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Much awaited merger with its subsidiaries a positive

Move aimed at simplification of the group’s corporate structure

* TATA announced the merger of seven of its Indian subsidiaries to simplify its mammoth corporate structure. The company, as of 31st Mar’22, had 156 subsidiaries (32/124 Indian/foreign subsidiaries). In addition, it also had 25 joint ventures (12 Indian and 13 foreign). It closed/merged eight subsidiaries in FY22 and liquidated ~32 subsidiaries that had no assets/liabilities/transactions in FY22. It also had 24 subsidiaries under liquidation as of 31st Mar’22.

* The creation of a massive number of subsidiaries over the last several decades was due to multiple reasons in our view, which includes, but is not limited to, diversifying into new businesses and areas during the MRTP regime, and legacy subsidiaries acquired during the acquisition of Corus, NatSteel, TSTH, BSL, etc.

* TATA has been trying to simplify the group structure, which will reduce its regulatory costs and improve synergies. However, we also note that in the past, the management had highlighted it will keep certain subsidiaries alive to maintain a focused approach on growth in those segments (for example, TSLP was envisioned as a growth vehicle for the group in long steel products).

* We expect simplification of the group structure to continue ahead, but a big reduction in the number of subsidiaries will only occur after the sale /closure of its international subsidiaries, including TSE, TSTH, and NatSteel, if it happens.

* There is no change in our earnings estimates at present as we await clarity on the synergies and timelines for the merger.

* We maintain our Neutral rating with a SoTP-based TP of INR106.

The merger will offer synergies, especially a reduction in regulatory costs

* TATA is currently paying an additional royalty of 22.5% of IBM prices for the quantum of iron ore supplied to TSLP and TSML. This is over and above the normal royalty, NMET, and DMF (works out to 19.8%) already paid for the iron ore dispatched from its mines.

* The management expects savings of INR7-8b on an NPV basis due to the non-payment of additional royalty on iron ore supplies to these subsidiaries post-merger. The savings on additional royalty will however depend on iron ore prices in Jharkhand/Odisha, where these mines operate.

* TATA can use the tax shield on account of unabsorbed business loss/depreciation of these subsidiaries. However, we believe these are not large enough. We await further clarity on the same.

* It will also save on other regulatory costs like audits, filings/compliances under various acts which is not only costly time consuming, especially in cases where the size of operations does not justify the regulatory costs.

* There are typical synergistic benefits that will accrue with simplification of any group structure like common IT services, lower administration overheads, common procurement, and fungibility of manpower, /cash/debt.

Valuation and view

* As the entities merging with TATA are already part of its consolidated accounts, there is no incremental profitability that accrues to the group, other than the elimination of regulatory costs like additional iron ore royalty.

* Spot HRC prices in Europe have corrected by ~30% in 2Q, which will likely reflect in the financials of TSE in 2HFY23, as its steel contracts get reset.

* Correction in steel prices outweighs any correction in the input costs, especially in iron ore and coking coal. With an earlier than normal onset of La Nina (normal times is from November in Australia) and expectations of a wetter than normal season, we feel a surge in coking coal prices are imminent.

* Expansion in its India operations will fructify from FY25, while the benefits from its pellet plant will stay muted as domestic pellet prices have crashed after the imposition of export duty.

* We also note that any move towards reduction/elimination/calibration of export duty on steel/pellet/iron ore will be positive for the entire industry and stocks will react positively to the news, despite the slowdown in the domestic market. Reduction /elimination of export duty will boost steel exports and help reduce inventories, which is the key reason why prices remain subdued in the domestic market. Weak international prices and monsoon are important factors that have driven down domestic steel prices.

* The stock is trading at 4.3x/4.6x FY23E/FY24E EV/EBITDA. In terms of P/B, the stock is trading at 1.1x/1x FY23E/FY24E BV. We expect TATA to generate a RoE of 18.5%/14.4% in FY23/FY24 as compared to 44.4% in FY22. We maintain our Neutral rating.

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