTA to 40 MTA by 2030 and beyond · Phased commissioning of 6 MTA Kalinganagar pellet plants has begun · Sees robust steel demand, especially long products in India in line with nominal GDP growths and huge infra stimulus and construction/housing sector · Aiming to increase long products (like Tata Tiscon) from existing 5 MTA to 13 MTA by 2030 · The overall strategy remains an ideal mix of flats and longs and focuses on innovative solutions and operating models to move up the value chain · Working on B/S optimization by targeting 2x net debt/EBITDA; 4x interest cover and 15% ROIC · Global steel spreads have been subdued especially in Europe, partly due to inflated energy cost · Global steel prices continued to moderate till mid-Nov but since then have begun to recover on inflation and China cues · In China, reopening has led to a surge in COVID cases but has also sparked expectations of a demand rebound and led to improved sentiment · Iron ore prices rose from <$100/t to $120/t levels by end December · Coking coal prices continue to remain volatile and are close to $300/t · In Europe, steel spot spreads have moderated to around $270/t level and the spread incl. natural gas, electricity & carbon costs are <$200/t level · Economic activity in India remained resilient despite subdued global cues · Apparent Indian steel consumption rose +8% on a QoQ basis · India's export duty on steel was removed on 19th November · Infra / Construction and Capital goods continued to improve while automotive witnessed a marginal drop · In Europe, economic activity remains subdued. Industrial output has declined by around 1.3% QoQ basis due to sustained inflationary pressures · India finished products deliveries 4.74 MTA in Q3FY23 vs 4.91 MTA sequentially (-3.46%) 4.42 MTA yearly (+7.24%) · Industrial products and projects grew around +15% (y/y) including various railway & infra projects · Increasing demand from various branded products in general engineering, appliances, and white consumer durables (PC, Washing Machine, Refrigerator and air conditioners) · The sequential drop in revenue is primarily due to lower realizations across geographies · The sequential decrease in raw material costs is primarily due to lower cocking coal consumption cost · Other expenses increased due to higher logistics, repairs, and consumables charges · EBITDA margin declined mainly due to lower margin in European operations, partially offset by higher margin in Indian operations · Indian deliveries grew by around +11% against Indian steel apparent consumption by +8% (y/y) · Higher growths than the industry average due to strong brand appeal/market segments and agile business model · Strong direct sales (B2C) through expanding dealer networks and virtual/e-commerce platforms (to the retail, small dealer, and MSME sectors) · Looking ahead realization/spread may improve amid higher steel prices due to expected higher Chinese and Indian demand (huge infra stimulus), while raw material costs are likely to be range bound · Indian (TSI) production will be expanded by 1 MTA in FY24 (NINL), and further 5 MTA in FY25-26 (Kalinganagar), and 0.75 MTA (Ludhiana) along with the parallel expansion of various downstream operations · Separately, phased commissioning of 6 MTA pellet plants at Kalinganagar has begun and the company should stop buying pellets from outside from Q2FY24, which should reduce operating cost · Automotive sales (CRM sheets) are now around 15% of overall sales, which may further rise with the commissioning of the CRM complex and incremental capacity at Kalinganagar · Also focusing on growths of high-margin long products in the retail housing segment · In Europe (TSE), Steel deliveries stood around 2 MT; though the volumes were higher by 6% sequentially, the sharp drop in realizations on subdued demand and elevated costs, including energy, have weighed on steel spreads · Looking ahead, uncertainty persists about supply-demand fundamentals, despite the recent pickup in the EU prices driven by hopes of a milder and shorter down cycle. · European steel realizations will remain subdued in the fourth quarter, given the lag effect of some of the contracts · India steel prices remained subdued for most of the quarter · The fall in prices of long products prices was higher than in flat products due to extended monsoon and the stoppage of construction in Delhi and the NCR region as per the ruling of the NGT · However, the raw material prices were also lower as coking coal prices declined by around $82 per ton on a consumption basis. · The royalty-related expense also declined by about 14% sequentially to Rs. 7.75B · Overall, the