december 7, 2011 global weakness a concern, but india...

India steel

METALS & MINING

EQUITY RESEARCH

Structurally superior to global peers

Global weakness a concern, but India stocks discounting a distress scenario

December 7, 2011

Action: Stocks are building in distress; we recommend buying After the recent correction, India steel stocks are factoring in steel prices of USD550/t (current prices ~USD630/t), at which close to 50% of global capacity should turn unprofitable despite the fall in raw material prices, as per World Steel Dynamics. We don’t expect such a capitulation in steel prices to be sustained and hence remain positive on the sector. We prefer integrated steelmakers such as TATA Steel and SAIL in our coverage universe, although TATA Steel is our top pick, given near-term catalysts such as 2.9 mtpa expansion by FY12.

Catalysts: Q3FY12 to be weak, but a recovery likely from Q4FY12 We expect Q3FY12 to be a weak quarter on: 1) a seasonal slowdown and 2) companies still using high-cost raw materials. However, with lower raw material costs and seasonal improvements in the demand scenario, Q4FY12 should record an earnings rebound, in our view.

Valuations: Stock price correction sharper than earnings downgrade We believe steel stocks in general have been de-rated as stock prices have come off more than the cut in consensus earnings estimates. Current multiples for global peers are close to 10.5x P/E and 5.6x EV/EBITDA, while India steel stocks are trading at 5-6x P/E and 4.5-4.7x EV/EBITDA. India steel stocks have generally traded in the range of 8-12x P/E and 5-7x EV/EBITDA (during the past five years).

In this report, we cut target prices for steel firms under our coverage by 20-30%, driven by the 15-25% earnings estimate cuts and 5-10% cut in target multiples as we believe stocks should trade near the low end of historical multiples, as we don’t expect a significant recovery in the steel cycle given headwinds from global economic uncertainties (although nor do we expect a deterioration in the steel cycle from current levels).

We don’t expect utilization issues for India firms as even 5-6% demand growth would keep domestic steel demand-supply balanced.

While coking coal prices have fallen to USD240/t (from USD300/t in Q2FY12), iron ore prices have rebounded to USD140/t (from USD120/t in Oct-11). This is an ideal scenario for India steelmakers, in our view, as they are dependent on imported coking coal, but source iron ore locally.

Fig. 1: Stock for action

Note: Pricing as of 1 Dec closing. Source: Nomura estimates

Anchor themes

Indian steel companies have better earnings visibility compared to global peers due to captive iron ore and better utilization. Their leverage at less than 1 also reflects strong balance sheets.

Nomura vs consensus

Our earnings estimates are 10-15% below consensus on lower steel price estimates. However our target prices are 5-10% higher meaning consensus is advocating much lower multiples, which we don't agree with.

Research analysts

India Metals & Mining

Alok Kumar Nemani - NFASL [email protected] +91 22 4037 4193

Company Ticker Rating Current price Target price

TATA Steel TATA IN BUY 403 568↓

JSW Steel JSTL IN BUY 620 739↓

SAIL SAIL IN BUY 85 120↓See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Nomura | India steel December 7, 2011

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Contents

3 We concur with global concerns, but Indian firms appear to be in a different league

3 Global uncertainty, coupled with domestic issues, has led to a steep stock price correction

4 India companies appear to have structural advantages, which are not reflected in stock performance

5 More than consensus earnings estimate cuts; it’s a de-rating of stocks

5 Stocks building in a distress scenario

6 We expect iron ore prices to remain high – spot prices have recovered from their lows

7 Weaker INR, though resulted in forex losses during Q2FY12, should help operating performance going forward

8 Shortage of domestic iron ore is a concern: would persist with integrated steelmakers

8 Near-term earning risks on mismatch of steel and raw material prices

9 Q4FY12 should see some recovery – as lower raw material prices start to come through P&L

10 Indian steel demand has been weak thus far in FY12 – supply-side issues have kept market balance

11 We don’t expect volume issues with major steel players

12 We revise earnings to incorporate a weaker steel outlook …

12 … and revise downward our target prices

13 SAIL: lacks catalysts but attractive valuations

13 JSW Steel: Iron ore issues getting resolved but pace is the issue

13 Key risks

14 Tata Steel

28 Steel Authority of India

42 JSW Steel

53 Appendix A-1


3

We concur with global concerns, but Indian firms appear to be in a different league India steel stocks have been under pressure on account of concerns over global economic growth as well as internal issues such as the ban on iron ore mining in Karnataka. While we acknowledge the deterioration in global steel demand and the pricing outlook, we believe the INR depreciation has shielded India’s domestic prices. We believe the market has failed to recognise the two key distinct features of the India steel industry: 1) high visibility on capacity utilisation (despite just 2.9% growth YTD, India companies have operated at rated capacity); and 2) profitability advantage from iron ore integration – India companies don’t face the structural issue of margin compression on account of higher iron ore prices.

Our China analyst, Matthew Cross, has highlighted that the Chinese steel sector (and we believe it is true for most of the global steelmakers) is facing structural issues, where any profit potential is being captured by miners (especially iron ore). Therefore, we can conclude that Indian companies are structurally better than their global peers owing to captive iron ore. However, Indian steel stocks have not been treated any differently by the market, and are in fact trading at a discount to their global peers.

We are building in a weaker steel outlook with: 1) our steel price (HR coil FOB) assumptions down from USD700/t to USD625/t for H2FY12 and FY13F; 2) lower coking coal price estimate to USD240/t from USD265/t. We lower our earnings estimates by 10-20% and TPs by 20-30% for companies under our coverage. However, we remain positive on India companies as these stocks are building in a much worse scenario. We prefer integrated steelmakers such as TATA Steel and SAIL in the sector, though TATA Steel is our top pick on near-term catalysts such as 2.9mtpa expansion at Jamshedpur.

Global uncertainty, coupled with domestic issues, has led to a steep stock price correction

Globally, steel stocks have been under pressure on account of the debt crisis in Europe and concerns over a softening in China’s demand, in our view. In India, stocks such as JSW Steel have suffered from internal issues such as shortage of iron ore due to the ban on mining in Karnataka. Global steel prices have corrected by more than 10% during the past two months, driven by the uncertain demand environment in Western countries and the expectation of a slowdown in China. Even raw material prices have corrected sharply, with iron ore prices falling by close to 35% to USD120/t during October 2011. However, iron ore prices have since increased to USD140/t.


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Fig. 2: India steel stocks have underperformed global peers during past six months

Source: Bloomberg, Nomura research

Fig. 3: Underperformance against mining stocks is more stark

Source: Bloomberg

India companies appear to have structural advantages, which are not reflected in stock performance

In our view, the key problem faced by global steel producers is that they have not been able to take advantage of the better demand scenario, as any increase in steel prices often leads to an increase in raw material prices, especially in iron ore. In our view, this is the most ideal scenario for India steel companies, owing to their captive iron ore mines.

We expect iron ore prices to remain at higher levels, given most of the expansion projects are at least two-three years away and the pricing power enjoyed by the miners due to the consolidated industry structure.

However, Indian steel stocks have not been treated any differently than their global peers, while the stock prices correction is more than their peers.

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BHP RIO VALE TATA Steel


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More than consensus earnings estimate cuts; it’s a de-rating of stocks

In the case of steel stocks in general and India steel stocks in particular, consensus earnings estimates have come down by 20-25% during the past six months; however, stocks have corrected by more than 35%. In our view, this clearly shows that stocks have seen a significant de-rating. While we acknowledge that the stocks should trade near the lower band of their historical multiples given the global macro uncertainty, we believe current stock prices reflect a much weaker scenario.

Stocks building in a distress scenario

India steel stocks, particularly TATA Steel and SAIL, are building in a distress case scenario, in our view. TATA Steel and SAIL look attractive, we believe, even if benchmark steel prices fall to USD550/t (from the current level of USD630/t) – at this price close to 50% of the global steel capacity is likely to be unprofitable, even if iron ore prices fall to USD120/t (from the current rate of USD140/t) and coking coal prices to USD220/t (from the current level of USD240/t), according to World Steel Dynamics.

At USD550/t benchmark steel prices and USD220/t coking coal prices, TATA Steel India would generate an EBITDA/t of USD260/t and assuming European operations generating USD30/t, our total FY13E consolidated EBITDA estimate would be close to USD2.7bn. With net debt at close to USD9bn (not assuming any working capital release that would take place due to a fall in raw material prices), the stock would be trading at a FY13F EV/EBITDA of 5.9x. Therefore, we believe the stock is building in a distress case scenario.

Similarly, in a distress case scenario, SAIL would generate total EBITDA of USD1.1bn in FY13F, based on the above assumptions and hence the stock would be trading at an EV/EBITDA of 4.5x adjusted for capex.

Fig. 4: Stock valuations in a distress-case scenario

Source: Company data, Nomura estimates. *SAIL’s EV/EBITDA is adjusted for CWIP

TATA Steel SAIL* JSW Steel

Benchmak steel price (US$/t) 550 550 550

Net realization (INR/t) 31,332 30,993 31,324

EBITDA/t (INR) 13,060 3,893 4,164

Total standalone EBITDA (INR mn) 112,317 57,721 43,358

EBITDA from other entities (INR mn) 25,000 - 7,088

Consolidated EBITDA (INR mn) 137,317 57,721 50,446

Current market cap (INR mn) 370,174 367,606 124,211

Net debt (INR mn) 436,687 226,678 154,823

EV (INR mn) 806,861 267,025 279,034

EV/EBITDA (x) 5.9 4.6 5.5


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Fig. 5: Relative valuation

Source: Bloomberg, Nomura estimates. Bloomberg consensus for NR companies. *SAIL’s EV/EBITDA is adjusted for capital work in progress. Prices are as of Dec 1 2011

We expect iron ore prices to remain high – spot prices have recovered from their lows

As our China analyst, Matthew Cross, highlighted in his steel sector initiation report (“Can China avoid the steel industry’s boom and bust history?”, October 31 2011), higher steel volumes have not helped steelmakers’ profitability in a meaningful way, as most of the benefits from this have been taken away by miners. Since raw material producers take time to increase production, while steel production can be ramped up faster, a shortage of iron ore was created. This resulted in raw material prices increasing faster than steel prices, which squeezed steelmaking profits.

Even with flat steel demand in China, we believe raw material prices would remain high because a meaningful non-China supply of iron ore (which can replace high cost Chinese iron ore) would take at least two-three years to start, according to Nomura estimates. The marginal cost of iron ore production, even at the current level of steel production, is more than USD120/t, due to the high cost Chinese mines.

In the past one-two months, we have seen a deterioration in the growth outlook for Western countries (on debt crisis in Europe) and signs of a demand slowdown in China. Steel prices have come down by USD90-100/t during the past two months. However, iron ore prices have started to recover after a steep decline to USD120/t in October. With iron ore prices back to USD140/t, we believe steel prices should find support at the USD600-650/t level.

Company Name Ticker Nomura ratin Analyst Currency Price P/E (x) P/B ROE EV/EBITDACY12/FY13E CY12/FY13E CY12/FY13E CY12/FY13E

Nucor Corp NUE US Not rated USD 39 12.3 1.5 12.5% 6.0 SID Nacional CSNA3 BZ Not rated BRL 15 8.8 2.2 25.4% 5.2 BAO Steel 600019 CH NEUTRAL Matthew Cross CNY 4.9 12.5 0.7 5.9% 5.8 Angang Steel 347 HK REDUCE Matthew Cross HKD 5.2 40.1 0.7 1.7% 6.8 Nippon Steel 5401 JP NEUTRAL Yuji Matsumoto JPY 194 10.2 0.6 6.1% 6.6 JFE Holding 5411 JP NEUTRAL Yuji Matsumoto JPY 1,484 13.1 0.5 4.0% 6.1 Posco 005490 KS BUY Cindy Park KRW 398,500 6.2 0.8 13.1% 5.2 Arcelor Mittal MT NA NEUTRAL Neil Sampat EUR 14.1 4.3 0.3 7.6% 5.1 Severstal-CLS CHMF RU Not rated USD 13.5 5.6 1.3 22.9% 5.6 Tata Steel TATA IN BUY Alok Nemani INR 403 5.7 0.8 13.8% 4.6 JSW Steel JSTL IN BUY Alok Nemani INR 620 6.8 0.8 14.2% 4.7 SAIL* SAIL IN BUY Alok Nemani INR 85 4.2 0.8 9.4% 3.5

Average 10.8 0.9 11.4% 5.6


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Fig. 6: Steel price (European) vs spot iron ore (CIF) and contract iron ore prices


Weaker INR, though resulted in forex losses during Q2FY12, should help operating performance going forward

All the Indian metal companies reported forex losses during Q2FY12 on account of foreign currency liabilities (both FCCB and short-term liability). However, in our view, operationally a depreciating INR is good for Indian companies due to domestic steel prices being decided on the import parity. Please note that we have built in a USD/INR rate of 50 for FY13F (compared to the current exchange rate of 51.5).

Indian domestic steel prices have been helped by close to 14% depreciation of the INR over the past three months. Since domestic steel prices are determined by import parity, the depreciating INR has helped India steelmakers maintain prices. (Please see below for our calculation of steel prices.)

Fig. 7: Calculation of India domestic steel prices

Source: Nomura estimates

As per our calculations, India’s domestic prices are at a premium of close to INR1,000/t compared to the landed cost of imports. We are building in USD625/t of benchmark steel prices, which translates into domestic steel prices of INR37,749/t. Please note that we were earlier building in USD700/t of benchmark steel prices resulting in HRC domestic prices of INR37,872/t, which is largely unchanged as the INR has depreciated.

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Now EarlierFOB Steel prices (US$/tonne) 625 700 Add: Freight + Insurance (US$/tonne) 20 20 Add: Import duty of 5% (US$/tonne) 32 36 CIF prices (US$/tonne) 677 756 Add: CVD of 10% (US$/tonne) 68 76 Add: In land freight (US$/tonne) 10 10 Landed cost (US$/tonne) 755 842 Domestic prices (INR/tonne) 37,749 37,872


8

Shortage of domestic iron ore is a concern: would persist with integrated steelmakers

Apart from global growth concerns, Indian steel companies like JSW Steel have faced domestic issues, such as shortages of iron ore. There has been a concerted effort to control illegal mining of iron ore, leading to a mining ban in Karnataka. The Supreme Court appointed committee has since recommended clearance of 24 mines in the Bellary region and two mines in the Chitradurga-Tumkur region, although production from these mines will take some time to start (post the actual approval from the Supreme Court).

For companies like JSW Steel, which are dependent on iron ore from Karnataka, production has started to improve as ore is being made available through e-auctions of inventory. However, we would prefer integrated steelmakers like TATA Steel and SAIL at current levels, as iron ore issues are likely to take at the least six months before they are fully resolved, in our view.

Near-term earning risks on mismatch of steel and raw material prices

Q2FY12 results have been a mixed bag and the outlook for Q3FY12 remains bleak on the mismatch of steel and raw material prices, in our view. For companies like TATA Steel and JSW Steel, we expect coking coal prices to remain high even in Q3FY12, because of the lag with which these flow to the P&L. Q2FY12 coking coal contracts were signed at close to USD310/t vs USD330/t in Q1FY12 and USD285/t for Q3FY12.

