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Tata Steel gains from captive resources; Corus still a concern

Tata Steel gains from captive resources; Corus still a concern

The shares of Tata Steel Ltd have risen 10.5% since hitting a low of Rs584.45 last week. The climb has started two trading sessions before the company’s results were announced—so it’s not the results that caused the jump.

Although volumes grew by only 11%, a sharp increase in realizations led to a 47% jump in revenues and, since the company has access to both captive iron ore and coking coal, costs didn’t rise by the same rate. The upshot: operating margin jumped by nearly 10 percentage points and operating profit rose by 83% from a year ago.

Realizations improved by about 17% even compared with the March quarter, signifying the sharp rise in steel prices last quarter before a freeze in price increases.

The price of inputs such as iron and coal do not affect Tata Steel as much as other steel manufacturers because of its captive sources for both of these commodities. Keeping that in mind, while the recent decision of steel companies to continue to hold prices beyond the price freeze deadline of 8 August is a negative, Tata Steel won’t be affected as much as its peers. The company’s operating profit on a per-tonne basis is as high as $600 (Rs25,200). Compare that with its domestic rivals. After accounting for the full impact of the jump in raw material costs, government-owned Steel Authority of India Ltd and JSW Steel Ltd are expected to have an operating profit of only between $200 and $230 a tonne, according to an analyst with a foreign brokerage firm.

In fact, the company’s expansion at its Jamshedpur facility, which will add 7 million tonnes to its capacity, will disproportionately add to the profit of the domestic operations for the same reason.

But Tata Steel’s fortunes now largely depend on the performance of Corus Group Plc., its fully owned UK subsidiary. Consolidated results will be announced later this month, and Corus’ numbers aren’t expected to be as impressive as those of the domestic operations, since it doesn’t have access to captive resources.

Yet, UK steel companies have taken cumulative price increases amounting to about 50% in the past six months, and the full impact of this should be seen by the September quarter.

According to Indiainfoline Research, Corus sells 70% of its produce in the spot market, and the company’s performance can be expected to be strong in the September quarter.

Tata Steel stock currently trades at about six times estimated earnings for the current year, which makes valuations look compelling.

But on the other hand, Corus continues to be a relatively high-risk investment, given its high operating and financial leverage. Add to that concerns about a possible recession in Europe. These seem to be the reasons for the markets’ caution with the stock.

Demand for investment is still strong in the country

A study of 700 companies whose balance sheets have been posted shows investment demand is alive and well. For these companies, capital work-in-progress totalled Rs76,978 crore on 31 March, up 88.7% from that at the end of the previous fiscal year.

Capital work-in-progress measures the amount of capital expenditure that has started but is yet to be finished, that is, the amount that has been spent on assets under construction.

A comparison of capital work-in-progress over the years tells us how much of assets are under construction at the end of the year. This indicates the outlook for capital expenditure.

A look at the data shows the steady rise in capital work-in-progress for the sample of companies in the past eight years, but there’s a spike at the end of the financial year to March, which indicates the huge amount of assets in construction at the end of the fiscal year.

The rise in capital expenditure is also apparent from another metric—the purchase of fixed assets in the cash flow statement. As the table shows, such purchases rose 46% in 2007-08, compared with a rise of 25.8% in 2006-07. In absolute terms, too, the amount of capital expenditure, at Rs93,717 crore for these 700 firms, was much higher than in the preceding years. The capital work-in-progress outstanding at the end of March is an indication that capital expenditure in the pipeline is strong.

At the same time, however, with rising interest rates, it’s also an indication that many companies will be hit by the higher rates because once the work is finished, interest costs will cease to be capitalized and will start to bite. Depreciation charges will also be substantially higher.

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