When in doubt, chill out. Investors in Tata Steel Ltd appear to be following this motto. Financial Times reported last weekend that the European Union (EU) authorities will likely block the proposed joint venture (JV) between Tata Steel Europe and Thyssenkrupp AG, citing threat to user industries. But Tata Steel’s shares haven’t shown any major sign of stress.
The stock has lost 4.6% so far this week, which is slightly more than the 4% drop in the Nifty Metal index. This is not the first time investors brushed aside possible risks to the JV.
The Street gave little weight to the management’s post-March quarter results commentary warning that further remedial measures may be needed to gain approval from the European regulators; and that this may require revisiting of the rationale of the proposed JV, as to whether expected synergies will be remunerative or not.
The reducing influence of the European operations partly explains this. When Tata Steel first announced the JV, the low-margin European unit generated 27.6% of the consolidated entity’s operating profit in the preceding fiscal year (FY17). In FY19, this dropped to 17.6%, reflecting the expanded capacity base in the better profitable Indian market.
The contribution from Europe will reduce further in FY20 as Tata Steel de-bottlenecks the capacity base in India. Of course, it has also made a large domestic acquisition to boost capacity.
Even so, if the EU throws a spanner in the works, the company’s European operations will come in the way of the company’s deleveraging plans. While the long delay in the completion of the proposed JV should have raised alarm bells already, the market still expects the European unit to move out of Tata Steel, says an analyst with a multinational brokerage firm.
If the deal falls through, it will lead to a reset in the Tata Steel stock price, warns an analyst at a domestic brokerage firm. The European unit has unsustainably high debt and lost money in FY17 and FY18. The losses are being made good by the consolidated entity, especially India operations.
While FY19 earnings are not available yet, analysts see no noticeable improvement from FY18 given the general slump in steel prices.
If the deal does not go through, then the investors will have to account for the “leaking bucket" in the Tata Steel portfolio again, says the second analyst cited above. This will not only stall the balance-sheet deleveraging exercise but also impact future cash flow calculations, as Tata Steel will have to set aside money for Europe.
Some analysts expect the JV approval to come through possibly with more caveats and limited synergies. Even then, how beneficial this option will be has to be seen.
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