Typically for TATA Steel, spot steel prices flow to the P&L with a lag of less than one quarter, while coking coal price impact comes with a lag of 1.5 quarters. Thus, in Q2FY12 while steel realisations for the company were down QoQ, raw material costs increased. We expect a similar trend to continue in Q3FY12, resulting in EBITDA/t for India operations at INR17,300/t (INR16,989/t in Q2FY12) and European operations at USD8/t (USD29/t in Q2FY12). TATA Steel should see the impact of lower coking coal prices from Q4FY12 only, while the impact of a decline in steel prices has started from Q2FY12 itself.

Fig. 8: TATA Steel: realisations lag spot prices by <1 quarter(INR/t)

Source: Company data, Nomura estimates

Fig. 9: Contract RM costs flow with lag of 1.5 quarter (INR/t)


For SAIL, Q2FY12 was a weak quarter due to high raw material costs as well as internal issues at Bhilai. We expect a better Q3FY12 since both spot steel price impact and coking coal cost impact comes with a lag of less than one quarter. Thus, we should see some reduction in SAIL’s coking coal costs in Q3FY12 (we expect a reduction of close to USD20/t), although we estimate that the realisation drop would be limited (USD10/t only). We expect EBITDA/t of INR5,364/t (INR 4,657/t in Q2FY12).

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Fig. 10: SAIL: realisations lag spot prices by <1 quarter (INR/t)


Fig. 11: Contract RM costs flow with lag of 0.5 quarter (INR/t)


Fig. 12: JSW Steel: realisations lag spot prices by <1 quarter(INR/t)


Fig. 13: Contract RM costs flow with lag of 1 quarter (INR/t)


Q4FY12 should see some recovery – as lower raw material prices start to come through P&L

Continuing with the above logic, Indian steel companies should see lower raw material prices in Q4FY12 along with limited steel price falls. At the same time, this is seasonally the best quarter in terms of volume for both India and Europe operations. As a result, we expect a swift recovery in profitability for all the companies in our coverage space.

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Fig. 14: Quarterly EBITDA/t for India companies INR/t - LHS, USD/t - RHS


Indian steel demand has been weak thus far in FY12 – supply-side issues have kept market balance

According to the Joint Plant Committee, Indian steel demand has grown just 2.9% so far in FY12, while production has increased by 8.7%. This has resulted in net imports falling from close to 3mtpa in FY11 to just 0.7mn tonnes so far in FY12. Please note that supply-side issues due to the mining ban in Karnataka have also helped in preventing a surplus scenario.

We expect India steel demand to increase by 5% in FY12F and 8% in FY13F. Since we expect GDP growth of 7.2% in 2012 and 8.1% in 2013, steel demand growth should pick up in FY13F. Please note that FY12F steel demand has suffered on account of low investment activity and even slowdown in infrastructure spending. We expect a modest recovery in FY13F

To date, weaker demand has not impacted the utilisation of domestic steelmakers as imports have been replaced by domestic production. However, if the demand scenario doesn’t improve, we could see a surplus which may lead to an erosion of the premium that domestic prices had over landed cost of imports (close to 3-5%). However, we believe even 5-6% demand growth would be enough to maintain the India demand supply balance.

Fig. 15: India steel – demand supply scenario

Source: Joint Plant Committee, Nomura estimates

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TATA Steel India SAIL JSW Steel TATA Steel Europe (USD) RHS

('000 tonnes) FY09 FY10 FY11 FY12E FY13E FY14E FY15E

Capacity 66,347 68,847 72,847 82,564 90,100 100,700 115,000

Crude steel production 58,437 60,624 65,935 71,491 78,427 86,372 95,072

Production growth (%) 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5%

salable steel production 50,947 55,208 62,013 67,201 73,721 81,190 89,368

Imports 5,841 7,382 6,540 5,753 4,710 4,634 4,589

Exports 4,437 3,251 3,358 4,500 4,500 4,500 4,500

Consumption 52,351 59,339 65,195 68,455 73,931 81,324 89,457

Demand growth (%) 0.4% 13.3% 9.9% 5.0% 8.0% 10.0% 10.0%


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We don’t expect volume issues with major steel players

Even with demand growth of just 2.9%, the India steel market has seen a balanced demand/supply scenario, and since incremental capacity addition has been slow (with just TATA Steel’s 2.9mtpa and SAIL’s 2mtpa expansion expected in FY13F), we believe there will be incremental crude steel production of close to 7mtpa. Demand growth of just 5-6% would be enough to absorb the additional production, in our view.

Fig. 16: India steel market should remain in balance – net imports to come down

Source: Joint Plant Committee, Nomura estimates

Please note that on our estimates, net imports will come down to 1.25mn tonnes in FY12 and 0.2mn tonnes in FY13 from 3.2mn tonnes in FY11 on improved supply.

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Crude steel production Consumption Net importsKTonne KTonne


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Fig. 17: Supply by company in India

Source: Company estimates for not rated companies, Nomura estimates for rated companies

We revise earnings to incorporate a weaker steel outlook …

We have revised downwards earnings estimates for companies under our coverage to adjust for a fall in steel prices (although adjusted for INR depreciation, this does not amount to a major change in realization). We have also factored in a delay in the benefits of modernization and expansion plans at SAIL and iron ore issues at JSW Steel.

While benefitting steel prices, INR depreciation has negatively impacted coking coal costs. Despite a decline in quarterly contract prices of coking coal, we believe the benefits will be eroded by a weaker INR. We have revised FY12F and FY13F earnings by 1.8% and 14.5% for TATA Steel (consolidated), 15.1% and 24.2% for SAIL and 25.2% and 28.3% for JSW Steel, respectively.

… and revise downward our target prices

As a result of the above earning downgrades, we have lowered target prices for the stocks under our coverage. Please note that we have lowered average target multiples for the companies on account of global macro uncertainties. We believe there are global macro headwinds which will not allow a recovery in steel cycle in near term and hence stocks should trade near the low end of historical earnings multiples. Of the target price reductions of 15-30%, 15-25% is on account of lower earnings and the rest from multiple cuts.

(mn tonnes) FY10 FY11 FY12E FY13E FY14E FY15E

SAIL 12.9 12.9 12.9 14.5 18.5 23.0 Tata Steel 6.8 6.8 6.8 9.7 9.7 12.7 JSW Steel 7.8 7.8 11.0 11.0 11.0 13.0 Ispat Inds. 3.2 3.2 3.2 3.2 3.2 4.0 RINL 3.6 3.6 3.6 3.6 6.3 6.3 JSPL 3.0 3.0 3.0 4.6 4.6 7.6 Bhushan Steel 1.0 2.3 2.3 2.3 5.2 5.2 ESSAR Steel 3.6 3.6 8.6 8.6 8.6 8.6 Monnet Ispat 1.0 1.0 1.0 1.0 1.0 1.0 Lloyds Metals 0.5 0.5 0.5 0.5 0.5 0.5 Usha Martin 0.6 0.9 0.9 1.1 1.1 1.1 JSL 0.7 0.7 0.7 1.0 1.0 1.0 Others 24.1 26.5 28.0 29.0 30.0 31.0 Total 68.8 72.8 82.6 90.1 100.7 115.0 % of others 35.0% 36.4% 33.9% 32.2% 29.8% 27.0%

SAIL 13.2 13.5 13.2 13.9 16.4 20.0 Tata Steel 6.6 6.9 6.9 8.8 9.8 9.8 JSW Steel 6.0 6.5 8.0 9.0 9.5 9.8 Ispat Inds. 2.6 2.6 2.4 2.5 2.6 3.2 RINL 3.2 3.2 3.2 3.2 3.5 4.5 JSPL 2.8 2.9 2.9 3.2 4.0 4.3 Bhushan Steel 0.7 1.2 2.0 2.2 3.2 4.2 ESSAR Steel 3.1 3.2 4.5 6.5 7.5 8.2 Monnet Ispat 0.3 0.6 0.8 0.8 0.8 0.8 Lloyds Metals 0.5 0.5 0.5 0.5 0.5 0.5 Usha Martin 0.3 0.5 0.7 0.8 0.8 0.9 JSL 0.7 0.7 0.7 0.7 0.8 0.9 Others 20.7 23.7 25.7 26.4 27.0 28.0 Total 60.6 65.9 71.5 78.4 86.4 95.1 Finished steel production 55.2 62.0 67.2 73.7 81.2 89.4

Crude steel year end capacity

Crude steel production


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TATA Steel: We value TATA Steel on a sum-of-the-parts basis (SOTP) at INR568 per share, down from INR653 previously. We value India operations at 6x EV/EBITDA at EV of INR804bn (USD16bn). It contributes INR644 to our target price down from INR690/share earlier. We value overseas steel operations at FY13F EV/EBITDA of 5x at EV of USD3.3bn, contributing INR-90/share to the target price (down from INR-59/sh). We have also attributed INR15/share to 35% stakes in Riversdale’s (RIV AU, Not rated) Benga project. This is based on a valuation of USD1.2bn for the Benga project.

SAIL: We value SAIL at INR120/sh, based on 5x FY13F EV/EBITDA at INR402.7bn (USD8bn) and net debt adjusted for CWIP would be close to INR113bn (USD2.2bn). Please note that earlier we had valued SAIL at 10x P/E and added CWIP at its book value at a target price of INR183/share. Key reasons for the reduction in our target price are: 1) the delay in its expansion plans; 2) modernization plans that have not been able to improve profitability as expected; and 3) our weaker outlook on the steel cycle.

JSW Steel: We value JSW Steel at INR739/share on an SOTP basis (from INR 1,038 earlier), with INR728 from core operations at 5x FY13F consolidated EV/EBITDA (earlier we valued it at 5.5x EV/EBITDA at INR1,005/share) and INR0.4/share from 49.5% stake in JSW ISPAT Industries (JSWI IN, not rated) which is valued at 5x FY13E EV/EBITDA (earlier valued at 5.5x EV/EBITDA at INR17/share). We attribute INR11/share to JSW Steel’s 4.75% stake in JSW Energy (JSW IN, INR44.9, REDUCE).

SAIL: lacks catalysts but attractive valuations

SAIL’s stock price correction has been a result of both the deteriorating steel cycle and reported earnings disappointments during the past four quarters. We had expected the company to start seeing an improvement in operations due to modernization and upgrade capex. However, it is taking longer than expected. The stock’s correction of 40% over the past six months (compared to a 30% fall in BSE Metal index) clearly shows that it has been penalized for these delays, in our view. As we get nearer to the expansion (we expect the first 2mtpa by 2QFY13), we believe market will start assigning value to its CWIP. We maintain our Buy recommendation on the stock, but believe it lacks catalysts and near-term earnings could remain under pressure.

JSW Steel: Iron ore issues getting resolved but pace is the issue

JSW Steel’s stock has corrected sharply (43% over the past six months) after the Supreme Court banned iron ore mining in Karnataka. JSW Steel has been able to capture more than 4mn tonnes of iron ore during the e-auctions at reasonable prices and capacity utilization has improved from close to 30% to more than 60% during the past month. However, the key issue now is transportation of this ore already bid. Once it starts getting this iron ore, we believe its utilization will be back to rated capacity.

Although we maintain our Buy rating on the stock on weak valuations, it has come down in the pecking order on account of: 1) relative outperformance compared to TATA Steel and SAIL during the past two months (flat vs TATA Steel down 8% and SAIL down 17%); 2) iron ore issues will take at the least six more months to get back to normal activities – that, too, with much more scrutiny; and 3) a sharp increase in working capital expected due to the delay in the transportation of the bid iron ore.

Key risks

Steel prices fall more than expected: We expect steel prices at USD625/t and a correction on INR1,000/t in domestic steel prices. If average prices fall below these levels, there is a risk to our estimates. India steel demand growth turns weak: Demand for India steel has recovered during last two months at more than 9% y-y growth. Our projections build demand growth continuing at the 8-10% level. If demand growth falls significantly (below 6%) from here, it would be a risk to our view.

Key company data: See page 2 for company data and detailed price/index chart.

Tata Steel TISC.NS TATA IN

METALS & MINING

EQUITY RESEARCH

Triggers in place – attractive valuation

Robust earnings, improved balance sheet & free cashflow positive at distress valuations

December 7, 2011

Rating Remains

Buy

Target price Reduced from 653

INR 568

Closing price December 1, 2011

INR 403

Potential upside +40.9%

Action: Buy for expansion and improving cashflow TATA Steel stock has underperformed its global peers despite its comparatively stronger Indian operations and better-than-expected performance in its European business. We maintain our Buy rating given our view that: 1) the 2.9mtpa expansion in India by end-FY12 should drive earnings growth; 2) an expected USD0.6bn decline in working capital on falling raw material prices should further reduce leverage; and 3) TATA should turn free cashflow positive from FY13F despite capex of USD2bn.

Catalyst: Earnings rebound likely 4QFY12F & 2.9mtpa expansion TATA Steel has triggers expected to unfold over the next 2 quarters with 1) a forecast earnings rebound at its European operations on falling raw material prices; and 2) a 2.9mtpa expansion expected by end-FY12.

Valuations: Building in a distress scenario At its current price, the stock looks to be building in a distress scenario of steel prices falling to USD550/t (from USD630/t currently), as well as EBITDA/t of USD250/t for the Indian operations (USD400/t in 1HFY12) and USD30/t for the European operations (USD50/t in 1HFY12). At these assumptions, World Steel Dynamics estimates nearly half of global capacity would be unprofitable.

We cut our target price to INR568 (from INR653). Indian operations contribute INR644 (from INR690) at 6x EV/EBITDA and overseas operations contribute INR-90/share (from INR-59) at 5x EV/EBITDA.

The lower TP primarily reflects our 14.5% earnings cut in FY13F due to our weaker steel outlook.

31 Mar FY11 FY12F FY13F FY14F

Currency (INR) Actual Old New Old New Old New

Revenue (mn) 1,187,531 1,183,653 1,180,075 1,259,190 1,223,621 1,305,785 1,295,543

Reported net profit (mn) 89,827 98,206 90,809 80,141 61,682 84,138 76,151

Normalised net profit (mn)

66,725 57,551 50,154 80,141 61,682 84,138 76,151

Normalised EPS 71.07 59.44 51.80 82.52 63.51 86.63 78.41

Norm. EPS growth (%) na -16.4 -27.1 38.8 22.6 5.0 23.5

Norm. P/E (x) 5.7 N/A 7.8 N/A 6.3 N/A 5.1

EV/EBITDA (x) 5.6 6.1 5.6 4.8 4.8 4.5 4.3

Price/book (x) 1.1 N/A 0.9 N/A 0.8 N/A 0.7

Dividend yield (%) 3.0 N/A 3.2 N/A 3.2 N/A 3.2

ROE (%) 30.8 24.5 22.9 16.8 13.4 15.4 14.8

Net debt/equity (%) 144.2 103.1 106.7 85.3 92.3 70.5 79.0


Anchor themes

TATA Steel should see an earnings and cashflow inflection with its 2.9mtpa expansion, easing concerns on high debt. In Europe, the company is well prepared to face a slowdown, with streamlined operations.

