Valuation of Tata Steel After Corus Acquisition

Valuation of Tata Steel after the

Corus Acquisition

Overview

Tata steel is one of the largest private sector steel company. The company's products include steel bearing

rings, forgings, flanges, steel tubes, cold rolled strips , seamless tubes and metallurgical machinery. The

company’s strengths are its strong market position , acquisition of corus and vertical integration . It faces

considerable threat from consolidation in steel industry , economic /industry downturn and environmental

regulations. The company has launched the Customer Value Management initiative with the objective of

creating complete understanding of customer problems and finding solutions jointly. The company's Retail

Value Management addresses the needs of distributors, retailers and end consumers. The company has also

launched India's first steel retail store – steel junction – for making steel shopping a happy and memorable

experience.

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Group’s Expansion Plans :

Expansion Oversees

The group has been expanding its operations in countries like Vietnam , Singapore and Africa. A Vietnam-

based steel company, signed a memorandum of understanding (MoU),with Tata Steel Group in steel making

for a proposed steel complex with capacity of 4.5 million tonnes per year.

Further,Tata Steel Global Holding in Singapore, signed a joint venture agreement with Vietnam Steel

Corporation and Vietnam Cement Industries Corporation for a steel complex in Ha Tinh province in Vietnam.

The company will have a stake of 65% in the above project .Additionally, Tata Steel and Riversdale Mining, a

company listed in Australian Stock Exchange,entered into a MoU, whereby Tata Steel would become a

strategic investor in Riversdale's Mozambique Coal Project by acquiring a 35% stake in it for a sum of AUD100

million $86.8 million.

Tata Steel and SODEMI (a state owned company for mineral development) entered into joint venture

agreement for the development of Mount Nimba Iron ore deposits in Ivory Coast (West Africa).

the company is setting up High Carbon Ferro Chrome plant at Richards Bay, South Africa with 134,500 tonne

capacity in first phase . The business model of the plant includes taking high quality Chrome Ore from India

and elsewhere, convert it into Ferro Chrome in Richards Bay, and exports the finished

product to various customer destinations.

Tata Steel Group’s expansion in foreign countries would further increase the geographic reach of its product

and services.

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Expansion in India

Tata Steel Group is also expanding its operations in India. In January 2008, Tata Steel and Steel Authority of

India (SAIL) signed an agreement to establish a 50:50 joint venture company for coal mining in India. The joint

venture would identify, acquire, and develop coal blocks in India.

Also, Tata Steel signed a joint venture pact with Jasper Industries to establish a coal-based power plant in the

eastern state of Orissa, in June 2008.Jamshedpur works unit as part of the INR140,000 million (approximately

$3,477.6 million) brownfield expansion to augment its production capacity to 10 million tonne in over two

years.The group’s expansion in India would help it to generate additional revenues.

Recommendation : Buy/Sell/Hold

As per our calculation, the company is valued somewhere between $456 and $489 ( values derived by the

ReoI and FCF Valuations respectively) . While in the last week, its share price has been hovering between $480

and $520, we feel the stock is over- priced. Thus, our recommendation is to sell stocks of Tata Steel . This is

supported by a mix of negative trends that the industry and firm in going through currently.

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KEY ASSUMPTIONS TAKEN FOR VALUATION

We have arrived at the valuation using the following assumptions :

1. According to data monitor report, April 2009, CAGR 18.6% growth forecasted for Europe for the steel

industry. Therefore, we have assumed peak growth in 2013. After that the growth slows down linearly

till it hits 6% in 2025 (GDP growth rate in a mature economy). We have assumed terminal growth

rate to be 4% due to rising costs and competitive factors

2. For 2009-10, Tata Steel posted a 49.5% fall in consolidated profits. Sales and profits tumbled because

of the global economic crisis (contraction in demand from the automotive and construction sectors).

This is reflected in the NEGATIVE COI in 2009-10. We are assuming that with slow down, tata Steel

will decrease its Net working capital by increasing liabilities.

3. Profit margins are derived from those of comparables companies in mature economies

- Arcelor mittal – 8.36% , Nucor Steel – 7.74%

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4. Profit margins & ATO have been considered at 2009 levels on a conservative basis, assuming no

increases or decreases.

