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Focus back on growth but with an eye on leverage

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 INR1,210.

Refocusing on growth, but deleveraging remains core focus

* After some muted years, FY21 has ushered in an unexpected bonanza on pricing-led EBITDA growth for TATA, fueling growth ambitions. It now wants to double its steelmaking capacity in India to 35–40mt by 2030, from 19.6mt currently. The resumption of the 5mt expansion at Kalinganagar (KPO-II) is the first step in this direction, with likely completion by FY24-end. KPO-II would involve capex of INR235b (including a 2.2mtpa CRM and pellet plant), of which ~INR75b has already been spent.

* TATA, however, plans to tread cautiously on the growth path as debt repayment remains the focal point for the management. While consolidated net debt declined sharply by INR245b in FY21 (supported by a strong working capital release of INR165b), it remained high at INR826b (2.7x of FY21 EBITDA).

* With the earnings outlook remaining strong, we expect net debt to decline further to INR621b by Mar’22 (1.1x of FY22 EBITDA), which should create an appetite for further growth plans. TATA has a long-term target of maintaining net debt/EBITDA below 2.5x.

Rising carbon costs and Brexit to structurally increase TSE’s costs

* While the near-term outlook for TSE is strong, driven by higher prices, the structural increase in costs from tightening emission norms and Brexit is a longer term concern for sustained profitability and cash-neutrality.

* In FY21, despite TSE production falling 7% YoY and emissions being flat YoY (at 1.97 tCO2/tonne of steel), TSE fell short of 1.5mt of carbon credits. We believe this was due to the agreed upon linear decline in allowed annual credits under the EU Emissions Trading System (EU ETS). Thereby, as production normalizes from the pandemic impact, the carbon credit shortfall would keep rising.

* With carbon credit prices trading at EUR52/t (135% YoY) currently and the 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 EUR12/t recently levied by Tata Steel UK, the sustainability would depend on demand-supply tightness.

* Moreover, with the UK’s transition period under Brexit ended 1st Jan’21, trade between the UK and EU is likely to be impacted due to the quotas. Tata Steel UK (TSUK) previously supplied ~1mt of steel from the UK to the EU, representing ~25% of its output. Furthermore, with the UK planning to remove import tariffs for certain steel products, TSUK’s efforts to achieve breakeven on its high costs would be challenged.

* After a gap of several years, TSE reported positive FCF of GBP66m in FY21 (v/s negative GBP774m in FY20) on the back of a working capital (WC) release of GBP595m and lower capex of GBP316m (v/s GBP376m in FY20). However, a portion of the WC release came from selling of 6.5mt of CO2 emission rights in 1QFY21, which has been provisioned and will be purchased in FY22. Adjusted for this cash outflow deferral, FCF remained negative in FY21.

* The Annual Report also reveals that TSE received a short-term loan of USD320m (GBP230m) from T S Global Holdings Pte Ltd in Apr’21, repayable by Mar’22. This is likely to help TSE buy the provisoned carbon credit shortfall of ~8mt in FY21, which should cost EUR350-400m.

Other highlights from the annual report

* TATA aims to reduce carbon emissions in its India operations to 2.3 tCo2/tcs.

* Tata Steel Netherlands plans to reduce carbon emissions by 5mt (40%) by 2030.

* The merger of subsidiary Tata Steel BSL (TSBSL) into TATA has enabled TATA to reduce its income tax outgo by ~INR36.0b in FY21 – through offset of its profits against carried forward losses and unabsorbed depreciation at TSBSL.

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 ~INR33,000/t in 1QFY22).

* TSE’s margin should also be strong in FY22 (we expect >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 INR2,134b/INR592b/INR326b in FY22.

* Deleveraging should remain strong despite the resumption of growth capex. We expect net debt to decline a further INR204b to INR621b in FY22.

* We arrive at our TP of INR1,210/sh on FY23E EV/EBITDA of 5x for its India 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.

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