Nomura vs consensus

Our earnings estimates are 5-7% below consensus, while our TP is 10% above. We think the Street is building in a de-rating that we do not expect given earnings growth visibility.

Research analysts



See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Nomura | Tata Steel December 7, 2011

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Key data on Tata Steel Income statement (INRmn) Year-end 31 Mar FY10 FY11 FY12F FY13F FY14FRevenue 1,023,931 1,187,531 1,180,075 1,223,621 1,295,543Cost of goods sold -823,792 -918,854 -917,140 -939,057 -991,720Gross profit 200,139 268,677 262,936 284,565 303,824SG&A

Employee share expense -164,630 -152,869 -153,094 -161,034 -164,337Operating profit 35,509 115,808 109,842 123,530 139,486

EBITDA 80,427 159,956 152,899 171,508 190,936Depreciation -44,917 -44,148 -43,058 -47,978 -51,450Amortisation

EBIT 35,509 115,808 109,842 123,530 139,486Net interest expense -30,221 -27,700 -29,199 -31,848 -29,708Associates & JCEs 1,269 664 664 664 664Other income 11,859 9,810 3,000 5,000 6,000Earnings before tax 18,416 98,581 84,306 97,346 116,442Income tax -21,518 -32,459 -34,755 -36,267 -40,893Net profit after tax -3,103 66,122 49,551 61,080 75,548Minority interests -152 603 603 603 603Other items

Preferred dividends

Normalised NPAT -3,255 66,725 50,154 61,682 76,151Extraordinary items -16,837 23,102 40,655 0 0Reported NPAT -20,092 89,827 90,809 61,682 76,151Dividends -8,785 -13,078 -14,772 -14,772 -14,772Transfer to reserves -28,877 76,749 76,037 46,910 61,379

Valuation and ratio analysis

FD normalised P/E (x) na 5.7 7.8 6.3 5.1FD normalised P/E at price target (x) na 8.0 11.0 8.9 7.2Reported P/E (x) na 4.2 4.3 6.3 5.1Dividend yield (%) 2.1 3.0 3.2 3.2 3.2Price/cashflow (x) 2.9 7.0 2.4 3.4 3.2Price/book (x) 1.6 1.1 0.9 0.8 0.7EV/EBITDA (x) 10.4 5.6 5.6 4.8 4.3EV/EBIT (x) 23.1 7.7 7.7 6.7 5.8Gross margin (%) 19.5 22.6 22.3 23.3 23.5EBITDA margin (%) 7.9 13.5 13.0 14.0 14.7EBIT margin (%) 3.5 9.8 9.3 10.1 10.8Net margin (%) -2.0 7.6 7.7 5.0 5.9Effective tax rate (%) 116.8 32.9 41.2 37.3 35.1Dividend payout (%) na 14.6 16.3 23.9 19.4Capex to sales (%) 6.8 8.8 10.9 6.7 7.1Capex to depreciation (x) 1.5 2.4 3.0 1.7 1.8ROE (%) -8.9 30.8 22.9 13.4 14.8ROA (pretax %) 3.4 10.2 8.8 9.6 10.5

Growth (%)

Revenue -30.5 16.0 -0.6 3.7 5.9EBITDA -55.6 98.9 -4.4 12.2 11.3EBIT -74.4 226.1 -5.2 12.5 12.9Normalised EPS -103.2 na -27.1 22.6 23.5Normalised FDEPS -103.2 na -27.1 22.6 23.5

Per share

Reported EPS (INR) -24.25 95.67 93.79 63.51 78.41Norm EPS (INR) -3.93 71.07 51.80 63.51 78.41Fully diluted norm EPS (INR) -3.93 71.07 51.80 63.51 78.41Book value per share (INR) 257.34 370.94 450.24 498.54 561.73DPS (INR) 8.57 12.26 13.04 13.00 13.00Source: Nomura estimates

Relative performance chart (one year)

Source: ThomsonReuters, Nomura research

(%) 1M 3M 12M

Absolute (INR) -14.7 -14.1 -34.4

Absolute (USD) -18.4 -23.0 -42.2

Relative to index -6.0 -10.6 -13.8

Market cap (USDmn) 7,504.3

Estimated free float (%) 68.5

52-week range (INR) 737/367

3-mth avg daily turnover (USDmn)

50.81

Major shareholders (%)

TATA Sons 31.5

Source: Thomson Reuters, Nomura research

Notes

2.9 mtpa expansion to drive earnings growth in FY12F and FY13F

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Cashflow (INRmn) Year-end 31 Mar FY10 FY11 FY12F FY13F FY14FEBITDA 80,427 159,956 152,899 171,508 190,936Change in working capital 103,746 -80,178 29,436 6,505 -5,947Other operating cashflow -68,602 -25,981 -19,033 -61,848 -63,335Cashflow from operations 115,571 53,797 163,303 116,166 121,654Capital expenditure -69,424 -104,160 -128,306 -82,000 -92,000Free cashflow 46,147 -50,363 34,997 34,166 29,654Reduction in investments 9,933 -24,296 19,980 0 0Net acquisitions

Reduction in other LT assets 668 -607 0 0 0Addition in other LT liabilities 1,116 1,280 0 0 0Adjustments

Cashflow after investing acts 57,864 -73,986 54,977 34,166 29,654Cash dividends -8,785 -13,078 -14,772 -14,772 -14,772Equity issue 80,765 60,462 13,168 0 0Debt issue -68,002 75,840 -10,000 -41,012 0Convertible debt issue -54,725 15,000 7,750 0 0Others -723 -23,190 -7,140 603 603Cashflow from financial acts -51,469 115,034 -10,994 -55,181 -14,169Net cashflow 6,395 41,048 43,983 -21,015 15,485Beginning cash 61,484 67,878 108,926 152,909 131,893Ending cash 67,878 108,926 152,909 131,894 147,379Ending net debt 463,125 512,917 466,685 446,689 431,204Source: Nomura estimates

Balance sheet (INRmn) As at 31 Mar FY10 FY11 FY12F FY13F FY14FCash & equivalents 67,878 108,926 152,909 131,893 147,378Marketable securities 0 0 0 0 0Accounts receivable 116,240 148,163 130,269 128,578 133,904Inventories 186,866 240,552 224,011 216,903 230,468Other current assets 67,694 100,045 100,045 100,045 100,045Total current assets 438,678 597,686 607,234 577,420 611,795LT investments 54,178 78,473 58,493 58,493 58,493Fixed assets 457,958 523,934 609,182 643,204 683,754Goodwill 145,418 152,982 152,982 152,982 152,982Other intangible assets 0 0 0 0 0Other LT assets 1,149 1,756 1,756 1,756 1,756Total assets 1,097,381 1,354,831 1,429,647 1,433,855 1,508,781Short-term debt

Accounts payable 233,886 266,711 261,719 259,425 272,369Other current liabilities 65,942 70,899 70,892 70,892 70,892Total current liabilities 299,827 337,610 332,611 330,317 343,261Long-term debt 485,263 576,441 574,191 554,191 554,191Convertible debt 45,741 45,402 45,402 24,391 24,391Other LT liabilities 29,396 30,676 30,676 30,676 30,676Total liabilities 860,227 990,129 982,880 939,575 952,519Minority interest 8,841 8,889 9,492 10,095 10,697Preferred stock 0 0 0 0 0Common stock 8,867 11,369 9,714 9,714 9,714Retained earnings -28,877 76,749 76,037 46,910 61,379Proposed dividends 8,785 13,078 14,772 14,772 14,772Other equity and reserves 239,538 254,617 336,752 412,789 459,699Total shareholders' equity 228,314 355,814 437,275 484,185 545,564Total equity & liabilities 1,097,381 1,354,831 1,429,647 1,433,855 1,508,780

Liquidity (x)

Current ratio 1.46 1.77 1.83 1.75 1.78Interest cover 1.2 4.2 3.8 3.9 4.7

Leverage

Net debt/EBITDA (x) 5.76 3.21 3.05 2.60 2.26Net debt/equity (%) 202.8 144.2 106.7 92.3 79.0

Activity (days)

Days receivable 43.9 40.6 43.2 38.6 37.0Days inventory 89.4 84.9 92.7 85.7 82.3Days payable 103.0 99.4 105.4 101.3 97.9Cash cycle 30.4 26.1 30.4 23.0 21.4Source: Nomura estimates

Notes

TATA Steel should turn free cashflow positive on improved operations and release of working capital

Notes

Balance sheet stretch should come down as D/E ratio falls below 1 and company turns net free cashflow positive


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Triggers lined up for next two quarters Amid concerns over the global macro economy, global steel stocks have fallen sharply across the board (30-50% over last six months). We believe TATA Steel, which in our view has amongst the best steel operations globally in terms of both resource base and efficient operations, provides an attractive investment opportunity. The current stock price reflects a distress-case scenario, with steel prices correcting to USD550/t (at which almost half of the global steel capacity would turn unprofitable as per World Steel Dynamics). We consider this scenario unlikely, and even if it were to happen, we believe we would see a swift recovery as such an outcome would likely lead to large production cuts resulting in a global steel shortage.

Against the current backdrop, we reduce our target price by 13% to INR568 to incorporate the current weakness in steel cycle and global macro uncertainty. We also cut our earnings estimates by 1.8% and 14.5% in FY12F and FY13F, respectively. Of note, our earnings estimates build in benchmark steel prices of USD625/t for 2HFY12F and FY13F and coking coal prices of USD275/t in FY12F and USD240/t in FY13F.

TATA Steel is our top pick in the Indian steel sector, reflecting: 1) Earning visibility – Despite our conservative estimates and expected weakness in the European operations, we expect TATA Steel to see consolidated EBITDA growth of 10.6% and 11.9% in FY13F and FY14F, respectively. 2) Healthy balance sheet –The D/E ratio has improved to 1x as of 1HFY12 and should fall to 0.9x by FY13F, based on our estimates. Net debt stands at USD9.2bn as of 1HFY12, and with USD0.6bn of working capital expected to be released by the end of FY12F amid lower raw material prices, we look for it to fall to USD8.6bn. 3) Turning cashflow positive – We look for TATA Steel to swing to cashflow positive in FY13F, following its 2.9mtpa expansion, even as it maintains capex of USD2bn.

What is the share price building in – benchmark steel prices falling below USD600/t, a distress scenario?

At its current stock price, TATA Steel will have total EV of close to USD16bn. We expect consolidated EBITDA of USD3.5bn in FY13F on conservative estimates (Indian operations EBITDA/t falling to USD310/t from USD390/t in 2QFY12 and only 60% utilization from the incremental 2.9mtpa expansion at Jamshedpur; European volumes falling to 13.5mn tonnes in FY13F from 14.9mn tonnes in FY11 and EBITDA/t of USD49/t). Thus, the stock is trading at less than 5x FY13F EV/EBITDA and 6.3x FY13F P/E, based on our estimates. Note that we have not taken into account any value from investments in raw material projects, such as the Benga coal mine and iron ore mines in Canada for above calculations.

Therefore, the stock either has de-rated (historically TATA Steel has traded in the range of 5-8x EV/EBITDA and 6-12x P/E) or is building in a weakening steel scenario. While we agree that given global macro uncertainty TATA Steel should trade near the lower end of its historical multiples, we do not concur with the de-rating theory, as the stock has maintained its strong profitability, and with iron ore prices remaining high (and our house view that they should remain strong at least for next 2-3 years), we think the Indian operations (78% of EBITDA in FY13F) will maintain their advantages.

At the same time, TATA Steel should be commissioning a 2.9mtpa expansion at Jamshedpur by end-FY12, which in our view should have similar profitability to existing Indian operations (EBITDA/t of close to USD 310/t). However, we have built in just 60% utilization in FY13F from this as production ramp-up could take as long as six months after commissioning.


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Fig. 18: TATA Steel historical P/E chart


Leverage no longer an issue; working capital should decline with raw material prices and further ease pressure

A key concern on TATA Steel used to be the high debt on its balance sheet. We believe leverage is no longer a problem for the company, however, with: 1) a reduction in net debt following the sale of investments – stakes in Riversdale and sale of Teesside plant; 2) forecast higher earnings from the Indian operations with its 2.9mtpa expansion (coming on stream by the end of FY12 and expected to contribute in FY13F); and 3) expected excess cashflow generation by FY13F.

TATA Steel has lowered its net debt to USD9.2bn, despite capex of close to USD2bn/year and a sharp increase in working capital due to higher raw material prices. This reduction in debt was primarily on account of strong operating cash flow and monetization of investments in Riversdale and sale of non-performing assets in European operations.

Fig. 19: TATA Steel’s leverage has come down to comfortable levels


TATA Steel’s D/E ratio has come down from close to 2x in FY10 to 1x as of 1HFY12 and should fall to 0.9x by FY13F, on our estimates. With forecast operating cashflow generation of USD2.6bn in FY13F, we expect TATA Steel should generate free cashflow even while maintaining capex at USD 2bn.

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Fig. 20: TATA Steel should turn free cashflow positive from FY13F

Source: Company data, Nomura estimates, FY12F cash flows include INR 25bn of cash flows from sale of investments.

Fig. 21: Key details – Indian operations (INR mn)

* Part of capex in FY11 for Indian operations was reported in loans and advances as it was done through a subsidiary – our numbers adjusted for the same. Source: Company data, Nomura estimates

TATA Steel to turn free cashflow positive

TATA Steel should generate USD3.5bn of consolidated EBITDA in FY13F and USD3.9bn in FY14F, up from USD3.2bn in FY12F, as per our estimates. Therefore even after capex of close to USD2bn, we expect TATA Steel should generate free cashflow of USD0.5-0.6bn.

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Cash f low s FY10 FY11F FY12F FY13F

EBITDA 89,521 114,329 116,461 133,949

Other income 8,538 7,907 3,000 5,000

Interest -15,084 -13,005 -9,584 -12,874

Other items 8,329 -436 4,395 -700

Tax payment -21,675 -29,112 -31,925 -33,851

Operating cash flows 69,629 79,683 82,346 91,524

Change in w orking capital 6,291 11,273 6,003 5,898

Capex* -26,070 -90,000 -95,306 -50,000

Net cash flows 49,850 956 -6,957 47,423

Ex India operations

EBITDA -9,094 45,628 36,439 37,559

Other income 3,321 1,903 0 0

Interest -15,137 -14,696 -19,614 -18,974

Other items -2,890 4,057 1,869 1,869

Tax payment 157 -3,347 -2,830 -2,416

Operating cash flows -23,644 33,545 15,864 18,039

Change in w orking capital 97,455 -91,451 23,440 607

Capex -43,354 -14,160 -33,000 -32,000

Net cash flows 30,457 -72,067 6,303 -13,354

Consolidated operating cash f low 149,731 33,050 127,653 116,069

Consolidated free cash 80,307 -71,111 -653 34,069


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Sale of investments in FY12 to date has seen TATA Steel reduce its net debt to USD9.2bn. From 2HFY12F, we expect the company to see a release in working capital of USD0.6bn, which should further improve liquidity. In FY11, cashflow was hit by a working capital increase of INR80.2bn as raw material prices increased sharply, while in FY12F, we look for working capital to decline by INR29.3bn as raw material prices have come down.