drop in costs more than offset the greater-than-expected decline in net realization and that has led to margin expansion for TSI (Indian operations) · TSE (European operations), reported an EBITDA loss of around £166M despite higher deliveries as there was a sharp drop in realizations amid subdued steel prices (economic slowdown), higher energy costs, and NRV loss (on slab stocks in Netherlands plant-exceptional) despite lower cocking coal cost · Net FX impact was positive for around Rs.14.27B on consolidated levels · Total consolidated tax provision INR 29.05B vs 13.09B sequentially (+122.08%) and 25.67B yearly (+13.15%) · Higher tax provision due to higher tax in line with profitability (including windfall/export tax) and one-time provision for BBPS · Reported operating cash flow around Rs.50.00B vs Rs.17.00B sequentially amid favorable/reduced WC requirement/movement due to lower inventory at Tata Steel U.K. and India (on account of low commodity prices), while partially offset by higher slab stocks at Netherlands plant (relining) · CAPEX was around Rs.36.32B (mainly in Kalinganagar and NINL; M9FY23 CAPEX was around Rs.97.46B and targeting to spend another Rs.30.00B in Q4FY23 (as CAPEX) · Gross debt Rs.876.49B vs 875.16B sequentially, almost flat · Not able to deleverage in FY23 meaningfully due to high volatility in earnings, working capital (WC), and higher (best) dividends payout (Rs.60.00B) · The focus was on completing the Kalinganagar project expansion and NINL acquisition (Rs.100.00B) · Net debt to EBITDA is within long-term target levels of around 2x · Long term target for deleveraging continues unchanged at $1B; will continue to deleverage in FY24 and subsequent years · Looking ahead, the next few quarters are likely to be weaker for TSE as markets continue to be subdued Realizations for the fourth quarter are forecast to be weaker and the drop will be higher than the drop expected in the coal and iron ore prices. Furthermore, Tata Steel Netherlands is undertaking the blast furnace relining in 1QFY24. Tata Steel is working on minimizing the impact of all of these aspects, including working capital and margins · Moreover, there are a few asset-specific challenges. Some of the heavy assets in Tata Steel UK are reaching the end of their useful life. Any long-term solution in the UK also has to address the rising cost of carbon and the local emission reduction goals. The UK government has provided a framework of support for the proposed transition of Tata Steel UK to a low-carbon configuration consisting of a potential partial capital expenditure grant, policy on electricity pricing, and regulatory intent to ensure a level playing field for steel manufacturers · Tata Steel currently evaluating the offer of support and developing investment options, which will be most capital-efficient, economically viable, bankable, and value accretive. It will be reviewed internally over the next couple of months to determine the way forward. In the interim, Tata Steel will continue to run Tata Steel UK optimally for cash with minimal support from Tata Steel India · Full commissioning of the NINL plant will help in the overall reduction in cost · India's net realization was lower than expected due to softer prices of steel/end products and export duty despite lower RM cost · Presently NINL operation is at EBITDA loss on a standalone basis as the current levels are around 50% of minimum viable 1 MT, which is expected to reach in FY24; long-term target 4-5 MT at least to cover additional acquisition cost/CAPEX of captive iron ore and 2500 acres of land (to bridge with nearby Kalinganagar plant) · Expecting margin expansion for TSE in Q4FY23 due to higher spot prices and; the worst may be over in Q3 · As Tata Steel Netherlands has around €600M cash in hand, it will not require any cash from Tata Steel India during the unplanned 120-days of maintenance shutdown, which may result in negative cash flow €250-275M due to blast furnace relining CAPEX (for DRI/EV transition) · But Tata Steel UK may need a continuous cash injection from India operation of around Rs.10B per quarter; the company is trying to minimize this · Expecting coking coal prices range bound between $250-350/T unless there are further escalations in geopolitical tensions (Russia-Ukraine) and adverse weather events in Australia · China is now also sourcing coking coal from Russia and other sources after it stopped buying from Australia; so there will be minimal volatility even if China again starts buying from Australia · Tata Steel Netherland is traditionally EBITDA/cash positive except Q3FY23 due to an unplanned maintenance