Tata Steel Ltd’s shares are trading close to a 52-week high. Its market capitalization is just 5% lower than the peak in end-2007. But business fundamentals don’t seem to support this level of optimism. Analysts at Credit Suisse pointed out back in November that steel production has risen at a rapid pace and could lead to oversupply. On the one hand, the cost of raw materials is expected to rise as a result of the higher production and, on the other, steel prices may not keep pace to recover the higher costs.
In a recent report, IIFL Research put some numbers on how much raw material costs could rise in 2010-11. “A look at prices in the spot market suggests that metal prices are poised for another surge in FY11. We expect iron ore prices to increase by at least 60%, to hit a new 10-year high, and coking coal prices by 55%, to their second highest level in the past 10 years,” it said.
In the past, cost increases were passed on to customers since steel demand was growing at a healthy pace. While global steel demand has picked up reasonably since mid-2009, some markets such as Europe remain weak.
In such an environment, it may not be possible to pass on cost increases to customers. The IIFL report says: “We believe that in the best case, Tata Steel Europe (Corus Group Plc) will be able to just recover the higher input cost; expectations of a meaningful improvement in profitability in FY11 are misplaced.”
On the other hand, Tata Steel’s domestic operations are set for a jump in profit as a result of its backward integration. It has captive mines to meet all its iron ore needs and around two-thirds of its coking coal needs. A large part of the increase in steel prices next year will flow into its profit as a result. This will more than offset the likely pressure on Corus’ profitability, and company-wide profit should grow at a decent pace.
Graphic: Yogesh Kumar/Mint
But the company’s valuations seem to be factoring in a much better outcome. Based on IIFL’s estimates for FY11, the company enjoys an enterprise vale/Ebitda (earnings before interest, tax, depreciation and amortization) valuation of seven times. This compares with a median valuation of 4.4 times in the past eight years.
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