Indian operations going strong…

We estimate that TATA Steel’s Indian operations should account for 35% of total capacity in FY14F, up from just 18% in FY09, and contribute 78% of EBITDA by FY13F.

Fig. 22: Indian operation’s to become a bigger part of the consolidated company


…European operations a drag but not a bottomless pit

Though European operations remain a drag on TATA Steel’s overall business, we believe it is becoming a smaller part of the overall company (European operations are expected to be just 50% of total volumes in FY13F from close to 65% in FY11). At the same time, with the restructuring initiatives (discussed below), it should be more resilient to steel cycle fluctuations.

TATA Steel has reduced fixed costs by close to USD1.5bn over the past three years through the sale of the Teesside plant, as well as a restructuring of operations (which involves closure of inefficient capacities and a shifting of operations). The company is further reducing its long product capacity in Europe by 1mtpa and focussing on the flat product division, as evident from its investment in Port Talbot and Ijmuiden. TATA Steel Europe has also started focussing on aerospace steel and rails, which are more profitable.

While the company is likely to see pressure on capacity utilization as a result of the eurozone crisis, we think these steps to lower costs and streamline operations should help TATA Steel Europe to mitigate the impact of the eurozone crisis. We expect EBITDA/t of USD49/t for FY12-13F, since the contribution margin is expected to remain stable at USD525-550/t. However, we have built in lower volumes in FY13F to reflect the weaker demand outlook in Europe. TATA Steel Europe is expected to contribute 18.6% to consolidated EBITDA in FY13F, on our estimates, despite an estimated volume contribution of almost 50%.

FY09 FY10 FY11 FY12E FY13E FY14E% steel capacity 18.8% 26.8% 26.3% 28.2% 33.6% 35.1%% Revenues 16.5% 24.4% 24.8% 26.3% 30.4% 31.7%% EBITDA 50.4% 111.3% 71.5% 76.2% 78.1% 78.3%


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Fig. 23: European operations – We have built in lower volumes & capacity utilization falling to 75-80% in FY13-14F


We expect the European operations to see earnings bottom in 3QFY12F, as they will be using high-cost raw materials, while steel prices have fallen significantly. At the same time, as 3Q is the seasonally weakest quarter in terms of volume, the company will likely have negative operating leverage. We expect earnings to rebound in 4QFY12F with higher volumes (seasonally strong quarter) and a fall in raw material prices.

Fig. 24: European operations – EBITDA/t should rebound in 4QFY12F


Our earnings estimates build in a fall in domestic steel prices from current levels…

We have built in steel prices corresponding to USD625/t of benchmark HR coil prices. This translates into net realization of INR35,330/t for TATA Steel. We have built in a decline of close to INR1000/t from current levels in 2HFY12F and onwards.

The depreciating INR has to a great extent shielded domestic steel prices from decline. However, it will also limit the benefits of falling coking coal prices. We estimate TATA

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22

Steel’s Indian operations will report EBITDA/t of INR16,980 (USD347/t) and INR15,560 (USD310/t) in FY12F and FY13F, respectively.

Fig. 25: TATA Steel India - EBITDA/t vs. iron ore prices


Fig. 26: We are building in a fall in steelmaking margin


In the figure above, we are building in weaker steel margins for FY12F and FY13F, though we expect mining EBITDA margin to remain high. We are building in shrinkage of steelmaking margins to USD170-180/t, which would represent the lowest level in the past 6-7 years. However, since iron ore and coking coal prices remain relatively high, we think TATA Steel would have mining EBITDA of USD165/t in FY13F and would be able to keep the overall EBITDA/t high.

Note in the figure below that TATA Steel’s EBITDA/t from steelmaking operations itself is comparable to Posco’s and more than those of Nippon Steel and JFE Steel, which are amongst the most efficient companies in the world.

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Fig. 27: TATA Steel’s steelmaking operations are comparable to the best globally (US$/t)

Source: Company data, Nomura research

Fig. 28: Key estimates – Indian operations


Cutting our earnings estimates by 1.8% in FY12F and 14.5% in FY13F

We have reduced our consolidated earnings estimates by 1.8% in FY12F and 14.5% in FY13F on account of lower steel price assumptions. We estimate EBITDA/t of USD347/t in FY12F and USD310/t in FY13F at the Indian operations and USD49/t at the European operations. We expect total consolidated EBITDA of INR153bn (USD3.2bn) in FY12F and INR172bn (USD3.5bn) in FY13F, driven primarily by volume growth from the 2.9mtpa expansion to be commissioned from FY13.

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Nippon Steel JFE Posco TATA Steel India - steelmaking EBITDA/t

FY10 FY11 FY12F FY13F FY14F

Total sales volume (mn tonnes) 6.29 6.40 6.60 8.35 9.30

Blended realization (INR/tonne) 33,229 38,395 39,909 39,257 39,543

Cost of production (INR/tonne) 24,572 26,992 28,299 27,650 27,356

EBITDA/tonne (INR) 13,688 17,179 16,980 15,560 15,642

Standalone EBITDA (INR mn) 89,521 114,329 116,461 133,949 149,515

Interest cost (INR mn) 15,084 13,005 9,584 12,874 11,374

Standalone profit (INR mn) 50,468 68,657 71,059 75,346 85,435

Standalone EPS (INR)* 56.9 71.6 73.2 77.6 88.0

Consolidated EPS (INR) -22.6 93.6 93.5 63.5 78.4

Previous estimates

Total sales volume (mn tonnes) 6.29 6.41 6.50 8.50 9.30

Blended realization (INR/tonne) 33,229 38,991 39,631 39,740 40,165

Cost of production (INR/tonne) 24,572 26,860 28,527 27,392 27,830

EBITDA/tonne (INR) 13,688 17,094 16,677 16,174 15,964

Standalone EBITDA (INR mn) 89,521 114,326 112,715 143,280 150,995

Interest cost (INR mn) 15,084 13,004 12,191 14,587 15,587

Standalone profit (INR mn) 50,468 68,656 72,377 84,713 86,964

Standalone EPS (INR) 56.9 71.6 74.5 87.2 89.5

Consolidated EPS (INR) -22.6 93.6 101.1 82.5 86.6


24

Fig. 29: Consolidation of EBITDA


Fig. 30: Consolidation of earnings


Fig. 31: Key estimates – European operations


Consolidation of EBITDA

(INR mn) FY10 FY11 FY12F FY13F FY14F

TATA Steel India 89,521 114,329 116,461 133,949 149,515

European operations -11,034 41,991 31,991 32,227 35,118

Others 1,940 3,637 4,448 5,332 6,303

Consolidated EBITDA 80,427 159,956 152,899 171,508 190,936

% from Indian operations 111.3% 71.5% 76.2% 78.1% 78.3%

Previous estimates

TATA Steel India 89,521 114,326 112,715 143,280 150,995

European operations -11,034 41,991 32,311 33,818 35,325

Others 1,940 3,637 4,345 6,672 6,672

Consolidated EBITDA 80,427 159,956 149,371 183,770 192,992

% from Indian operations 111.3% 71.5% 75.5% 78.0% 78.2%

(INR mn) FY10 FY11 FY12E FY13E FY14E

TATA Steel India 50,468 68,657 71,059 75,346 85,435

European operations -73,924 13,630 -11,211 -16,672 -13,140

Others 3,364 7,540 30,961 3,009 3,855

Total consolidated profit -20,092 89,827 90,809 61,682 76,151

EPS (INR) -22.6 93.6 93.5 63.5 78.4

Previous estimates

Tata Steel India 50,468 68,656 72,377 84,713 86,964

European operations -75,040 -6,494 -6,840 -8,787 -7,296

Others 4,480 27,665 32,669 4,215 4,471

Total consolidated profit -20,092 89,827 98,206 80,141 84,139

EPS (INR) -22.6 93.6 101.1 82.5 86.6

FY10 FY11E FY12E FY13E FY14E

Production volume (mn tonnes) 14.4 14.6 13.9 13.5 14.0

Sales volume (mn tonnes) 14.2 14.9 13.9 13.5 14.0

Realization (US$/tonne) 1,034 1,111 1,150 1,100 1,100

Raw material cost/tonne (US$) 497 578 618 575 577

Contribution (US$/tonne) 537 545 532 525 523

Fixed costs (US$ mn) 5,439 5,077 4,647 4,473 4,572

Total operating cost/tonne (US$) 1,051 1,061 1,101 1,051 1,049

EBITDA (US$mn) -246 923 681 658 717

EBITDA per tonne (US$/tonne) -17 62 49 49 51

Net profit (US$ mn) -1,646 300 -239 -340 -268


25

Maintain Buy with lower target price of INR568/share

We maintain our Buy rating on the stock with a reduced target price of INR568/share. We have valued standalone operations at 6x FY13F EV/EBITDA at INR644/share (from INR690 earlier) and the European and SE Asian operations at 5x FY13F EV/EBITDA at INR-90/share (from INR-59 earlier). We have valued the 35% stake in the Benga project at INR15/share, or a value of USD1.2bn. Given that we continue to value TATA Steel India at 6x FY13F EV/EBITDA and overseas operations at 5x FY13F EV/EBITDA, our lower target price is primarily related to our earnings estimate revisions.

We have valued TATA Steel’s Indian operation at a premium to peers (6x FY13F EV/EBITDA vs. the peer average of 5.6x FY13F EV/EBITDA on account of the sustainability of its profitability despite weaker steel price assumptions and near-term volume growth.

Fig. 32: Sum-of-the-parts valuation of TATA Steel


Expect earnings to bottom in 3QFY12 – recover from 4QFY12

We expect 3QFY12F to be a weak quarter, given higher raw material costs will flow through the P&L during the quarter.

Typically for TATA Steel, spot steel prices flow to the P&L with a lag of less than one quarter, while the coking coal price impact comes with a 1.5-quarter lag. Therefore in 2QFY12, while realizations for the company fell q-q, raw material costs rose. We expect a similar trend to continue in 3QFY12F, resulting in EBITDA/t for Indian operations at INR17,300/t (vs INR16,989/t in 2QFY12) and European operations at USD8/t (USD29/t in 2QFY12). We think TATA Steel should see the impact of lower coking coal prices from 4QFY12F only, while the impact of the fall in steel prices started from 2QFY12.

Similarly, with a fall in coking coal prices from 3QFY12, TATA Steel should see lower coking coal prices from 4QFY12F onwards, in our view. Therefore, we expect profitability should start improving, along with a release of working capital.

Valuation Per share Valuation Per share

TATA Steel standalone EV (INR mn) 803,697 859,680

TATA Steel standalone equity value (INR mn 625,239 644 670,561 690

EV of European operations (US$ mn) 3,288 3,758

European ops equity value (US$ mn) -1,832 -92 -1,362 -63

Stake in Benga project (US$ mn) 420 15 665 22

SE Asia business (US$ mn) 37 2 87 4

Target price (INR) 551,441 568 634,188 653

P/E (FY13F) 8.9

Now Old


26

Fig. 33: Realizations lag spot prices by <1 quarter INR/t


Fig. 34: Contract RM costs flow with lag of 1.5 quarters


Sensitivity analysis

European operations: EBITDA could be in the range of USD450mn to USD1.2bn The two key variables for European operations in our view would be 1) contribution margin (ie, realizations less raw material cost/t); and 2) capacity utilization.

We believe capacity utilization at the European operations should be in the range of 75-85% on reduced capacity of 17mn tonnes. Note that even in FY10 (post 2008 crisis), TATA Steel Europe had sales volume of 14mn tonnes, which at current capacity would be close to 85% utilization. At the same time, European operations have a reported contribution margin of close to USD550/t over the last 5-6 years, despite wide fluctuations in steel prices and raw material costs.

Therefore, we believe TATA Steel Europe should have EBITDA/t in the range of USD35-85/t in FY13F and total EBITDA of USD450mn to USD1.2bn. Our base-case estimates are USD49/t of EBITDA/t and USD681mn of EBITDA for FY13F.

Fig. 35: European operations EBITDA/t – FY13F sensitivity (US$/t)


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Fig. 36: European operations – total FY13F EBITDA (USDmn)


Indian operations For Indian operations, the two key variables are benchmark steel prices and coking coal prices. If steel prices remain in the range of USD600-650 and coking coal prices in the range of USD225-275/t, TATA Steel India should have EBITDA/t of USD275-390/t and total EBITDA of USD2.3-3.3bn in FY13F, based on our analysis.

We estimate EBITDA/t of USD311/t and USD3bn of EBITDA in FY13F.

Fig. 37: Standalone India operations: EBITDA/t in FY13F (US$/t)


Fig. 38: Standalone India operations: total EBITDA in FY13F (USDmn)


Key risks

Steel prices fall more than expected We are expecting steel prices of USD625/t going forward and a correction on INR1,000/t in domestic steel prices. If average prices fall below these levels, there would be downside risk to our estimates.

Worse-than-expected demand at European operations We have built in 13.5mn tonnes of deliveries for European operations in FY13F, down from 14.87mn tonnes in FY11 and 13.9mn tonnes expected in FY12F. If the demand situation is worse than expected, there could be downside risk to our estimates.

Delay in expansion plan We have built in 60% production from 2.9mtpa in FY13F. This would mean we are expecting rated production in 2HFY13 from this capacity. Any delay in expansion would negatively impact our estimates.

475 500 525 550 575 60065% (475) (200) 74 348 622 896 70% (322) (26) 269 564 860 1,155 75% (168) 148 464 781 1,097 1,414 80% (15) 322 660 997 1,335 1,672 85% 138 497 855 1,214 1,572 1,931 90% 291 671 1,050 1,430 1,810 2,190

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Steel Authority of India SAIL.NS SAIL IN

METALS & MINING

EQUITY RESEARCH

Expect normalised earnings from Q4FY12

Worst in price – just normalised operations should be enough at current value

December 7, 2011

Rating Remains

Buy


INR 120


INR 86


Action: Forget expansion, Buy for current operations While we believe SAIL is definitely a play on capacity expansion and modernisation over the next two to three years, at its current value, just normalised operations should be enough to drive the stock’s performance. With earnings disappointing during the last four to five quarters and the lack of clarity surrounding the company’s expansion, the stock has started to factor in current depressed earnings (on account of one-offs) for perpetuity. We expect earnings to rebound from Q3FY12 onwards on lower coking coal prices resolution of internal operational issues.

Catalyst: Lower coking coal prices and resolution of internal issues In our view, the stock is amongst the most attractive global plays on higher iron ore and lower coking coal prices. Earnings improvement from Q3FY12 should be a key catalyst.

Valuations: Building in all problems to continue with no end in sight At its current price, we believe the stock is building in all issues related to earnings disappointment and expansion delays to continue with no end in sight. We have valued the stock at 5x FY13F EV/EBITDA and added CWIP less net debt to arrive at our TP of INR120 (from INR183 earlier).