shutdown in summer; expected to be normal from Q1FY24 · Overall TSE spread was around €200/T in Q3 against a long-term target of €240/T due to an unexpected surge of energy & gas costs due to the Russia-Ukraine war/economic sanctions, but now it's normalizing · Tata Steel U.K. has various issues ranging from higher energy costs and end of life for plant (leading to unplanned outages; although raw material and energy costs are now reducing, U.K. operation will continue to be EBITDA/cash negative and require cash from Indian operation; Tata Steel will take a prudent call (decision) in this regard · Overall TSE is also being affected by higher-than-expected inflation, impacting both demand and raw material cost; i.e. resulting in lower spreads (little pricing power) · U.K. plant upgradation and EV transition CAPEX amount will depend on the amount of British government subsidy, which is still under negotiation; the $1B media number is a pure speculation · The main problem for the U.K. plant is that energy cost always remains double that EU · Tata Steel is presently negotiating with British and also other EU governments for at least 50% of CAPEX as grants (subsidy) for the transition to EV/green steel (in line with EU general policy) and other similar policy support for energy cost, carbon border adjustment mechanism and also OPEX under EV transition (because currently, metallurgical coal price has a correlation with steel prices; but gas & hydrogen doesn't have such correlation as they are also used in other applications); otherwise TSE may not justify the green transition cost · Long term ROIC target is around 15% · Indian steel prices are also moving in line with global prices, especially in South East Asia; expecting an upsurge of around $100/T by Mar’23 · Presently imports are not a big threat as China virtually stopped exporting due to unfeasible realizations, but there are some exports from Russia and also Japan (due to lower JPY) · But in India, steel prices need to be higher with lower volatility to support expansion CAPEX/cash flow to meet incremental demand · The expected merger of various subsidiaries with parent Tata Steel by FY24 after the due regulatory process · Presently having around 50-60% of the market share in hot rolled and 30-40% in cold rolled/high-end galvanized automotive steels; the latter has some scope to increase, while overall, automotive steel sales continue to be in 15-20% of total volumes · The oil & gas segment is another bright spot for Tata Steel, especially for the Kalinganagar plant · Focusing mainly on captive use of iron ore including for future pellets plant; but has also started selling a small quantity of iron ore selectively (inferior grades) in the secondary market despite huge logistic issues · May decide on further inorganic expansion like the acquisition of RINL assets at an appropriate time; not in a hurry right now as existing inorganic/organic expansion will fulfill the target of 40MT by FY26 · The steel industry including Tata Steel is looking for additional policy support (grants/subsidy) from Europe to become carbon neutral amid unique and stricter EV regulation · No comments about divestments of overseas assets at the previous pick cycle or any future pick cycle, most of which are loss-making · Repaid debt by around Rs.13.00B in Q3FY23, but it was offset by currency devaluation; in any way, the focus was on the completion of the NINL acquisition and Kalinganagar expansion amid subdued cash flow; but now the company is perusing to become net debt free by FY24 · European EBITDA/T may not weaken further in Q4FY23 because as per the latest estimate, the realization will be lower by £70/T, while the cost will be lower by £102/T sequentially; but the company is watching all costs very closely, especially gas prices and energy costs · Expecting most of the new European annual contracts for 2023 in the range of €850-1000/T, lower than last year but higher than current spot prices · For Q4FY23 Indian operation, expecting net realization by around Rs.1400-1500/T higher sequentially because of firmer steel (spot) prices, while coal prices would be around $10/T lower; deliveries/sales volume may be +0.50 MT higher · U.K. operation may improve but still not out of woods; Netherlands operation not a challenge, but the U.K. · As Indian steel makers including Tata Steel are dependent on imported Australian cocking coal (as a cheaper source of energy), it's subject to price volatility due to various factors in Australia (like adverse weather/monsoon, rail logistic issues) · Indian Steel producers, including Tata Steel, may face high volatility