Analyst Corner: Assign ‘neutral’ on Tata Steel with TP of Rs 1,210

Rising carbon costs in Europe a key concern: Tata Steel (TATA)’s FY21 Annual Report highlights the ambition of the company to maintain leadership in volumes, cost, and sustainability. With improved cash flows, the focus is back on growing the India business, wherein it aims to double capacity to 35–40mt by 2030.

However, it plans to tread cautiously on this path as debt repayment remains the focal point for the management. On Tata Steel Europe (TSE), the management palpably appears concerned about the tightening emission norms in Europe, rising carbon credit costs, and the resulting lower competitiveness against imports to Europe, which pose a key challenge in the longer term. While we expect deleveraging to continue on the back of higher prices, rising carbon costs and the burden of sustainability capex in TSE are key concerns, in our view. Thus, we assign a Neutral rating, with TP of Rs 1,210.

Rising carbon costs and Brexit to structurally increase TSE’s costs: While the near-term outlook for TSE is strong, driven by higher prices, then structural increase in costs from tightening emission norms and Brexit is a longer term concern for sustained profitability and cash-neutrality.

With carbon credit prices trading at €52/t (135% YoY) currently and then growing need for carbon credit purchases, we believe the burden of carbon costs on TSE is likely to increase in FY22 and beyond. While a part of this increase should be offset by the carbon surcharge of €12/t recently levied by Tata Steel UK, the sustainability would depend on demand-supply tightness.

Valuation and view: With the availability of captive iron ore, TATA’s India operations are a play on steel prices which we believe should stay higher for longer. We therefore expect margins to stay high in the medium term (with standalone EBITDA/t likely at a new lifetime high of Rs 33,000/t in 1QFY22). TSE’s margin should also be strong in FY22 (we expectn >USD100/t), though sustenance of the same would be challenged by rising carbon costs. We expect consolidated revenue/EBITDA/PAT to grow 36%/94%/2.9x to Rs 2,134b/ Rs 592b/Rs 326b in FY22. Deleveraging should remain strong despite the resumption of growth capex. We expect net debt to decline a further Rs 204b to Rs 621b in FY22. We arrive at our TP of Rs 1,210/sh on FY23E EV/EBITDA of 5x for its Indian operations and 4x for Europe.

Our TP implies EV/capacity of USD902/t, a 30% premium to the past five-year average of USD700/t to factor in the benefit from likely deleveraging from the current upcycle. Given limited upside, we however rate it Neutral.