The reduction in our TP is on account of the 25-30% cut to our FY12F and FY13F earnings estimates, respectively, coupled with lower valuation multiples.

We have delayed all expansion and modernisation benefits by one year and now build in the benefits to start from FY14F and to be reflected fully from FY15F onwards.



Revenue (mn) 434,922 474,945 446,799 522,982 470,463 551,924

Reported net profit (mn) 48,010 49,192 41,513 60,134 40,405 48,453

Normalised net profit (mn) 47,558 49,192 41,513 60,134 40,405 48,453

Normalised EPS 11.51 11.91 10.05 14.56 9.78 11.73

Norm. EPS growth (%) -28.7 0.1 -12.7 22.2 -2.7 19.9

Norm. P/E (x) 7.4 N/A 8.5 N/A 8.7 N/A 7.3

EV/EBITDA (x) 5.0 8.8 7.4 7.9 7.4 6.4



ROE (%) 12.4 1,191.0 10.0 1,455.9 9.0 10.8

Net debt/equity (%) 7.2 35.7 31.3 52.0 53.1 69.1


Anchor themes

In our view, SAIL stands to gain the most from lower coking coal and high iron ore prices. The stock should see earnings improvement from H2FY12 on account of internal issues getting resolved. However benefits of expansion/ modernisation would start from FY14F only.

Nomura vs consensus

Our earnings estimates are 10-15% below consensus despite our TP being 5% higher.

Research analysts




Nomura | Steel Authority of India December 7, 2011

29

Key data on Steel Authority of India Income statement (INRmn) Year-end 31 Mar FY10 FY11 FY12F FY13F FY14FRevenue 413,723 434,922 446,799 470,463 551,924Cost of goods sold -273,688 -297,298 -315,064 -322,663 -376,200Gross profit 140,035 137,624 131,735 147,800 175,724SG&A



EBIT 85,867 61,391 48,805 59,184 80,157Net interest expense -4,020 -4,750 -7,321 -10,215 -14,566Associates & JCEs

Other income 18,610 13,812 16,394 9,588 4,630Earnings before tax 100,457 70,453 57,878 58,558 70,222Income tax -33,777 -22,896 -16,365 -18,153 -21,769Net profit after tax 66,680 47,558 41,513 40,405 48,453Minority interests

Other items

Preferred dividends

Normalised NPAT 66,680 47,558 41,513 40,405 48,453Extraordinary items 864 452 0 0

Reported NPAT 67,544 48,010 41,513 40,405 48,453Dividends -15,906 -11,525 -11,525 -11,525 -11,525Transfer to reserves 51,638 36,485 29,988 28,880 36,928


FD normalised P/E (x) 5.3 7.4 8.5 8.7 7.3FD normalised P/E at price target (x) 7.4 10.4 11.9 12.3 10.2Reported P/E (x) 5.2 7.4 8.5 8.7 7.3Dividend yield (%) 4.5 3.3 3.3 3.3 3.3Price/cashflow (x) 4.4 13.6 5.6 5.9 5.1Price/book (x) 1.1 1.0 0.9 0.8 0.8EV/EBITDA (x) 3.0 5.0 7.4 7.4 6.4EV/EBIT (x) 3.4 6.2 9.8 9.8 8.4Gross margin (%) 33.8 31.6 29.5 31.4 31.8EBITDA margin (%) 24.0 17.5 14.5 16.7 19.0EBIT margin (%) 20.8 14.1 10.9 12.6 14.5Net margin (%) 16.3 11.0 9.3 8.6 8.8Effective tax rate (%) 33.6 32.5 28.3 31.0 31.0Dividend payout (%) 23.5 24.0 27.8 28.5 23.8Capex to sales (%) 26.6 23.1 31.3 29.8 25.4Capex to depreciation (x) 8.2 6.8 8.9 7.2 5.7ROE (%) 19.2 12.4 10.0 9.0 10.8ROA (pretax %) 21.0 11.7 7.5 7.5 8.6

Growth (%)

Revenue -6.6 5.1 2.7 5.3 17.3EBITDA 10.4 -23.2 -15.3 21.9 33.1EBIT 11.4 -28.5 -20.5 21.3 35.4Normalised EPS 10.2 -28.7 -12.7 -2.7 19.9Normalised FDEPS 10.2 -28.7 -12.7 -2.7 19.9

Per share

Reported EPS (INR) 16.35 11.62 10.05 9.78 11.73Norm EPS (INR) 16.14 11.51 10.05 9.78 11.73Fully diluted norm EPS (INR) 16.14 11.51 10.05 9.78 11.73Book value per share (INR) 80.66 89.75 97.01 104.00 112.94DPS (INR) 3.85 2.79 2.79 2.79 2.79Source: Nomura estimates



(%) 1M 3M 12M

Absolute (INR) -22.8 -20.8 -52.8

Absolute (USD) -26.1 -29.0 -58.4

Relative to index -14.1 -17.3 -32.3



52-week range (INR) 197.05/79.9


9.16


GOI 85.8


Notes

We expect EBITDA improvement from Q4FY12, but meaningful earnings growth to come from FY14F

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Cashflow (INRmn) Year-end 31 Mar FY10 FY11 FY12F FY13F FY14FEBITDA 99,240 76,249 64,610 78,731 104,766Change in working capital -1,428 -36,821 5,492 390 -3,557Other operating cashflow -18,323 -13,381 -7,292 -18,780 -31,704Cashflow from operations 79,488 26,047 62,810 60,341 69,505Capital expenditure -110,202 -100,667 -140,000 -140,000 -140,000Free cashflow -30,714 -74,620 -77,190 -79,659 -70,495Reduction in investments -161 -153 0 0 0Net acquisitions

Reduction in other LT assets 0 0 -9,792 -11,629 -12,154Addition in other LT liabilities 0 0 0 0 0Adjustments -987 181

Cashflow after investing acts -31,862 -74,593 -86,982 -91,288 -82,649Cash dividends -15,906 -11,525 -11,525 -11,525 -11,525Equity issue

Debt issue 89,484 36,542 47,008 47,988 49,840Convertible debt issue

Others

Cashflow from financial acts 73,579 25,018 35,484 36,464 38,315Net cashflow 41,717 -49,575 -51,498 -54,824 -44,334Beginning cash 182,647 224,364 174,789 123,290 68,466Ending cash 224,364 174,789 123,290 68,466 24,132Ending net debt -59,251 26,866 125,373 228,185 322,358Source: Nomura estimates

Balance sheet (INRmn) As at 31 Mar FY10 FY11 FY12F FY13F FY14FCash & equivalents 224,364 174,789 123,290 68,466 24,132Marketable securities 0 0 0 0 0Accounts receivable 34,939 41,613 42,880 45,153 53,033Inventories 90,275 113,028 113,814 110,824 126,504Other current assets 41,234 51,474 51,474 51,474 51,474Total current assets 390,812 380,904 331,458 275,917 255,143LT investments 6,688 6,841 6,841 6,841 6,841Fixed assets 286,414 373,085 497,280 617,733 733,124Goodwill 0 0 0 0 0Other intangible assets 0 0 0 0 0Other LT assets 0 0 9,792 21,421 33,575Total assets 683,914 760,830 845,371 921,912 1,028,683Short-term debt 0 0 0 0 0Accounts payable 62,324 61,188 67,326 64,447 75,606Other current liabilities 123,311 127,293 128,699 131,251 140,094Total current liabilities 185,635 188,480 196,025 195,698 215,700Long-term debt 165,113 201,655 248,663 296,651 346,491Convertible debt 0 0 0 0 0Other LT liabilities 0 0 0 0 0Total liabilities 350,747 390,135 444,688 492,349 562,191Minority interest 0 0 0 0 0Preferred stock 0 0 0 0 0Common stock 41,304 41,304 41,304 41,304 41,304Retained earnings 51,638 36,485 29,988 28,880 36,928Proposed dividends 15,906 11,525 11,525 11,525 11,525Other equity and reserves 224,319 281,381 317,866 347,854 376,735Total shareholders' equity 333,167 370,695 400,683 429,563 466,492Total equity & liabilities 683,914 760,830 845,371 921,912 1,028,683

Liquidity (x)


Leverage

Net debt/EBITDA (x) net cash 0.35 1.94 2.90 3.08Net debt/equity (%) net cash 7.2 31.3 53.1 69.1

Activity (days)

Days receivable 28.8 32.1 34.6 34.1 32.5Days inventory 128.0 124.8 131.8 127.1 115.1Days payable 69.2 75.8 74.6 74.5 67.9Cash cycle 87.5 81.1 91.7 86.7 79.7Source: Nomura estimates

Notes

Capex of INR140bn per year would keep cashflows under pressure

Notes

Despite large capex D/E ratio is low and has strong balance sheet.


31

A play on high iron ore/low coking coal prices SAIL’s stock price correction (halved during past 6 months vs. SENSEX -11.7%) is more on account of its earnings disappointment and delay in expansion, in our view, rather than just a global steel slowdown. While SAIL has continued its massive capex plan, the benefits have not been visible, due to a delay in capacity additions and temporary operational issues masking the modernisation benefits. However, we remain positive on SAIL given that: 1) the stock appears to be amongst the most attractive global plays on lower coking coal prices and high iron ore prices; 2) most internal operational issues should be resolved by Q3FY12 and hence earnings should rebound; and 3) at the current price, the stock is discounting all USD4.5bn of capex already incurred. While we are also disappointed with management’s inability to execute its expansion plans, we believe the market has unfairly penalised the company by discounting all capex made by SAIL. We believe near-term earnings improvement will come just by resolving issues such as the:1) the shutdown of coke oven batteries at Bokaro and Bhilai, 2) production disruption at Bhilai (SAIL’s most profitable plant) and 3) the lack of domestic coal at IISCO steel plant.

While we are not advocating sharp margin improvement before FY14F on account of capex, we believe SAIL’s current stock price provides investors with an attractive opportunity, as we believe it is not only discounting capex, but also building in all issues to continue with no end in sight.

The stock has corrected both on global issues, earnings disappointments and concerns over public sector units

In our view, SAIL is the worst-performing metal stock globally, primarily on account of its earnings disappointments during the last 4-5 quarters, concerns over the government diverting the cash holdings of PSUs to cut its fiscal deficit, and delay in expansion plans.

The earnings disappointments were largely on operational issues and one-off items during results. The company has faced disruptions in coke oven battery at Bhilai and Bokaro, which we expect will be over by Q3FY12. As well, in previous quarters, one-offs like excess employee costs on account of leave travel allowance (it occurs once every 3 years) and production impact during refurbishing of blast furnaces impacted the results.

Fig. 39: SAIL is amongst the worst-performing global steel stocks


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At the same time, despite spending close to USD4.5bn (over the last three years) on capex, SAIL has failed to show any benefits and there have been frequent expansion delays. We believe the benefits will take at the least two years to come on line.

There had been a concern in the Indian market that PSUs (public sector units) sitting on large cash piles might be asked to finance government deficit (Financial Express, Nov 28 2011, Buyback of PSU shares: DOD seeks minsters’ opinion). However since then, clarification from the government has come (Financial Express, Dec 1 2011, “Buy stakes in PSUs: govt to LIC, banks) and SAIL shouldn’t be impacted, in our view.

As SAIL has no excess cash, we don’t see a risk of cash outflow

According to news reports, Department of Divestment on Nov 25 2011 floated a cabinet note according to which PSUs with excess cash would be asked to go for buy backs and cross-holdings in other government companies (so that the government can sell their shares to group companies without going to the open market). PSUs having surplus cash of more than 50% of its turnover should BUY 5% equity in other PSUs while having cash more than 100% of turnover should BUY 10% stake in other PSUs.

However, SAIL would not be impacted, in our view. This is primarily because despite having cash of INR174.8bn (as of end FY11F), the company has net debt of close to INR201.7bn and we expect the debt to increase to INR248.7bn by FY13F as capex of INR140-150bn is likely to continue for the next two to three years. Since SAIL’s expansion plans would require all of this cash, the company would therefore have no excess cash.

Fig. 40: SAIL doesn’t have excess cash (INR mn)


Earnings disappointment during last four or five quarters on one-offs

SAIL has been impacted by operational issues, such as disruption at coke oven batteries, near-term production issues on account of refurbishment of blast furnaces and disruption of supply of low cost coal at the IISCO plant. While the coke oven issues are being resolved, refurbishment of blast furnaces is a part of the modernisation plan that will continue until FY13. Thus, we believe near-term earnings would remain under pressure.

However, EBITDA/t should rebound from current levels of USD90-100/t to USD125-130/t with one-off issues reaching resolution.

FY09 FY10 FY11 FY12F FY13FCash and equivalents 182,647 224,364 174,789 123,149 68,261 Gross debt 75,628 165,113 201,655 248,663 296,651 Capex 60,901 110,202 100,667 140,000 140,000


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Fig. 41: SAIL has disappointed during the last four to five quarters


However, earnings should rebound from Q3FY12 with lower coking coal prices and internal issues reaching resolution

We estimate SAIL to report EBITDA/t of INR5,364/t in Q3FY12 and INR5875/t in Q4FY12 from INR4,657 in Q2FY12. We expect the improvement to come largely from stable contribution margins and a gradual improvement at Bhilai and Bokaro.

Please note that since the Bhilai Steel plant is the most profitable of SAIL’s plants, any production disruption here impacts the company more negatively. Therefore, once the issues from coke oven batteries are fully resolved, we believe Q4FY12 should see strong recovery.

Fig. 42: SAIL plant-wise profitability details (INR/t)

Source: Company data, Nomura research

The sharp in IISCO plant’s EBIT/t in Q2FY12 is on account of the use of imported coking coal in place of low cost domestic coking coal due to supply problems.

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SAIL is incurring losses in the steel business – even normalised operations should reverse it

We believe SAIL is making losses in its steelmaking operations and all its EBITDA is coming on account of captive iron ore. This is primarily on account of the near-term earnings impact as described above.

While we continue to believe that with all the modernisation and expansion in steel capacity SAIL would be able to improve EBITDA/t to close to INR 8,000-10,000/t, we do note that it will take at the least two more years to realise.

Based on current figures, SAIL’s steelmaking operations would be making losses of close to USD20-25/t, as despite having amongst the best iron ore at USD20/t, the company is making EBITDA/t of just USD90-100/t. With normalisation of operations, i.e., one-off issues reaching resolution, EBITDA/t should improve to USD120-130/t, which we believe would be more sustainable until modernisation benefits start to flow.

Fig. 43: SAIL is making loses in steelmaking operations


Expansion – no tangible benefits, despite USD4.5bn capex

In our view, the key issue for the stock is that despite incurring capex of more than USD4.5bn over the past 3-4 years, the company has not seen any tangible benefits, either via higher production or improved efficiency.

Out of SAIL’s total capex of INR618bn (USD12.4bn, spread over FY09-13), close to INR391bn (USD7.8bn) was for capacity expansion and INR227bn (USD4.6bn) went for modernisation of existing blast furnaces. Blast furnaces at Bhilai and Bokaro have been refurbished and we have seen improved production from these post-refurbishment. However, this has been offset by the production impact from the shutdown of furnaces during the refurbishing period.