5. Risk free rate at 8.4% source www.debtonnetindia.com at 22 april 2009.

6. Industry beta 1.53 - http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html

7. Market Risk premium for Indian Companies assumed at 9.23%

(http://pages.stern.nyu.edu/~adamodar/pdfiles/country/india.pdf)

8. Re is at 22.52% using formula Rf + B* Rm

9. Rd is taken at 8% since Tata steel’s new debt amounted to 8 Billion dollars due to the CORUS

acquisition. The same has been financed with Corus cash flows. This new Debt generates 640 Million

dollars in annual interest charges which works out to be 8 & annual interest cost.

10. Calculations for WACC are shown in the excel model tab labeled WACC

11. Effective tax rate assumed to be 39.5% from P&L sheet.

Pricing Basis and Risks:

Industry trends:

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Growing Sectors like Infrastructure, construction, automobiles and consumer durables are increasing

the demand for steel specially in developing countries. We see that this demand is going to grow in

the next few years.

In August 2009, the index for basic metals has recorded growth rate of 8.5%. The production has

grown 7.6% compared to last year’s 6.6 .The investment demand is strong and rising.. We find that

there is subsequent rises in the in steel prices. We can expect long steel prices too to go up. But the

recent rupee appreciation can dampen the pricing power of the players. The steel producers need to

be careful on dumping of steel in India, as this could take away benefits of strong growth and pricing

from steel players in domestic market.

Increased Chinese production and resultant sluggish steel prices with falling net realisations to

adversely impact profitability.

Overall steel sector outlook has dampened (also depicted by fall in market price), due to prospects of

further slowdown in profit growth amid declining steel prices and rising iron ore & coal costs

Other Industry threats are Rising interest rates , high cost of energy , cyclical nature of steel industry

and deficit infrastructure

Big ticket investment by POSCO and Mittal could swallow the market (specifically export)

Acquisition of Corus :

Its acquisition of corus in April 2007 has resulted in improvements in operating efficiencies and reduction in

cost , thus strengthening its position in the steel industry. However, it had taken huge debt to finance corus

acquisition . This could harm its abilitiy to refinance itself for existing loans. Corus product range is

concentrated on highly specalised requirement of aerospace, engineering , automotive and construction. Its

products are priced at a premium as compared to Tata Steel’s product.

Since last year , corus growth has been slow. It is operating at a capacity of 80 percent and has

reduced capacity by 30%. .The management has guided 2010 capacity utilization of 67-68% .

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The prices in Europe has bottomed but reduction in annual raw material prices would help them

maintain/increase their margins.

The company expects staff cost of Corus to reduce in 2011 due to reduction in number of workers.

Currently Corus is not getting benefits of government scheme to share 50% of the employee cost as

some of other companies in this sector majorly due to regulations in UK , given that Corus has huge

employee base in UK .

The management expects Corus to turn EBITDA positive by third quarter of 2010. This will depend on

rate at which Europe recovers from the slowdown.

Corus’ subdued performance was mainly on account of: i) unwillingness of the UK government to

support employee expenses (thereby placing European players at an advantage, ii) higher energy

costs still plaguing the company’s UK operations . Also, higher priced coking coal inventory (in

absence of new contracts) and loss-making Teesside operations further subdued results

With Corus acquisition, raw material selfsufficiency has decreased from 80% to 17%.

Equity dilution from acquisition of Corus would reduce its earning per share.

The estimated synergies will take time to materialize. Its integration to main business group is still

underway

The cost of production per tonne of steel for Corus is very high on account of inaccessibility raw

material (iron ore and coal) and high labor costs. Tata Steel has intended to reduce the cost by

sourcing raw material from the source of origin. The company is exposed to increase in raw material

prices due to acquisition.

The deal values Corus at $751 per ton on EV basis, which is slightly higher than Arcelor-Mittal deal,

valued at $725 per ton. Though there is immense difference in the profitability of both.

Since Corus does not have any captive source of raw material , its profitability is highly sensitive to

prices of coal and iron ore. With nearly 90% of globally traded iron ore concentrated in top 5

producers, there may be sharp jump in iron ore prices.

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While rightsizing (dropping 5,000 employees) and restructuring operations are masked as strategic

initiatives to save costs, the measures echo Management’s view on non-profitability of steelmaking in

the UK.

Global Developments :

Due to decline in cooking coal and iron ore costs by 60% and 33% , new contracts have been

negotiated globally which would help performance of TATA Steel.

