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Cost headwinds ahead; DI pipe thesis intact

We lower our TP to Rs1440 (Rs1480 previously) and re-iterate BUY rating on Tata Metaliks (TML). We have lowered FY22/FY23 estimates to account for higher royalty structure for iron ore and surge in coking coal cost (partly offset by higher realisations). The performance in 2QFY22 was subdued due to moderation of pig iron spreads. We expect operating profit to remain weak in 2HFY22 mainly due to exponential surge in coking coal cost until 1QFY23 when the high price Ductile Iron (DI) pipe contracts kick in. We remain positive on TML’s long term prospects led by deficit market dynamics for DI pipe.

* Record PI sales and realisations drives performance:

TML reported record high Pig iron dispatches at 91kt (+6% yoy; +2% qoq) on recovery in domestic demand from foundries. Pig iron realisation touched record highs at Rs43,915/tonne, +36% yoy;4% qoq due to pass on of raw material cost. Performance of DI pipe division was muted (sales: 52kt) due to Covid related labor restrictions, monsoon related weakness and maintenance shutdown at plant. However, DI pipe realisation grew 5% qoq basis to Rs47,156/tonne due to execution of contracts booked at higher price. Effectively, revenues surged by 24% yoy to Rs6.45bn.

* Higher royalty on iron ore dents margins; impact to reduce in next quarter:

Increase in royalty on iron ore sourced from Tata Steel and high coking coal cost has together led to fall in gross margins to 40% vs 50% yoy. TML has recorded a cumulative royalty charge for 2quarters (Rs470mn) in 2QFY22. The dent due to change in royalty will moderate going forward. Despite a hike of Rs5000-6000/tonne in pig iron price in last month, we expect coking coal led cost pressure to keep spreads muted for the next 2 quarters. Effectively, TML reported EBITDA at Rs998mn; -9% yoy; -35% qoq. EBITDA margins fell to 15.5% vs 21% yoy. PAT also declined 33% yoy to Rs546mn.

* DI pipe deficit market a huge opportunity for TML:

Although pig iron spreads have started compressing, we remain bullish on TML’s business due to the supply deficit DI pipe market and its capacity expansion plan (to be commissioned in 4QFY22). The management has indicated that due to massive spending by government for water projects, the industry is facing demand which is 3x the current DI pipe capacity which in turn has led to 30% hike in DI pipe pricing. We remain positive on TML’s long term prospects due to expectation of record high margins for DI pipe business led by deficit market scenario, robust order book (14months) and new capacity to ramp up output.

* Valuation and risks:

We have lowered estimates for both FY22E/FY23E to account for higher royalty structure for iron ore and the exponential surge in coking coal prices (partly offset by higher realisations). We also shift from March’23E based valuation (previously) to Sept’23E based valuation and value TML at 7x Sept’23E EV/EBITDA to arrive at a target price of Rs1440/share. Key risks: Commodity price risk and delay in capacity expansion.

Valuation – Strong case of re-rating; BUY with a TP of Rs1440

EV/EBITDA based Valuation

We believe there is a strong case for re-rating for TML due to the structural shift to higher margin profile (on commissioning of the new DI pipe plant), which would further mitigate the commodity price risk and provide stability for the spreads.

Government’s focus on providing drinking water to every household by 2024 and prioritizing development of water infrastructure in the country has created demand 3x the current capacity for DI pipes in India which has in turn led to 25-30% surge in DI pipe realisations. Impeccable capital allocation history and superior corporate governance provides further comfort for re-rating.

We have lowered estimates for both FY22E/FY23E to account for higher royalty structure for iron ore and the exponential surge in coking coal prices. This impact is partly offset due to the shift from March’23E based valuation to Sept’23E based valuation. We value TML at 7x Sept’23E EV/EBITDA to arrive at a target price of Rs1440/share. At CMP of Rs1089, stock trades at 6.1x FY23E EV/EBITDA.

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