No end in sight for Tata Steel's woes

Just a day before Tata Steel announced its results, Citigroup downgraded global steel major ArcelorMittal from a Buy rating to Neutral. The rationale behind this downgrade has more implications for Tata Steel than its own quarterly performance.

 

Tata Steel disappointed the street with its numbers, reporting less than expected profit. The gains made by improvement in profitability in Europe was eaten away by a lower than expected performance in India and South East Asia.

Tata Steel’s earnings sensitivity to Europe makes it more important to look at the development in that continent rather than its Indian or for that matter consolidated performance.

 

For the September 2014 quarter, Europe contributed over 56 per cent of the consolidated turnover but its contribution to earnings before interest, tax, depreciation and amortisation (EBITDA) is less than 25 per cent. The reason for this discrepancy is that Europe’s EBITDA per tonne is less than one-fifth of what it is in India. As Europe has a higher contribution to turnover, even a slight change has a huge impact on the profits.

 

Though turnover from Europe was lower in September 2014 as compared to the same quarter previous year on account of lower sales volume, its EBITDA showed a sharp jump from Rs 554 crore to Rs 929 crore. This jump in operating profit was more than enough to cover up the fall in EBITDA from its Indian unit.

 

India story for the company and other steel players in the country remains intact. If one wants to play an India specific steel story there are other companies available in the market. But if we are looking at playing the global recovery then for an Indian investor, there are few alternatives available which are as good as Tata Steel.

 

Given this context, the rationale behind downgrade of ArcelorMittal by Citigroup matters a lot. ArcelorMittal was downgraded because iron ore prices are continuously trending downwards and are expected to remain low for some time. Iron ore prices are a direct reflection of the steel demand. Iron ore prices have already fallen by 44 per cent this year and trades at levels last seen five years ago. Citigroup is expecting this price to fall further.

 

While there are no signs of pickup in demand, supplies of iron ore continues to increase. Two of the biggest players in iron ore -- Rio Tinto and BHP are fighting for market share globally. At the same time, demand from China has not picked up and because of credit tightening in the country, exports of iron ore from China has risen. Falling iron ore prices have a direct correlation with steel prices.

 

Commenting on Tata Steel’s results, Kotak Institutional Equities says that it retains its cautious view on the company because of softening global steel prices. On account of continuous pressure from China, Kotak has cut Tata Steel’s EBITDA by 3-5 per cent.

 

Tata Steel Europe’s managing director and CEO Karl-Ulrich Kohler said after the results “We see headwinds constraining steel demand growth globally. In Europe we are increasingly concerned about the impact of rising imports, particularly from China, on EU steelmakers.”

 

Changing Tata Steel Europe’s product mix and selling some units in Europe are short term measures. Unless demand in Europe and China picks up, revival of Tata Steel’s Europe unit and its contribution to bottomline will remain low, thus affecting the overall performance of the company.