TATA Steel has successfully negotiated with its lenders on the debt covenants and the lenders have

unanimously agreed on the freezing of covenants till March 2010 and would be relaxed thereafter.

We believe this is a positive development for Tata Steel.

Shipments and average steel selling price are expected to be higher in fourth quarter than in third

quarter . However, its operating environment remains challenging .Real demand from Europe and US

has not yet recovered.Its India operations will benefit by strong volume growth , robust demand in

India and better pricing environment.

Slowdown in the steel cycle is a key risk . With the acquisition of Corus, tata steel is financially and

operationally leveraged than its counter parts. Also, the global steel cycle is currently dependent on

China for its fortunes. Any major policy change will have an impact in global steel and iron ore

industry. Demand has significantly weakened due to economic down cycle triggered by financial crisis.

Earnings are under pressure due to poor shipments and high input cost ,which will continue to pain

steel companies.

Whole sector has witnessed higher cost of production due to higher iron ore and coking coal prices.

The cost is relatively high in overseas operation than domestic operation.

Long steel prices have been relatively more volatile than flat steel due to higher sensitivity to

construction . The prices have remain low due to lower construction activity.

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European steel production witnessed severe decline of 40% for last seven months and according to us

Europe will take more to recover.

Financial Outlook :

Expansion in Jamshedpur and Raw material Linkage

Tata Steel is expanding capacity by 2.9 mn tpa by FY12 at a Capex of USD 3 bn . FY10 capex is 30 bn ,

out of which 15 bn has been already spent. 50 bn capex will be spent in FY11 and the rest in FY12

Tata Steel has taken 35% stake in high value benga coal project. The total capex of project is USD 450

mn for developing mining capacity of 7-10 mn tpa. These are some major investments in Tata Steel’s

Books for coming 2 years.

The company is evaluating its debt profile and restricting high cost debt . This would reduce interest

cost from FY11 onwards . The company has a liquid cash of 61 bn which could be used to reduce debt

Recently ,Tata steel underwent a restructuring by converting bonds worth $870 mn for new

convertible bonds. This reduced its overall debt liability and increased the maturity of its existing debt

while benefiting investors by giving them an annual coupon . The company reported one time charge

of restructuring , impairment and disposal. If debt to equity ratio decreases for tata steel , they would

lose their tax leverage , wacc will increase . Our valuation is sensitive to wacc , hence it will change

with change in wacc.

Tata Steel’s profit declined in FY09 due to huge decline in net realization although its sales volume

increased. Also, interest cost surged 60%. These factors led to decline in profits.

The Greenfield projects announced by the company may take more time to commence production

than company’s estimate.

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Ratio Analyses

Current Ratio = Current Assets/Current Liabilities

Presently, TATA STEEL has a current ratio of 0.81. A current ratio of 2:1 is always considered as optimum

means that there is a 50 % safety margin in terms of assets to cover its current liabilities. However this

doesn’t mean higher current ratio is good. It may signify higher unused cash,

inventory which again may result in inventory carrying cost.

Debt/Equity Ratio:

As per Appendix 7 attached, TATA Steel has a D/E =1.7. A firm has two options when going for expansion one

is raising debt and other going for public issue. Generally very high debt is not

preferred by the investors because it signifies the risk and high form of equity has

threat of hostile bid and acquisition. Tatas have decreasing trend till 2006 and it has gone up in the year 2007

shows it has borrowed some money for investments. Thus , basically after the acquisistion of Corus , the Steel

Makers are in a position of heavy debt.

Asset Turnover Ratio: Gross Income/Net Operating Assets

The Tata Steel Group has a healthy Asset Turnover Ratio of 2.2 in 2009 and 1.93 in 2008. For future

projections, the ATO has been taken to be steady throughout at an average value of 2.

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REFERENCES

1. www.capitaline.com

2. http://www.sharetradingtips.com/blog/wp-content/uploads/2008/06/

financia_ratio_analysis_of_jindal_steel_with_tata_steel.pdf

3. http://www.etintelligence.com/etig/login/home.jsp

5. ISI Emerging Markets

4. Datamonitor

APPENDIX 1 – BALANCE SHEET

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APPENDIX 2 – PROFIT & Loss Statement

APPENDIX 3 – REFORULATED BALANCE SHEET

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APPENDIX 4 – REFORULATED P&L

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APPENDIX 5 – RATIO ANALYSIS

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APPENDIX 6- VALUATION16

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APPENDIX 7 – WACC

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