JSW STEEL JSW-Ispat merger: high scale, weak profitability

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1 EVENT UPDATE JSW STEEL JSW-Ispat merger: high scale, weak profitability India Equity Research Metals and Mining JSW Steel (JSW) has announced a merger with its 46.75% associate entity JSW Ispat (Ispat) in the ratio of 1:72. This merger makes JSW the largest steel company in India (14.3mtpa capacity) with potential synergy benefits of INR3-5bn p.a. over time. We currently ascribe negative equity valuation of INR31bn to Ispat considering its weak EBITDA and high net debt. The NPV of tax benefit of INR14bn does not offset this negative valuation and along with the 8.3% equity dilution leads to target price being revised down to INR868 (INR933 earlier). The proforma EPS for the merged entity is estimated to be revised down by ~10.6% and 9.7% for FY13 and FY14, respectively. This is despite 19.5% and 18.2% increase in FY13 and FY14 EBITDA estimates, respectively. Maintain BUY. Tax savings expected to be a key benefit As per the management, Ispat has accumulated losses of ~INR97bn which may help save tax of ~INR22bn. JSW will, however, have to pay MAT and therefore the tax savings will accrue over a period of nearly six years; NPV of which comes to ~INR14bn. Management expects savings of ~INR3-5bn p.a. over a period of time in raw material purchases, marketing and administration costs (not factored by us). Management expects Ispat s interest burden to reduce by ~ bps. Outlook and valuations: Incrementally negative; maintain BUY JSW s debt will effectively increase by ~INR88bn (including INR20bn of acceptances, which in our view is quasi debt) while its equity will dilute by 8.3%. In our opinion, the benefits of tax savings and additional EBITDA of INR14.5bn are not enough to fully offset the impact of additional debt and equity dilution. As a result, our price target is being revised down to INR868 from INR933 earlier. We continue to value JSW at 5.5x and Ispat at 4x FY14E EV/EBITDA. Maintain BUY/Sector Outperformer recommendation/rating. At CMP, the stock trades at 3.1x FY14E EV/EBITDA of our premerger financials. EDELWEISS 4D RATINGS Absolute Rating Rating Relative to Sector BUY Outperformer Risk Rating Relative to Sector Medium Sector Relative to Market MARKET DATA (R: JSTL.BO, B: JSTL IN) Underweight CMP : INR 694 Target Price : INR week range (INR) : 886 / 462 Share in issue (mn) : M cap (INR bn/usd mn) : 155/ 2,782 Avg. Daily Vol.BSE/NSE( 000) : 2,624.4 SHARE HOLDING PATTERN (%) Current Q4FY12 Q3FY12 Promoters % MF's, FI's & BK s FII's others * Promoters pledged share (% of share in issue) PRICE PERFORMANCE (%) Stock : 15.5 Nifty EW Metals and Mining Index 1 month months months (7.8) Financials (Consolidated) Year to March FY11 FY12 FY13E FY14E Revenues (INR mn) 239, , , ,695 Rev. growth (%) (5.5) 18.5 EBITDA (INR mn) 46,627 61,019 67,388 79,994 Adjusted net profit (INR mn) 16,751 13,399 18,127 26,831 Basic shares outstanding (mn) Diluted EPS (INR) EPS growth (%) (7.6) (20.0) Diluted P/E (x) EV/EBITDA (x) ROAE (%) Prasad Baji prasad.baji@edelcap.com Navin Sahadeo navin.sahadeo@edelcap.com September 1, 2012 Edelweiss Research is also available on Bloomberg EDEL <GO>, Thomson First Call, Reuters and Factset. Edelweiss Securities Limited

