Tata Steel’s share price has returned 280 per cent from Covid lows, following the prolonged steel cycle of that period. The post-Covid recovery in global demand, hampered by supply constraints after the pandemic, and then the Russia-Ukraine war, has allowed favorable pricing in the sector. The dispersion in the sector (realized prices minus costs) has reached a significant high and then corrected as input price inflation took the industry by surprise; and continue to be on the higher side.
The stock is now trading 25 percent below its past 5-year average EV/EBITDA one year forward while discounting the correction from peak spreads in the next two years. In such a scenario, we recommend that investors hold onto the stock. The cost-side outlook looks bleaker in the short term, but structural factors of limited steel supply globally may support steel prices in the longer term.
Tata Steel operates from two main regions, Tata Steel independently contributing to 53 percent of FY22 revenue and 79 percent of EBITDA and Tata Steel Europe (37 percent of revenue and 19 percent of EBITDA). The company operates from Thailand too.
Tata Steel’s consolidated realization almost doubled from ₹47,331/ton in Q1FY21 to ₹95,816/ton in Q1FY23, which was also a QoQ growth of 11 percent from Q4FY22. Domestic steel prices are following international trends which, over the last two years, saw strong demand for steel as the core infrastructure and capital goods sectors benefited from the stimulus packages announced across the economy. China, which accounts for half of the global steel industry, and Europe, are on a decarbonization path, further hampering the availability of steel on international markets. Russia and Ukraine, both of which also have strong contributions to steel production, saw their volumes decline in the final phase of the two-year period.
Steel realization is expected to correct 15-20 percent from its peak in the next two years. Domestically, steel prices may have corrected 15-20 percent from Q1FY23 as the announced new export duty limits will have an impact on prices realized in the market. With domestic demand recovering from autos and infrastructure, and tracking international prices, further declines in realization are not expected. Internationally, input prices are starting to be corrected which should also have an impact on realization corrections. On the supply side, either by decarbonising Europe (using fossil fuels has become prohibitively expensive) or by China’s self-administered production curbs, a flood of strong export markets is a distant possibility compared to previous decades. The high production costs of ‘green steel’ should maintain above average realizations internationally.
Increase in input costs
The main input costs are iron ore and coking coal. Coking coal’s surge is consistent with steel prices’ gains in the last two years, but jumped significantly in the last two quarters. Driven by energy costs, raw material costs per tonne have increased to around ₹35,000 in Q1FY23 from ₹20,000 in Q1FY21. The industry has seen coal prices almost triple to $600 a tonne from an average of $200 a tonne. This compares to steel prices in the $800-1,000 per tonne range and coking coal required at 0.7-1x steel production.
The recent spike in returns can be attributed in part to the Russo-Ukrainian war. With limited supplies from Russia to Europe and the strain on all other sources of energy (gas, LPG and nuclear), energy costs, especially in Europe, will remain high. The region’s stockpiling of energy, to last into next winter, will put downward pressure on energy prices globally, which may have started to recede from their peak at the end of Q1FY23 (expected to be reflected with a lag). Despite the short-term relief, coal prices are expected to increase.
Finance and Leverage
Tata Steel’s net debt has fallen from ₹1 lakh crore in FY20 to ₹54,500 crore in June 2022, which is 0.87x net debt to EBITDA. The company continues to target debt relief of $1 billion (₹7,800 crore) annually and has so far exceeded the target. The company has completed a ₹12,000 crore acquisition of Neelachal Ispat and hopes to restart 1 MTPA capacity in the next three months. Tata Steel operates a current capacity of 30 MTPA and plans to increase this to 40 MTPA in the next decade.
The company’s Kalinganagar facility has a capacity of 3 MTPA which is planned to be added to 5 MTPA. Tata Steel is looking at an additional 4 MTPA capacity which could also be opened in the Neelachal capacity. The company reasons that with most of the growth coming from domestic sources, the company can stop its expansion gradually without experiencing further overleverage if the steel cycle changes.
Amid the steel cycle, the company is trading at 4.3 times FY23 EV/EBITDA. Consensus forecasts also factor in unfavorable raw material prices, going forward, with only a mild contraction in revenue with a 6 percent CAGR drop to FY24 and a 22 percent drop in EBITDA. Investors may hold stock trades at lower valuations and with many negative commodity impacts expected to come in. Any recovery in commodity steel or input prices, along with executing capacity growth, could be a positive surprise at these levels.