We believe SAIL should see a gradual improvement in EBITDA/t as all these capex plans are likely to take at the least two years to be fully completed.

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While substantial improvement will take time – current EBITDA is not normal as well

We believe SAIL could reach EBITDA/t of INR9,000-10,000/t (in the current steel environment) post all the benefits of its expansion and modernisation. In our view, the key areas driving improvement would be: 1) lower employee cost/t, as capacity would double with the same employee strength; 2) improved coke rate, new plants should have higher coal injection, reducing the need for high-cost coke; 3) improvement in yield of older blast furnaces by refurbishing blast furnaces and 4) improvement in product mix — percentage of semis currently is 10% which would be sold after value addition. Although we estimate these improvements will take at least two years to come on line, near-term EBITDA/t currently plagued by internal issues is also not at normal levels.

But current valuations build this to continue with no end in sight

However, at current prices, the shares appear to be building in all the issues that are likely to continue into perpetuity and no benefits from the capex plan. While we believe there is some downside risk to consensus earnings estimates, we believe the stock has de-rated on earnings disappointments. Though we share the disappointment of the market due to the delay in expansion plans, we believe the stock has been over-penalised, as we believe the market is not ascribing any value to even the incurred expenditure.

SAIL appears to be the most attractive India play on lower coking coal and higher iron ore prices

In our view, the stock is amongst the most attractive global plays on higher iron ore prices and falling coking coal prices. SAIL procures all its iron ore from captive mines, while it has to import close to 70% of its total coking coal requirement. Thus, iron ore prices remaining high would indicate an increased mining profit for SAIL, while lower coking coal prices would reflect a fall in the cost of production. Hence, we believe SAIL is amongst the most attractive plays in India in this scenario.

Fig. 44: SAIL most attractive play on lower coking coal/higher iron ore prices


As can be seen above, SAIL’s coking coal costs are aligned to global coking coal prices (adjusted with some lags), while iron ore costs are independent of global prices due to captive mines.

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We revise our earnings estimates to incorporate delay in expansion and modernisation, and weaker steel prices …

We have reduced our FY12F and FY13F earnings estimates for SAIL by 26% and 32.8%, respectively, due to delays in expansion plans and lower steel price estimates.

We have lowered our EBITDA/t estimates from INR6,305/t and INR7,206/t FY12F and FY13F to INR5,455/t and INR6,288/t, respectively. Earlier we had built in some benefits of modernisation plans to flow through from FY13 itself. However, we have now delayed it by one year. At the same time, our FY12F earning cuts are largely on account of disappointment during H1FY12 and continued coke oven battery issues in Q3FY12.

We have reduced our sales volume forecasts from 12.5mn tonnes in FY12F and 14.8mn tonnes in FY13F to 11.8mn and 12.5mn tonnes, respectively, due to delay in expansion. At the same time, we have built in lower steel realisations on account of the decline in global steel prices (although the impact has been mitigated by depreciation of the INR).

Fig. 45: SAIL: Key estimates


… and reduce our target price to INR120 from INR183

We have reduced our target price to INR120 from INR183 previously on account of the above earnings revision and lower multiples to account for a weaker steel outlook. We have valued SAIL at 5x FY13F EV/EBITDA (INR 95/share) and added capital work in progress (CWIP) at its book value of INR 25/share to arrive at our TP. At our TP, the stock would be trading at 9x FY13F P/E, adjusted for CWIP. Please note that earlier we had valued the stock at 10x FY13F earnings and had added CWIP at its book value.

We have valued SAIL at a discount to TATA Steel India operations (6x FY13F EV/EBITDA) as we believe TATA Steel (INR403, Buy, TP: INR658) has more robust operations with a better cost structure and product mix.

Fig. 46: Valuations


FY10 FY11 FY12F FY13F FY14FSales Volume (mn tonnes) 12.3 11.9 11.8 12.5 14.8Realization (blended) (INR/t) 33,840 37,416 38,962 38,881 38,881Employee costs (INR mn) 54,168 76,233 82,929 88,616 95,566RM cost per tonne (INR) 15,025 17,448 18,187 17,098 16,615

EBITDA per tonne (INR) 8,058 6,418 5,455 6,288 7,062Total EBITDA (INR mn) 99,240 76,249 64,610 78,731 104,766Net profit (INR mn) 67,544 49,047 36,426 40,405 48,453

EPS (INR) 16.4 11.9 8.8 9.8 11.7 Cash EPS (INR) 19.6 15.5 12.6 14.5 17.7 Net cash (INR mn) 59,251 (26,866) (125,373) (228,185) (322,358) Coking coal assumption (INR/t) 8,786 11,021 10,860 10,135 10,135 Imported coking coal price (US$/t) 165 232 275 240 240

(INR mn)EBITDA (FY13F) 78,731 EV/EBITDA (x) 5.0 Core EV 393,655 Capital w ork in progress (FY13F) 327,258 Net debt (FY13F) 223,289 Equity value 497,624

Target price (INR) 120


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ISP – the biggest drag on profits; we expect improvement from H2FY13F post expansion

The IISCO steel plant has been a major drag on SAIL’s profit, primarily on account of inefficient and old blast furnaces.

The company is in the process of constructing a greenfield 2mtpa plant at IISCO, which management expects to be operational by Q1FY13. We expect rated production to start from Q4FY13. This plant’s sustainable turnaround is possible only after this expansion is complete as we believe current operations are too inefficient to show significant improvement. However, post expansion, we estimate that this should be able to generate EBITDA/t of INR8,000-INR10,000/t.

The company has gradually reduced manpower; however, complete rationalisation of costs only post expansion

SAIL reduced its number of employees from c.133,000 in FY07 to 111,000 in FY11. Management plans to further reduce headcount to 100,000 by FY14. Please note that most of the reduction in staff is happening on account of natural retirement; SAIL has stated that it will not fill these vacancies. Even for incremental capacity additions, apart from 2mtpa capacity at IISCO plant, SAIL is not considering major additions to staff.

Despite the reduction in employee strength, employee costs have remained at higher levels as per employee cost has increased significantly during the last five years. Wage cost revision applicable from end FY07 and significant increase in y-y costs on account of high inflation (a part of an employee’s salary is often linked to inflation) has led to steep rise in per employee costs.

Fig. 47: Employee cost should rationalize from FY15


Please note that SAIL’s employee cost/t increased significantly from FY09 after the wage revisions. While we have built in close to a 40% increase in per employee cost for SAIL during FY11-14 period (which should take care of next round of wage revision due from FY13), total employee cost is going up by 25% only as the number of employees should come down from 111,000 (in FY11) to 100,000 (FY14F), as per management. At the same time with production doubling, per tonne cost for SAIL should fall.

Any rationalisation in employee cost/t of steel would come only from FY14 when SAIL starts to operate on expanded capacity, in our view. We expect per tonne employee cost to fall from INR6,717/t in H1FY12 to INR5,000/t by FY15.

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Fig. 48: Lower no. of employees to compensate for high per employee cost


FPO issuance postponed

The follow on public offer (along with a stake sale by the government) has been postponed due to the steep decline in the company’s share price, as per management. The FPO had been an overhang on the stock, as it was expected by the market at a discounted price. However, at current levels these concerns should not be present.

The deferment of the FPO shouldn’t have any impact on SAIL, as in our view the company did not appear to have any pressing need for additional cash. This was more of a government decision. SAIL should be able to meet its capex requirements through internal accruals, existing cash and by raising debt to fund the expansion at a D/E ratio of 1:1.

Sensitivity analysis

Since most of SAIL’s EBITDA comes from iron ore mining operations and coking coal is almost 70% of raw material costs, we have analysed SAIL’s EBITDA and earnings in different steel price and coking coal price scenarios.

Please note that we estimate that FY13F EBITDA could be in the range of INR58-INR90bn if steel prices remain in the range of USD600-650/t and coking coal prices in the range of USD225-250/t. Our base-case scenario is EBITDA of INR78.7bn at steel prices of USD625/t and coking coal prices of USD240/t.

Fig. 49: SAIL – FY13F EBITDA sensitivity


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According to our sensitivity analysis, SAIL’s EPS changes by INR5.5 for every USD50/t change in steel prices and INR1.9 for every USD25/t change in coking coal prices. We expect EPS top remain in the range of INR6-12.

Fig. 50: SAIL – FY13F EPS sensitivity


Key risks

Steel prices falling significantly from current levels

We estimate benchmark steel prices of USD625/t (current prices at USD630/t). If there is a significant correction in steel prices, there would then be a risk to our estimates.

Sharper-than-expected increase in coking coal prices

We estimate coking coal prices at USD240/t in FY13F. If coking coal prices increase from these levels, there is a risk to our estimates.

Delays in expansion plan

While we have built in 2mtpa production at IISCO plant for one quarter in FY13F, we have delayed other expansions to end-FY1F4. If the project is delayed further, there would then be a risk to our estimates.

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Appendix While in our view the company has disappointed investors on the execution of expansion and modernisation plans, we believe it will come through by FY14F. Please note that we have not built any positive impact of the capex until FY14F. However, we highlight below the key benefits that we expect once all the benefits come through.

Despite having 100% captive iron ore and 30% domestic coking coal at lower costs, SAIL’s EBITDA/t is lower than JSW Steel’s, with just 10% captive iron ore and no coking coal benefits. On the other hand, TATA Steel with similar integration has reported more than double EBITDA/t. We highlight some key reasons for SAIL’s inefficiencies in this section.

• Poor product mix – 15-20% semis

• Old technology – low yield, high coke rate

• High employee cost – a legacy problem

Apart from Bhilai, SAIL’s other facilities have very low profitability

A look at plant-wise EBIT/t could indicate the potential for improvement in SAIL’s overall profitability, in our view. Apart from the Bhilai steel plant, which has normalised EBIT/t of INR9,000-10,000 (currently it is lower due to coke oven battery problems), other plants have very low profitability. We show plant-wise profitability in the chart below.

Fig. 51: Apart from Bhilai other steel plants have low profitability (INR/t)


Please note that most of the plants face common issues like high employee costs, higher coke rate. But some specific issues with SAIL’s plants are:

1) Durgapore steel plant – 54% of total production is semis.

2) Bokaro steel plant – High coke rate, close to 80% of coking coal used is imported, so impact from the high coke rate is high.

3) IISCO Steel plant – an inefficient and old plant; SAIL is constructing a Greenfield plant rather than upgrade the existing facilities.

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Smaller furnaces with older technology the key issue

SAIL has a total of 21 blast furnaces, with crude steel capacity of 13mn tonnes. This means an average of 0.6mn tonne capacity per furnace compared with newer capacities, which have a capacity of more than 3mn tonnes. A look at figure below shows that the problem is spread across the facilities.

Fig. 52: The key problem with SAIL is smaller capacities

Source: Company data

The company is taking steps to improve these furnaces by debottlenecking and introducing modernisation plans wherever possible. The new blast furnaces by SAIL are comparatively much bigger, at 2-3mn tones, according to management and hence, are comparable to the best in the world, in our view. However, management believes this still won’t bring SAIL on par with newer capacities.

SAIL’s modernisation plan is key to improved profitability

Factors such as: 1) high employee costs; 2) low yield at blast furnaces (BF) and casters; 3) poor product mix; and 4) high coke rate/energy consumption have weighed on SAIL’s steelmaking operations. Key improvements that could make a difference, in our view, are:

1) Employee cost/t rationalisation once full expansion is complete.

2) Higher yield with the commissioning of new BF and modernisation of older BF, together with sinter plant and 100% continuous casting (from 66% currently).

3) Improvement in product mix. Currently SAIL has close to 10% semis in its product mix, which will be rolled in value-added products. This should add to its profitability.

4) Reduction in coke rate and energy costs by using: 1) higher pulverised coal injection (PCI) – this will reduce coke requirement in the blast furnace, and 2) continuous casting, which will reduce energy losses. This should help SAIL reduce coke rate from the current levels of 520kg/t to 450kg/t, on our estimates.

All these initiatives together can increase the EBITDA/t of its steelmaking operations by USD65-70/t, on our estimates. Please refer to the figure below for more details:

Fig. 53: Key benefits that could come from the modernisation plan

Source: Add Source Here

We estimate that SAIL’s profitability would be somewhere in between TATA Steel’s and JSW Steel’s.

Steel capacity (mn tonnes) No of BFs

Bhilai Steel plant 4.0 7

Bokaro Steel plant 3.6 5

Rourkela Steel plant 2.2 4

Durgapore Steel plant 2.0 3

ISP, Burnpur 0.4 2

Gain (US$/t) Items Now FY15

Product mix improvement 15 % of semis 10-15% 0

Modernisation impact:

-Low er coke rate 35 Kg/t 517 450

-Higher yield - of BF, caster etc 15 % yield 92% 94%

Employee cost benefits 40 Cost/t (INR) 7,002 5,000

Total benefits 105

Higher imported coking coal 36 % of imports 70% 85%

Total expected improvement in 2 69


JSW Steel JSTL.NS JSTL IN

METALS & MINING

EQUITY RESEARCH

Improving visibility on iron ore supply

Utilisation at 80% on improved iron ore supplies – expect rated production from December

December 7, 2011

Rating Remains

Buy


INR 739


INR 620


Action: Buy on improving iron ore supplies, lower coal prices JSW Steel stock has rebounded from lows on improved iron ore supplies and capacity utilisation increasing to 70-80%. At the same time, we expect the company to benefit from a decline in coking coal prices. Although JSW ISPAT operations remain a concern, we see additional support to earnings with the US plates and pipes operations showing a turnaround and Chilean iron ore mines in ramp-up mode. We maintain our Buy rating, but lower our TP to INR739.

Catalysts: improving utilisation and mining resumption in Karnataka The Supreme Court’s decision to restart mining operations in Karnataka will be a key trigger, along with improving capacity utilisation.

Valuation: Despite rebounding from recent lows, the stock is trading at 6.6x FY13F P/E and 4.6x FY13F EV/EBITDA. We expect 19% EBITDA growth in both FY13F and FY14F on account of production ramp-up. We believe the current price does not yet fully reflect the benefit of improved production.

We value the stock at 5x FY13F consolidated EBITDA at INR728. We value its 4.75% stake in JSW Energy at INR11/share and its 49.3% stake in JSW ISPAT at 5x FY13F EBITDA at an EV of INR68.6bn contributing INR0.4 to our target price.

We reduce our FY12F earnings estimates by 25% (adj. for forex losses) and 17.8% for FY13F on lower steel price estimates. We also lower our target multiple to 5x from 5.5x on global macro headwinds which would not allow any material improvement in the steel cycle in the near term.



