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EBITDA contraction cycle continues

Tata Steel (TSL) reported consolidated EBITDA of Rs159bn in Q3FY22, slightly higher than consensus estimate of Rs150bn. Standalone EBITDA declined by ~Rs2,000/te QoQ. Tata Steel Europe (TSE) surprised with only US$30/te of QoQ drop in EBTDA; with higher coking coal prices and downtrending steel realisations, the fall should accelerate in the coming quarters. Net debt stands at Rs630bn (down Rs60bn QoQ); the announcement for NINL acquisition should potentially propel net debt to Rs750bn. We maintain REDUCE with a target price of Rs1,000/share at 0.95x FY23E P/B. If the EBITDA/te contracts for 4-5 quarters, won’t there be a better value discovery? We believe so

NINL acquisition has been showcased as an opportunity to ramp-up long products business. The key concerns are i) Rs121bn acquisition will undo the deleveraging efforts of last two quarters and ii) TSLP was an ideal vehicle to ramp up long product capacity via (carbon effective) scrap based EAF process. Rs1,000/te QoQ reduction was witnessed in the gross margin and rest was on account of operating leverage as volumes were down 4% QoQ. GM decline is yet to run out its full course with two staged decline expected hereon (in our view): i) higher coking coal prices and the inability of the producers to pass on the price increase and ii) decline in coking coal prices eventually and a sharper fall in steel prices (with a lead lag). This process would lead to the discovery of bottom EBITDA/te in this cycle. Other expenses continue with its elevated print – a bit surprising as the decline in royalty, rates and taxes (post the Tata BSL merger) has been offset by higher power costs.

Tata Steel Europe EBITDA surprised at US$181/te. The key surprise has been on account of higher realisations and nearly flat RM costs. Contracts and lead lag pricing have allowed gross margins to expand ~US$48/te QoQ in Europe. Management commentary highlights that increase in coal consumption cost due to high prices was offset by lower iron ore prices. With significantly higher coking coal prices and recent reluctance of European buyers to allow price increases, we expect EBITDA to maintain its downtrend in coming quarters. Other expenses increased primarily due to higher energy cost with higher repairs & maintenance expenses. US$86/te QoQ increase in ‘Other Expenses’ led to QoQ EBITDA compression.

Generated Rs63.4bn of FCF in Q3FY22, against EBITDA of Rs159bn. We continue to see working capital buildup (Rs20.5bn); capex incurred is Rs30bn. TSL has paid (higher than expected) cash tax of Rs40bn, which to our understanding shouldn’t recur every quarter; however, this is partly offset by low cash interest payment of Rs5.9bn. Thus, we see net debt reduction of Rs60bn in Q3FY22 (Rs125bn for 9MFY22, this is in line with management guidance of US$2bn of gross debt reduction while prioritising off-shore debt repayment). 9MFY22 capex stood at Rs72bn, while FY22E capex target has been maintained at Rs100-120bn.

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