India’s biggest steel maker Tata Steel Ltd’s consolidated results for the September quarter came as a pleasant surprise. Profit before exceptional items and tax soared by 178% to Rs6,366 crore on the back of higher realizations and cost cuts.
But the September quarter could well be the last time the company’s investors hear good news for a long time. The global slowdown has led to production cuts at Corus which, coupled with the free fall in steel prices, could lead to losses in the company’s overseas operations.
According to a research report by the India Infoline Ltd institutional equities team, Tata Steel’s overseas subsidiaries are likely to report losses from the December quarter because of the 30-35% drop in volumes and lower prices.
Corus has an extremely high operating leverage. When steel prices rise, it sees a large increase in profitability, but on the flip side, when steel prices fall, it could soon turn to losses.
Also See Losses in sight (Graphic)
According to estimates made by ABN Amro, a 1% change in steel price would impact Corus’ earnings in 2009-10 by at least 20%, compared with an impact of 5.4% for Tata Steel’s Indian operations.
Even though Tata Steel is aggressively cutting costs at Corus, it won’t make up for the negative impact of falling steel prices and lower production.
Tata Steel’s India operations, by contrast, are expected to continue generating high profits. Steel prices have fallen sharply even in the domestic market, but Tata Steel’s recently expanded capacity would ensure profit and cash flow generation remains high.
While this should even offset the losses in its overseas arms, the worry is that the consolidated cash flow would not be sufficient to service the large debt of $11 billion at the consolidated level. Tata Steel’s current share price doesn’t seem to reflect any risks on that front. The current low valuations of the stock only account for the fact that steel has entered a down cycle.
Steel manufacturers and intermediaries are reducing inventories rapidly due to the economic uncertainty. Some regions have even seen production cuts because prices have fallen below production cost.
Given this scenario, ABN Amro has assigned a valuation target multiple of a mere 0.2 times book value to reflect cyclically low valuations.
This would put a value of Rs115 for Tata Steel’s shares. The markets, however, were enthused by the results and drove the company’s share price up by 11% to Rs165 on Wednesday. Considering what the future holds, the bullishness looks rather misplaced.
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