Singapore/Mumbai: Tata Steel Limited’s (TSL) memorandum of understanding with thyssenkrupp AG to create a 50:50 JV in Europe paves the way for TSL to reduce exposure to a structurally weaker business, says Fitch Ratings.
However, according to Fitch, TSL’s Long-Term Issuer Default Rating (IDR) of ‘BB’ remains on Rating Watch Evolving until further clarity on the proposed JV emerges with the signing of definitive agreements, which is expected by March 2018. In addition, Fitch will look out for details on TSL’s plans to significantly expand capacity in India and evaluate its impact on TSL’s financial metrics and credit profile.
TSL’s operations in Europe face weak regional demand, high conversion costs and lack of captive raw-material sources. Fitch believes the reduction in direct exposure to this industry and the increase in the significance of its more-profitable Indian operations will not only reduce earnings volatility, but also improve TSL’s overall business profile.
TSL’s India operations are highly profitable; they generated EBITDA per tonne of around USD160 in the financial year ended March 2017 (FY17). TSL benefits from significant vertical integration in India as captive mines provided all of its iron ore and 36% of its coal requirements in FY17. The company has been steadily ramping up output from its Kalinganagar plant, which has capacity of 3 million tonnes a year, since its commissioning in May 2016. While recent steel demand growth in India has been muted at around 4% yoy in April-August 2017, the outlook is supported by accelerating public-sector spending and a preferential policy for locally processed steel in government procurement. In addition, long-term anti-dumping duties provide protection from the threat of imports should international steel prices weaken.
The proposed JV, which TSL announced on 20 September 2017, will be called thyssenkrupp Tata Steel. It will be formed on a non-cash basis, with both shareholders contributing assets and liabilities in order to achieve fair valuation. The JV will be the second-largest European flat steel producer with annual shipments of about 21 million tonnes. TSL intends to transfer its European flat steel assets and around EUR2.5 billion of term debt to the JV, while thyssenkrupp (BB+/Rating Watch Positive) would transfer pension liabilities of EUR3.6 billion and its European flat steel assets and steel mill services. The companies expect to sign definitive agreements after due diligence and shareholder approval by March 2018 and close the deal after anti-trust and other regulatory approvals in late 2018.
The proposed JV’s intended capital structure has been designed by the two partners to be self-sustaining, with the ratio of term debt to EBITDA in the last 12 months below 2x and expected cost synergies of EUR400 million-600 million annually. TSL expects to service offshore net debt of around INR170 billion with the help of dividends from the JV. Given the lack of recourse by the JV to TSL and cash-flow exposure limited to dividends, Fitch will use the equity accounting method for this new entity, rather than proportionally consolidate the JV’s financials when assessing TSL. Fitch will also place an emphasis on the significance of the Indian business when assessing the business profile of the group.
TSL has stated that it intends to double its capacity in India from 13 million tonnes in the next five years to enhance its market position. Apart from organic growth at its Kalinganagar and Jamshedpur sites, the company may acquire distressed assets in India. Indian steelmakers Essar Steel, Bhushan Steel and Electrosteel Steels are in bankruptcy proceedings. Fitch believes further details on TSL’s plans are likely to emerge over the next six to nine months. While the company has indicated a financially prudent approach to capacity growth, substantial investments over the next two to three years could hinder sustainable deleveraging. (Fitch Ratings)
TSL’s FFO adjusted net leverage improved to around 5x at FYE17, from 13x at FYE16. We estimate TSL’s leverage to decline further to 4x by FY19, driven by robust EBITDA in India and reduced capex. TSL’s capex averaged around INR120 billion each year over FY14-17 as it set up its Kalinganagar plant, and we assume roughly half of that level will be spent annually over the next three years resulting in positive FCF. However, higher-than-expected spending to pursue capacity growth is a key risk to our estimates.