Why Tata Steel's Kalinganagar expansion makes sense

Growing the more profitable integrated India capacities will boost earnings

Tata Steel's plan to expand the capacity of its Kalinganagar (Odisha) plant from three million tonnes per annum (mtpa) to eight mtpa in four years is a positive. For, the company's India business enjoys one of the highest profit margins among peers, both domestic and global. If the uptrend in the domestic steel cycle sustains, it should mean substantial growth in profit. Even if it doesn't, the lower capital cost should ensure a shorter payback period.

De-bottlenecking of the Jamshedpur plant and ramping up its new Kalinganagar capacity in the past few years helped domestic volume grow to 3.08 mt in the September quarter, from 2.15 mt in the June 2016 quarter. With the company achieving over three mt production in a quarter (annualised rate of over 12 mt), the expansion plans are necessary.

Unlike the ~25,000 crore spent on setting up the initial three-mtpa Kalinganagar capacity, the planned five mtpa capacity is expected to cost ~23,500 crore, indicating much lower capital cost per tonne. The existing unit is already profitable and cash flow is improving. So, the new capacity should take less time to contribute to Tata Steel's financials.

These come when the domestic steel cycle has also turned favourable. Domestic players have immensely benefited on realisation after imposition of a minimum import price (MIP) and other government measures since February last year. With improved realisations, Tata Steel's earnings before interest, tax, depreciation and amortisation (Ebitda) per tonne has stayed at over ~10,000 (Rs 10,786-13,586) in the past four quarters, the best among peers.

Meanwhile, its European operations, which will become a part of a joint venture with ThyssenKrupp, have been streamlined and are turning profitable after resolution of key issues.

All these developments have already turned the Street bullish on Tata Steel. Among recent ratings, Bank of America Merrill Lynch has a 'buy' on the shares, with a price objective of ~890. The brokerage expects 51 per cent annual growth in Tata Steel's earnings over FY17-19, assuming improving capacity/volume mix, with high-margin India capacity exceeding that of Europe for the first time since the acquisition of Corus in 2007. These should drive 146/638 basis points expansion in Ebitda margins/return on equity over FY17-19. The value-accretive India business' share is seen rising to 68 per cent (from about half currently) of consolidated capacity by FY22.

Most analysts maintain a positive view on the sector and expect further upside to the cycle. Analysts at Kotak Institutional Equities expect the domestic industry's capacity utilisation to improve to 90 per cent over the two to three years. They expect prices to increase and buoy earnings of Indian companies over the next two to three quarters and, hence, remain positive on Tata Steel, JSW Steel and Jindal Steel & Power.

The stock's reaction on Wednesday (down 1.1 per cent) is possibly due to Tata Steel's plan to raise ~12,800 crore through a rights offer, which will expand equity by 15-20 per cent. Concerns also stem from reports about a plan to bid for steel assets being auctioned by lenders, as any aggressive bidding to win the deal could weigh on the consolidated numbers.