Revenue (mn) 239,002 335,433 324,360 383,127 368,040 409,399 402,438

Reported net profit (mn) 17,261 18,660 9,529 28,138 20,258 31,231 27,153

Normalised net profit (mn) 17,261 18,660 14,659 28,138 20,258 31,231 27,153

Normalised EPS 83.34 80.15 65.70 112.59 90.80 123.83 121.70

Norm. EPS growth (%) -0.6 -3.8 -21.2 40.5 38.2 10.0 34.0

Norm. P/E (x) 7.4 N/A 9.4 N/A 6.8 N/A 5.1

EV/EBITDA (x) 6.0 5.2 5.9 3.8 4.7 3.4 3.8



ROE (%) 13.7 10.5 5.7 13.3 11.5 12.9 14.0

Net debt/equity (%) 87.3 67.5 90.8 52.1 85.6 43.9 72.5


Anchor themes

JSW Steel does not have captive raw materials and hence suffered from the supply side issues. With resolution of raw material issues we expect its 3.2mtpa expansion to drive earnings growth in FY13F.

Nomura vs consensus

Consensus earnings estimates are in a wide range from INR 50-125 for FY13F, showing divergence in steel cycle and production expectations. Our estimates are in the mid-range of consensus estimates.

Research analysts




Nomura | JSW Steel December 7, 2011

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Key data on JSW Steel Income statement (INRmn) Year-end 31 Mar FY10 FY11 FY12F FY13F FY14FRevenue 189,572 239,002 324,360 368,040 402,438Cost of goods sold -157,056 -201,605 -281,746 -314,365 -335,576Gross profit 32,516 37,398 42,614 53,675 66,863SG&A



EBIT 27,720 31,030 32,602 41,153 51,883Net interest expense -11,080 -9,454 -11,627 -12,918 -12,994Associates & JCEs 111 707 -1,891 219 219Other income 5,360 2,840 2,237 2,906 3,018Earnings before tax 22,111 25,124 21,320 31,361 42,126Income tax -6,467 -7,823 -6,108 -10,245 -13,583Net profit after tax 15,643 17,301 15,213 21,116 28,543Minority interests 332 239 -274 -579 -1,112Other items

Preferred dividends -289 -279 -279 -279 -279Normalised NPAT 15,686 17,261 14,659 20,258 27,153Extraordinary items 0 0 -5,130 0

Reported NPAT 15,686 17,261 9,529 20,258 27,153Dividends -2,120 -3,222 -3,222 -3,222 -3,222Transfer to reserves 13,566 14,039 6,308 17,036 23,931


FD normalised P/E (x) 7.4 7.4 9.4 6.8 5.1FD normalised P/E at price target (x) 8.8 8.8 11.1 8.1 6.0Reported P/E (x) 7.4 7.4 14.5 6.8 5.1Dividend yield (%) 1.5 2.0 2.0 2.0 2.0Price/cashflow (x) 5.6 3.8 4.6 3.3 2.5Price/book (x) 1.3 0.8 0.8 0.7 0.7EV/EBITDA (x) 7.3 6.0 5.9 4.7 3.8EV/EBIT (x) 10.7 8.9 9.6 7.2 5.6Gross margin (%) 17.2 15.6 13.1 14.6 16.6EBITDA margin (%) 21.5 19.5 16.0 17.2 18.9EBIT margin (%) 14.6 13.0 10.1 11.2 12.9Net margin (%) 8.3 7.2 2.9 5.5 6.7Effective tax rate (%) 29.2 31.1 28.6 32.7 32.2Dividend payout (%) 13.5 18.7 33.8 15.9 11.9Capex to sales (%) 9.4 22.8 12.2 9.4 11.1Capex to depreciation (x) 1.4 3.5 2.0 1.5 1.8ROE (%) 19.0 13.7 5.7 11.5 14.0ROA (pretax %) 8.1 8.0 6.7 8.4 10.2

Growth (%)

Revenue 19.0 26.1 35.7 13.5 9.3EBITDA 36.5 14.5 11.6 21.9 19.9EBIT 39.0 11.9 5.1 26.2 26.1Normalised EPS 50.7 -0.6 -21.2 38.2 34.0Normalised FDEPS 50.2 -0.3 -21.2 38.2 34.0

Per share

Reported EPS (INR) 83.86 83.34 42.71 90.80 121.70Norm EPS (INR) 83.86 83.34 65.70 90.80 121.70Fully diluted norm EPS (INR) 83.55 83.34 65.70 90.80 121.70Book value per share (INR) 494.91 740.84 777.58 829.23 935.50DPS (INR) 9.50 12.25 12.25 12.25 12.25Source: Nomura estimates



(%) 1M 3M 12M

Absolute (INR) -2.7 -8.7 -48.6

Absolute (USD) -6.9 -18.2 -54.7

Relative to index 6.0 -5.1 -28.1



52-week range (INR) 1240/479


33.66


Promoters 37.7

JFE holdings 15.0


Notes

JSW Steel should see strong EBITDA and profit growth driven by volume ramp-up

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Cashflow (INRmn) Year-end 31 Mar FY10 FY11 FY12F FY13F FY14FEBITDA 40,707 46,627 52,018 63,435 76,057Change in working capital -7,734 1,787 -1,619 -729 2,525Other operating cashflow -12,187 -14,437 -20,628 -20,256 -23,559Cashflow from operations 20,786 33,978 29,771 42,450 55,024Capital expenditure -17,741 -54,433 -39,500 -34,500 -44,500Free cashflow 3,044 -20,456 -9,729 7,950 10,524Reduction in investments -2,316 -22,856 0 0 0Net acquisitions

Reduction in other LT assets 0 0 0 0 0Addition in other LT liabilities 4,080 3,646 0 0 0Adjustments

Cashflow after investing acts 4,808 -39,666 -9,729 7,950 10,524Cash dividends -2,409 -3,501 -3,501 -3,501 -3,501Equity issue -556 58,641 0 -5,294 0Debt issue -3,772 3,013 19,118 -11,633 8Convertible debt issue

Others -133 -1,038

Cashflow from financial acts -6,870 57,115 15,617 -20,427 -3,492Net cashflow -2,063 17,449 5,888 -12,478 7,031Beginning cash 5,093 3,030 20,480 26,368 13,890Ending cash 3,030 20,480 26,368 13,890 20,921Ending net debt 158,700 144,264 157,493 158,338 151,316Source: Nomura estimates

Balance sheet (INRmn) As at 31 Mar FY10 FY11 FY12F FY13F FY14FCash & equivalents 3,030 20,480 26,368 13,890 20,921Marketable securities 0 0 0 0 0Accounts receivable 6,964 9,333 12,181 13,311 14,040Inventories 28,667 44,097 63,829 63,571 62,295Other current assets 16,038 21,739 25,189 28,965 31,399Total current assets 54,700 95,649 127,567 119,738 128,654LT investments 6,282 29,138 29,138 29,138 29,138Fixed assets 284,090 323,183 343,267 355,485 375,811Goodwill 8,992 10,932 10,932 10,932 10,932Other intangible assets 0 0 0 0 0Other LT assets 0 0 0 0 0Total assets 354,063 458,903 510,904 515,294 544,535Short-term debt 0 0 0 0 0Accounts payable 78,078 102,019 126,392 130,312 134,723Other current liabilities 2,649 3,995 4,033 4,033 4,033Total current liabilities 80,727 106,014 130,425 134,345 138,756Long-term debt 149,344 152,492 170,141 172,229 172,237Convertible debt 12,386 12,252 13,720 0 0Other LT liabilities 16,848 20,494 20,494 20,494 20,494Total liabilities 259,305 291,251 334,781 327,068 331,487Minority interest 2,187 2,358 2,632 3,211 4,323Preferred stock 2,790 2,790 2,790 2,790 2,790Common stock 2,481 8,135 8,135 2,841 2,841Retained earnings 13,566 14,039 6,308 17,036 23,931Proposed dividends 2,409 3,501 3,501 3,501 3,501Other equity and reserves 71,325 136,828 152,758 158,846 175,662Total shareholders' equity 92,572 165,293 173,492 185,015 208,726Total equity & liabilities 354,063 458,903 510,904 515,294 544,535

Liquidity (x)


Leverage

Net debt/EBITDA (x) 3.90 3.09 3.03 2.50 1.99Net debt/equity (%) 171.4 87.3 90.8 85.6 72.5

Activity (days)

Days receivable 10.5 12.4 12.1 12.6 12.4Days inventory 67.3 65.9 70.1 74.0 68.5Days payable 185.8 163.0 148.4 149.0 144.1Cash cycle -107.9 -84.7 -66.1 -62.4 -63.3Source: Nomura estimates

Notes

Cash flows may remain under pressure as USD275mn of FCCB comes for redemption and promoter warrants are unlikely to be converted

Notes

JSW Steel has a consolidated D/E of close to 1, which we believe is manageable given strong earnings growth going forward


45

Improving visibility on production JSW Steel has been facing near-term production issues on account of iron ore supplies after the mining ban in Karnataka. However the company has been able to procure iron ore at reasonable prices through E-Auctions. We believe JSW Steel should be able to maintain EBITDA/t of INR6,000-6,500/t going forward on improved production and a drop in coking coal prices (as at Q3 and Q4FY12 contracts have been signed at lower prices).

However, the stock has recovered from lows and has outperformed peers over the past two months. Although we believe the stock is still not building in the complete turnaround and has some more upside to it, we prefer TATA Steel (TATA IN, Buy) and SAIL (SAIL IN, Buy) at current levels, given valuation comfort and more earnings visibility owing to captive iron ore.

Iron ore is the key issue: The stock has recovered from lows on improved supplies

So far, the key issue facing JSW Steel has been a shortage of iron ore which resulted in capacity utilisation declining to 30% (from around an average of 100%). The ban on mining operations in Karnataka led to a shortage of iron ore for JSW Steel. Although the company tried to manage production by procuring iron ore from eastern India, high freight costs and logistic issues resulted in limited supply.

However, since then, the Supreme Court has allowed NMDC (NMDC IN, not rated) to produce 1mn tonnes of iron ore per month and sell 2.5mn tonnes per month from the inventory with miners, which we estimates is adequate to meet the requirements of steelmakers in Karnataka for six months. With improved iron ore supply, JSW Steel’s production has gradually improved to 70-80% of its rated capacity. This is also reflected in the JSTL stock rebounding from the lows. In fact, JSW Steel has outperformed SAIL and TATA Steel by 17% and 8%, respectively, over the past two months.

Fig. 54: JSW has outperformed peers over the past two months

Source: Bloomberg

Despite its recent stock outperformance, we believe JSW Steel has some more upside as the stock is not yet fully factoring in the capacity expansion. However, we would prefer TATA Steel and SAIL in the sector, on better earnings visibility owing to captive iron ore and weak valuations. JSW Steel is currently trading at 4.6x FY13F EV/EBITDA and 6.6x FY13F P/E, which is at a premium to TATA Steel (4.6x FY13F EV/EBITDA and 6.1x FY13F P/E) and SAIL (3x FY13F EV/EBITDA and 4.3x FY13F P/E adj for CWIP).

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46

E-Auction, a temporary solution; improving visibility on long term plans

Though E-Auction of iron ore from inventory would be able to support production at steel plants for six months, on our estimates, it is a temporary solution. We believe new iron ore production should start, in order to maintain production momentum at steel plants.

The Central Empowered Committee (CEC) has recommended 14 mines in Karnataka be allowed to resume mining operations as no irregularities were found at these mines. These 14 mines would be able to produce close to 8mtpa of iron ore, as per CEC. NMDC is allowed to produce 12mtpa (though it currently produces around 8mtpa), and these mines together should be able to meet close to 75-80% of the total iron ore requirement in the state of Karnataka, as per our estimates. Therefore, visibility of long-term iron ore security is improving in the state.

We expect Q3FY12F to be weak – Q4FY12F should see a recovery on production ramp-up

We estimate Q3FY12F would see weak production on account of a shortage of iron ore during October-November. JSW Steel produced 0.57mn tonnes in October and, we expect production to remain at similar levels even in November. At the same time, the company would see an increase in iron ore costs as well due to higher E-Auction prices. Therefore, we expect Q3FY12F will be a weak quarter for the company, with EBITDA/t of INR5,919/t and total EBITDA of INR10.6bn.

Fig. 55: Q4FY12F should see a recovery


However, Q4FY12F should see a recovery as we expect the company to start producing at full capacity by the first week of December. Thus, Q4FY12F would see volume growth. At the same time, we expect the prices of raw material, both iron ore and coking coal, to have fallen significantly which would flow through the P&L from Q4FY12F. As a combined impact, we expect EBITDA/t to improve to INR6,569/t and total EBITDA at INR15.1bn.

Acquisition of ISPAT Industries hasn’t panned out as planned – we expect a slow and gradual recovery

On acquiring ISPAT Industries (now JSW ISPAT, JSWI IN) in early 2011, JSW Steel had outlined four areas of improvement, listed below. However, apart from realising VAT benefits, the company has not been able to garner any other benefits to date.

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47

1) Reduction in power costs by sourcing from JSW Energy: ISPAT purchases power at INR6/unit which can be reduced to INR4.1/unit with long-term contracts. JSW Energy has signed an agreement to sell power to ISPAT at INR4.1/unit. However, the sale has not yet started as MSEB (Maharashtra State Electricity Board) did not approve the direct sale. However, ISPAT has now purchased a 26% stake in the 300MW power plant of JSW Energy; hence, this plant can be treated as captive and we expect power supply could start from Q4FY12.

2) Realising VAT benefits by cross selling: JSW ISPAT used to sell nearly 1mn tonnes of steel in Karnataka, while JSW Steel supplied HR coil to its mills in Maharashtra from Karnataka. Due to the inter-state transfers, JSW Steel had to pay VAT (Value Added Tax). By procuring its requirement from ISPAT there is a mutual benefit of INR1,500/t for both the companies on VAT savings.

3) Reduction in raw material cost through long-term contracts: JSW Steel planned to supply coke and pellets to ISPAT from JSW Steel at long-term contract prices. However, JSW Steel hasn’t been able to proceed due to the mining ban in Karnataka.

4) Lower interest burden with refinancing of loans: Though JSW Steel has been able to refinance ISPAT’s loans, rising interest rates have masked the benefits. The gains would be realised as and when interest rates come down.

Overall, ISPAT has remained loss-making until Sep 2011. We expect a gradual improvement as: 1) we expect power costs to decline from Q4FY12F; 2) JSW Steel is setting up a coke oven battery to supply coke exclusively to ISPAT – expected to come up over the next two years, and; 3) JSW Steel plans to use coke oven gas in the DRI plant instead of natural gas which will reduce production costs. We expect ISPAT to record EBITDA/t of INR3,804/t in FY12F and INR5,496/t in FY13F on account of above improvements.

Fig. 56: ISPAT – performance has remained subdued


US operations improve on strong demand for pipes

JSW Steel’s US operations have shown strong improvement, of late, with utilisation almost doubling to close to 40% on strong pipes demand from the oil and gas industry, as per management. In Q2FY12, its US operations reported an EBITDA of USD6.5mn up from USD3.7mn in Q1FY12. We expect EBITDA to improve further as management has indicated that demand has remained strong in Q3FY12 as well, along with a decent order book.

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48

We estimate the US operations to record FY12F and FY13F EBITDA of USD30mn and USD41mn, respectively.

