Tata Steel: Q3 operationally good but with some negative surprises

Analysts do not see a major increase in volumes, considering that India's steel demand is growing at about one per cent

Worries over growing debt, prolonged capex cycle and macro factors affecting the domestic industry saw Tata Steel's shares correct four per cent to Rs 374.35 after the company announced its results on Tuesday after market hours. Although the Street is positive about the improvement in the company's European business on account of volumes and operating margins, some analysts believe the same is largely factored in current valuations.

"On India business the company is pushing volume at the cost of realisation. Rising capex intensity in the Odisha project would increase leverage, and free cash flows would remain negative till first half of FY16. Current valuation offers little upside," said an analyst who is tracking the company at IDFC Securities. The Bloomberg consensus estimates suggests a target price of Rs 415, which indicates limited upside from current levels wherein the stock is trading at 8.5 times earnings and 5.2 times enterprise value (EV) to operating profit (Ebitda) based on FY15 estimates. However, most analysts are bearish on the stock only for the near-term perspective.

"The target price improvement has been adversely impacted by sharp increases in net debt on aggressive capex on Orissa project and increased working capital. We maintain our accumulate recommendation and advise investors to be patient and wait for declines to buy. We are cautious on the steel cycle for near-term but see Tata Steel as the best bet for investors who want to take exposure in domestic steel sector," said Saurabh Agrawal of Kotak Securities. The long-term confidence emerges from the expected start of the three-million-tonne Orissa project closer to end-FY15 and improving outlook for Europe. Since Indian operations earn high margins, former should drive profitability in FY16.

Meanwhile, the divergence in the performance for the December quarter also led to some disappointment for the Street. While revenues and operating profits were better than consensus estimates by about 2.95 per cent and 6.87 per cent, respectively, net profit was lower than expectations by a huge margin of 27 per cent despite the boost from one-off income of Rs 230 crore in Europe business. On a consolidated basis, net sales at Rs 36,736 crore were up 14.4 per cent year-on-year, while net profit stood at Rs 503 crore versus a loss of Rs 743 crore last year. The profits were lower than expected because of the higher tax (in earlier quarter the company had got tax credit) and interest cost. The latter was due to the increase in debt during the quarter by Rs 7,000 crore, led by working capital debt for the European business.

In the coming months, analysts do not have significant expectations from the domestic business which continues to see pressure on account of lower demand.

Analysts do not see major increase in volumes, which they estimate at 2.2-2.4 million tonnes a quarter, considering that India's steel demand is growing at about one per cent. The recent price increases in January and February though will have some positive rub-off on realisations.

Most analysts, however, have hopes over the European business. Recently, ArcelorMittal had indicated a positive outlook for steel demand and growth in the coming months. That apart, improvement in the European PMI data suggest the demand in the region should be better along with some expectations of improvement in prices. If that happens, it could have huge impact on the earnings of Tata Steel, because the European business is looking for break-even (at PBT level) in the coming years.