in cocking coal prices until the country has enough source of gas or hydrogen as an alternative (although the Indian government and also Tata Steel is taking various initiative to increase the usable supply of cocking coal domestically, it's too little; ash content in Indian cocking coal is very high) · Tata Steel is not buying any iron ore from outside at present till at least 2050, considering present/future captive source · Although Tata Steel is now buying some pellets from outside, from H2FY24, it may not need outsourcing as it will be self-sufficient due to expected production from Kalinganagar and Angul (Bhushan facility), helping lower cost Tata Steel fair Valuations: Rs.128-167 by Mar’24 and Mar’25; current fair value around Rs.99

Tata Steel reported a core operating EPS of Rs.47.52 in FY22 against 19.12 in FY21, 8.67 in FY20, 18.97 in FY19 (pre-COVID), and 14.31 in FY18. FY22 was a golden year for Tata Steel amid higher steel prices/realizations/spreads amid pent-up demand as the pandemic turned into endemic not only in India but almost globally. But steel prices/spread began to fall in late 2022 and tumbled further after the Russia-Ukraine war erupted on the concern of synchronized global macro headwinds and Chinese ZERO COVID policy, resulting in sporadic lockdowns in the world's biggest producer and consumer of steel. Prices of steel corrected almost CNY 6000 to 3500; now recovered to around 4160, while 3275 is strong technical support. For Tata Steel, India's operation/prospect is now quite upbeat due to huge infra demand and cheaper sources of iron ore (captive mining). In late May’22, to control domestic inflation, the Indian government imposed a 15% export duty on finished steel, which put pressure on export realizations and impacted domestic prices. Also, there will be a 20% additional export duty on iron ore and a 45% export duty on iron pellets, while the import duty of cocking coal was reduced to 0% from 2.5% (small 700/- per ton benefit). All of these are negative for the Indian iron & steel industries including Tata Steel. But as Tata Steel India exports only around 10-15% of its total volume, the overall effect was comparatively lower. And this export duty/windfall tax on Indian steel producers also ended in mid-Nov’22. Now although Tata Steel Netherlands is EBITDA/cash flow positive, Tata Steel U.K. is still a significant headache for the company. Now considering all pros & cons of Indian as-well-as European operations as discussed above, present stable steel prices/realizations (after China reopening), synchronized global/local infra/EV stimulus, and also production constraints in India, Tata Steel may report a decline of around -60% core operating EPS in FY23 after FY22 Golden Year’ core operating EPS Rs.47.52. But from FY24 onwards, Tata Steel may report around +30% CAGR (at least on an average) in core operating EPS (against a 50% average rate for the last 10 years) supported by gradual higher production capacity and better operational cost control coupled with stable steel prices/realizations. Also, after the Air India acquisitions, and the Adani saga, Tata group is now a preferred bidder of various infra projects including steel. Thus the FY23 core operating EPS may come to around Rs.19.01 (in line with the current quarterly run/trend rate) against FY22 Rs.47.52. Tata Steel's pre-COVID (FY19) core operating EPS was around Rs.18.97 against FY18 Rs.14.31; i.e. growth of above +32%. Now assuming +30% average CAGR (lower base effect, expected robust local/global demand, planned production hike, and cost-cutting), Tata Steel may report core operating EPS around Rs.24.71-32.12-41.76 in FY: 24-26. Further assuming an average core operating PE of 4, the fair value of Tata Steel may be around Rs.99.00-128.00-167.00 in FY: 24-26. As the financial market always discounts at least 1Y projected earnings in advance, Tata Steel may scale around 128 by Mar’24 and 167 by Mar’25. And there is also an upside risk in Tata Steel's valuation as the projected core operating PE is around 4, a very low considering the stable prospect of high double digits CAGR in core operating EPS. Looking ahead, whatever may be the narrative, technically Tata Steel now has to sustain over 102 levels for 115-125 zones. On the flip side, sustaining below 98-95, it may further fall to 87-82 levels. Investors may buy/accumulate around 102/95-87/82 levels. P&L Analysis: Tata Steel (consolidated)-QLY

P&L Analysis: Tata Steel (consolidated)-YLY

B/S Analysis: Tata Steel (consolidated)-YLY

C/F Analysis: Tata Steel (consolidated)-YLY

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