Fig. 57: US operations are gradually improving on strong pipe demand


Chilean iron ore mines in ramp-up mode

JSW Steel has started mining operations in Chile, with H1FY12 production at 0.38mn tonnes. The company plans to increase the run rate to 1mtpa by end-FY12F, improving it further to 2mn tonnes in FY13F. In 1HFY12, its Chilean operations recorded EBITDA of USD18.7mn. We estimate EBITDA of USD44mn and USD75mn for FY12F and FY13F, respectively.

Earnings estimates cut on lower steel prices and sales volumes

We have lowered our earnings estimates by 45% for FY12F and 17.8% for FY13F, on account of our lower steel price estimates and a drop in sales volumes. Our FY12F earnings cut is driven by forex losses of INR5bn reported during Q2FY12. Adjusted for one-offs, FY12F earnings would be down 25%.

Note that our EBITDA/t estimates have come down to INR6,242/t and INR6,364/t for FY12F and FY13F from INR6,549/t and INR6,894/t, respectively. This is primarily because we have lowered our realisation estimates by INR300/t and cut our sales volume estimates from 8.2mn tonnes and 9.2mn tones, to 7.8mn tonnes and 8.8mn tonnes for FY12F and FY13F, respectively.

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Fig. 58: JSW Steel –key details


Target price reduced to INR739, from INR1,038

We have reduced our TP to INR739 on account of: 1) our 17.8% earnings cut for FY13F and 2) reducing our EV/EBITDA multiple to 5x from 5.5x earlier. We have lowered our target multiple to account for a weaker steel outlook and global uncertainties.

We value JSW Steel at 5x FY13F consolidated EV/EBITDA at INR728/share (from INR1,004 earlier). We value its 4.75% stake in JSW Energy (as per current market cap of INR65bn) at INR11/share. We have valued its 49.3% stake in JSW ISPAT at 5x FY13F EV/EBITDA at an EV of INR68.5bn contributing just 0.4/share to our target price.

Fig. 59: Sum of parts valuation of JSW Steel



Sales volume 5.7 6.1 7.8 8.8 9.3

Gross blended Realization (INR/t) 31,689 38,524 40,068 39,249 39,549

Net realization (INR/t) 29,559 35,629 37,040 36,297 36,582

RM cost per tonne (INR/tonne) 18,335 23,371 25,900 24,933 24,506

Contribution(INR/t) 11,224 12,257 11,140 11,364 12,076

Cost of production per tonne (INR) 24,415 30,480 32,861 31,757 31,328

EBITDA per tonne (INR) 7,489 7,499 6,242 6,364 6,982

Iron ore price assumption (INR/t) 1,919 2,858 3,669 3,526 3,469

Coal and coking coal cost (INR/t) 10,408 12,958 14,265 13,348 13,166

Total EBITDA (INRmn) 42,730 45,736 48,418 55,841 64,632

EBIT (INRmn) 31,496 31,949 31,315 36,098 43,222

Interest cost (INRmn) 8,627 6,952 9,019 10,186 10,262

Net profit (INRmn) 20,228 20,108 13,393 19,896 24,840

Capex 23,410 50,966 35,000 30,000 40,000

Free cash f low post capex (INRmn) 3,695 -19,412 -5,235 8,911 8,776

EPS (INR) 108.1 90.1 60.0 89.2 111.3

Cash EPS (INR) 168.2 151.9 136.7 177.7 207.3

Gross standalone debt (INRmn) 115,851 119,513 134,131 122,498 122,507

Net debt (INRmn) 112,980 100,645 112,002 111,886 106,610

Gross consolidated debt (INRmn) 161,730 164,744 183,861 172,229 172,237

Net debt (INRmn) 158,700 144,264 157,493 158,338 151,316

Total value Per share for JSW

FY13F EBITDA (INRmn) 63,435

EV/EBITDA (x) 5.0

Total EV (INRmn) 317,173

Gross debt-FY12F (INRmn) 183,861

Cash + investments FY12F (INRmn) 29,038

Net equity value (INRmn) 162,350 727.6

EV of ISPAT 68,548

Equity value of ISPAT 184 0.4

4.75% stake in JSW Energy 11

Target price 739


50

Promoters unlikely to convert issued warrants

JSW Steel had issued 17.5mn warrants to be converted into equity shares at INR1,210/share. The company has indicated that the promoters are unlikely to convert the warrants owing to funding issues (though it could also be on account of a lower current share price).

FCCBs due for redemption – plans to replace it by new debt

JSW Steel has USD275mn of FCCBs due for redemption by June 2012. The company plans to raise debt to repay the FCCBs as it looks unlikely to be converted at the current share price. The FCCB is convertible at INR953/share; however, including the 42.8% premium on the redemption of the FCCBs, the share price should, at the least, be INR1,360 for the conversion to happen.

The refinancing would increase the interest cost as FCCB has an YTM of 7.25% while any new debt would be, at the least, at 8-10% rate.

Working capital to increase on iron ore sourcing… but declining coking coal prices would help balance

JSW Steel has procured nearly 4.4mn tonnes of iron ore from E-Auctions. However, this would increase the working capital by INR5-6bn, as the total bid value has to be paid in advance (rather than on delivery).

In fact, this is one of the key reasons why JSW Steel faced less competition during bidding as the smaller steel mills faced funding problems for large bids.

However, coking coal prices have come off and we expect this should lower working capital requirement. In all, we expect a marginal increase in working capital by end-FY12. However, in the interim we expect working capital would remain high.

Cash flows could be under pressure…company to slow down capex

As a result of no equity (from promoters) and redemption of FCCB, we expect JSW Steel to face some cashflow strain. We expect operating cash flow of INR30.5bn (USD0.6bn) in FY12F and INR39.7bn (USD0.77bn) in FY13F.

The company has indicated that it will slow down capex for its 2mtpa expansion and other capex towards CR mills etc. The company guides for capex to remain at INR30-40bn per year. This implies that the company won’t be generating any free cash flows for the next two years.

However, we do not expect any major liquidity issues for the company given that JSW Steel has cash and equivalents of INR17.5bn (as at end-H1FY12) and the consolidated D/E ratio of nearly 1x is also within limits.


51

Fig. 60: Cash flow generation (INR mn)


Key risks

Delay in resumption of mining operations in Karnataka

We have built in normal iron ore operations to commence at the recommended mines from Q2FY13. However, any further delays could be a risk to our estimates.

Coking coal prices rise without any corresponding increase in steel prices

If coking coal prices rise without any corresponding increase in steel prices, contribution margins would contract, and would be a risk to our estimates.

Delay in turnaround of ISPAT’s operations

We have built in an improvement in ISPAT’s EBITDA from Q4FY12 on lower power costs, as we expect supply from JSW Energy to start. However, any delays would be a risk to our estimates.

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52

Iron ore sourcing: medium- to long-term roadmap JSW Steel requires close to 18mn tonnes of iron ore to operate at full capacity of 11mn tonnes. It sourced iron ore largely from the state of Karnataka which is rich in iron ore. However, the Supreme Court/Lokayukta investigation revealed a case of blatant illegal mining. The state government had earlier imposed a ban on iron ore exports from the state in order to restrict illegal mining, which was not very successful.

In July 2011, the Supreme Court banned all mining activity in the Bellary region of Karnataka and also extended the banned to other parts of Karnataka as well. This created an acute shortage of iron ore in the state, resulting in companies such as JSW Steel operating at less than 30% capacity utilisation.

E-Auction provides short-term relief – enough inventory to last six months

Note that miners have mostly been the target of the investigation committee; in order to provide relief to steelmakers based out of Karnataka, the following short-term measures were taken:

1) NMDC has been allowed to produce up to 1mn tonnes of ore per month. Currently, it produces 0.7mn tonne of ore per month.

2) Sale of iron ore from inventory with miners: Miners had a total of 25mn tonnes of iron ore inventory, when the mining ban was imposed in July 2011. The Supreme Court has set up a committee to E-Auction the inventory at 2.5mn tonnes per month.

With the commencement of E-Auction, a total of 10mn tonnes of iron ore has been put up for sale – of this, there was bidding for only 6.9mn tonnes of iron ore as the remaining iron ore was found to have very low Fe content.

JSW Steel has been able to secure 4.2mn tonnes of iron ore through E-Auction.

Ore delivery slow on logistic issues…but has improved since

Despite E-Auction, actual delivery was slow on account of logistic bottlenecks and restrictions on the number of hours during which iron ore could be moved. However, the Supreme Court has now lifted the time restriction, which along with improved logistics has led to an improvement in the delivery of iron ore.

JSW Steel has largely procured low-grade ore at reasonable prices. As competition is lesser for low-grade iron ore, it could procure the same at marginally above base prices.

Going forward: resuming mining is the key – would take at least six months to resume normal operations

Nearly 120 mines in Karnataka had to stop production following the Supreme Court ban. As per latest updates, the CEC has recommended that 14 of the above 120 mines are completely clean and hence should be allowed to resume mining operations. Of the remaining, 49 mines had minor infringements and should be allowed to resume operations after paying a fine and going through a restructuring and rehabilitation program. CEC has recommended revoking the licenses of the remaining 55 mines.

The 14 mines would be able to start production immediately after receiving approval. They would be able to produce close to 8mtpa, as per CEC estimates.

The remaining 49 mines would take, at the least, six months to resume production, given all the measures as mandated by the CEC. Once these mines resume production, the overall requirements of steelmakers can be met, in our view.


Appendix A-1

Analyst Certification

I, Alok Kumar Nemani, hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

Issuer Specific Regulatory Disclosures Mentioned companies Issuer name Ticker Price Price date Stock rating Sector rating Disclosures JSW Steel JSTL IN INR 636 02-Dec-2011 Buy Not rated 49 Steel Authority of India SAIL IN INR 87 02-Dec-2011 Buy Not rated Tata Steel TATA IN INR 419 02-Dec-2011 Buy Not rated 4

Disclosures required in the U.S.

49 Possible IB related compensation in the next 3 months Nomura Securities International, Inc. and/or its affiliates expects to receive or intends to seek compensation for investment banking services from the company in the next three months.

Disclosures required in the European Union

4 Market maker Nomura International plc or an affiliate in the global Nomura group is a market maker or liquidity provider in the securities / related derivatives of the issuer.

Previous Rating Issuer name Previous Rating Date of change JSW Steel Neutral 01-Dec-2010 Steel Authority of India Reduce 16-Dec-2009 Tata Steel Reduce 18-Aug-2009

Rating and target price changes

Ticker Old stock rating New stock rating Old target price New target price

JSW Steel JSTL IN Buy Buy INR 1038 INR 739

Steel Authority of India SAIL IN Buy Buy INR 183 INR 120

Tata Steel TATA IN Buy Buy INR 653 INR 568

53


JSW Steel (JSTL IN) INR 636 (02-Dec-2011) Rating and target price chart (three year history)

Buy (Sector rating: Not rated)

Date Rating Target price Closing price 11-Aug-2011 1038.00 669.15 22-Jun-2011 1092.00 837.85 01-Dec-2010 1370.00 1205.45 01-Dec-2010 Buy 1205.45 05-Oct-2010 1486.00 1375.75 05-Oct-2010 Neutral 1375.75 23-Mar-2010 1482.00 1267.40 23-Mar-2010 Buy 1267.40

For explanation of ratings refer to the stock rating keys located after chart(s)

Valuation Methodology We value JSW on a sum-of-the-parts basis at INR739. We value JSW’s operations at 5x FY13F consolidated EV/EBITDA at INR 728/share. We also include INR11/share for its 4.75% stake in JSW Energy, based on the current market cap of INR 65.5bn . We value JSW Steel’s 49.3% stake in ISPAT Industries at INR 0.4/share valued at 5x FY13 EV/EBITDA. Risks that may impede the achievement of the target price 1) Delays in resuming mining operations in Karnataka; 2) coking coal prices increases without any corresponding increase in steel prices, and; 3) delay in turnaround of ISPAT operations.

Steel Authority of India (SAIL IN) INR 87 (02-Dec-2011) Rating and target price chart (three year history)


Date Rating Target price Closing price 22-Jun-2011 183.00 130.05 02-May-2011 193.00 159.20 17-Jan-2011 212.00 157.15 05-Oct-2010 264.00 223.75 03-Mar-2010 260.00 226.10 16-Dec-2009 250.00 211.30 16-Dec-2009 Buy 211.30 31-Jul-2009 132.00 175.45 30-May-2009 90.00 172.85 03-Feb-2009 65.00 76.20 03-Feb-2009 Reduce 76.20


Valuation Methodology We have valued SAIL at 5x FY13F EV/EBITDA (INR 95/share) and added capital work in progress (CWIP) at its book value of INR 25/share to arrive at our target price of INR120/share. Risks that may impede the achievement of the target price Steel prices falling significantly from current levels: We estimate benchmark steel prices of USD625/t (current prices at USD630/t). If there is a significant correction in steel prices, there would then be a risk to our estimates. Sharper-than-expected increase in coking coal prices: We estimate coking coal prices at USD240/t in FY13F. If coking coal prices increase from these levels, there is a risk to our estimates. Delays in expansion plans: While we have built in 2mtpa production at IISCO plant for one quarter in FY13F, we have delayed other expansions to end-FY1F4. If the project is delayed further, there would then be a risk to our estimates.

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Tata Steel (TATA IN) INR 419 (02-Dec-2011) Rating and target price chart (three year history)


Date Rating Target price Closing price 16-Aug-2011 653.00 468.90 22-Jun-2011 733.00 558.00 05-Oct-2010 846.00 668.80 01-Feb-2010 920.00 577.95 16-Dec-2009 926.00 557.55 18-Aug-2009 591.00 451.45 18-Aug-2009 Buy 451.45 29-Jun-2009 369.00 397.15 05-Jun-2009 407.00 463.90 05-Jun-2009 Reduce 463.90 02-Mar-2009 295.00 159.35 03-Feb-2009 281.00 170.70 03-Feb-2009 Buy 170.70


Valuation Methodology We value TATA Steel at INR568, with its domestic business contributing INR644/share, Corus contributing INR-92/share, its stake in Benga project of Riversdale Mining contributing INR15/share, and its SE Asia business contributing INR2/share. We value the India business at 6x FY13F EV/EBITDA and the European and SE Asian operations at 5x FY13F EV/EBITDA. The stake in the Benga project is based on a valuation of USD2.5bn. Risks that may impede the achievement of the target price Steel prices fall more than expected: We are expecting steel prices of USD625/t going forward and a correction on INR1,000/t in domestic steel prices. If average prices fall below these levels, there would be downside risk to our estimates. Worse-than-expected demand at European operations: We have built in 13.5mn tonnes of deliveries for European operations in FY13F, down from 14.87mn tonnes in FY11 and 13.9mn tonnes expected in FY12F. If the demand situation is worse than expected, there could be downside risk to our estimates. Delay in expansion plans: We have built in 60% production from 2.9mtpa in FY13F. This would mean we are expecting rated production in 2HFY13 from this capacity. Any delay in expansion would negatively impact our estimates.

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