2 Metals and Mining Merger to catapult JSW into top league Post the merger, JSW s installed capacity will increase from the current 11.0mtpa to 14.3mtpa, making it the largest steel company in India. JSW will issue 18.6mn shares in the ratio of 1:72 (every 72 shares of Ispat will be entitled to get one share of JSW). Table 1: JSW to become largest steel company in India JSW Steel JSW Ispat Merged Entity Crude steel capacity (mtpa) Expansion potential (mtpa) Location Proximity to iron ore & customers Coastal location; proximity to customers De-risking of geographical concentration Steel-making route Corex : 1.6mtpa BF: 2mtpa Broad-based BF-BOF : 8.4mtpa DRI: 1.6mtpa technology route Tax benefits INR 22bn over 6 years Other highlights Source: Company, Edelweiss research Merger will be effective from 1 st July 2012 and is likely to be completed by March 2013, subject to all requisite approvals. As part of the merger, JSW will hive off the downstream capacities of both the entities at Vasind Tarapur and Kalmeshwar into a 100% subsidiary. The total collective capacity of downstream production units is ~1.2mtpa which the company plans to expand to 1.7mtpa by end of the current fiscal. The Dolvi plant of Ispat has the potential to increase it s capacity to ~7.5mtpa from the current 3.3mtpa. Expansion plans for this brownfield project expansion is at a very nascent stage. Post the merger, promoters stake in JSW will reduce from the current 38% to 35.1%. Strategic partner JFE s stake will also reduce from 16.2% to 14.9%. Update on Karnataka operations: Production at the category A mines in Karnataka expected to start in the coming 3-6 months. Management however is hopeful that the honourable Supreme Court may also decide to restart category B and C mines soon. 2 Edelweiss Securities Limited

3 JSW Steel Proforma financials of merged entity indicate EPS downward revision In our estimates, the EPS of the merged entity is likely to be revised down by ~10.6% and 9.7% respectively. Table 2: FY13 proforma P&L Company JSW Steel JSW Ispat Combined entity Ownership by combined entity (%) Revenue 324, , ,852 EBITDA 67,388 13,145 80,533 Interest 19,175 10,914 30,088 Depreciation 21,524 6,154 27,677 Other Income 2, ,455 PBT 29,637 (3,415) 26,223 Tax 9,992 8,837 less: minority interest (175) (175) Add : profit of associates (1,433) 0 PAT 18,127 (3,415) 17,561 No. of shares 223 2, EPS 81.2 (1.4) 72.6 Change in EPS (%) (10.6) Table 3: FY14 proforma P&L Company JSW Steel JSW Ispat Combined entity Revenue 384, , ,057 EBITDA 79,994 14,526 94,520 Interest 20,531 10,883 31,413 Depreciation 22,486 6,192 28,678 Other Income 3, ,796 PBT 40,806 (1,581) 39,225 Tax 13,663 13,140 Less: minority interest (153) (153) Add : profit of associates (465) 0 PAT 26,831 (1,581) 26,237 No. of shares 223 2, EPS (0.6) Change in EPS (%) (9.7) Table 4: Current proforma key balance sheet items Company JSW Steel JSW Ispat Combined entity Net debt 183,890 67, ,640 Acceptances 82,782 20, ,370 Total net debt 266,672 88, ,020 Net worth 168,560 11, ,960 Net debt/equity Source: Company, Edelweiss research 3 Edelweiss Securities Limited

4 Metals and Mining Proforma capital structure pre and post merger Table 5: Equity dilution of 8.3% JSW Steel shareholding Pre-merger Post-merger No. of shares(mn) % holding No. of shares(mn) % holding Promoters of JSW Steel % % Investors % % JFE % % Promoters of JSW Ispat % Minority shareholders - JSW Steel % % Minority shareholders - JSW Ispat % Total % % New JSW Steel shares issued as part of transaction No. of shares (mn) JSW Steel - Promoters of JSW Ispat 6.9 Minority shareholders - JSW Ispat Source: Company, Edelweiss research Valuation: Target price revised down to INR868 JSW s debt will increase by ~INR88bn (including INR20bn of acceptances) while its equity will dilute by 8.3%. In our opinion, the benefits of tax savings and additional EBITDA of INR14.5bn are not enough to fully offset the impact of additional debt and equity dilution. As a result, our price target is being revised down to INR868 from INR933 earlier. We continue to value JSW at 5.5x and Ispat at 4x FY14E EV/EBITDA. Maintain BUY/Sector Outperformer recommendation/rating. Table 6: Fair Valuation of merged entity at INR 868/share FY14E JSW's steel business multiple (x) 5.5 Steel business EBITDA (INR mn) 78,901 International mining business multiple (x) 4.0 International mines EBITDA (INR mn) 1,093 JSW Ispat business multiple (x) 4.0 JSW Ispat EBIDTA (INR mn) 14,526 NPV of Tax Benefits (INR mn) 14,141 Enterprise value (INR mn) 510,572 Less: Net debt FY13 (INR mn) 313,403 CWIP - previous FY (INR mn) 44,502 Discount 50% Add: CWIP - previous FY (INR mn) 22,251 Less:Preference capital (INR mn) 7,645 Less:Minority interest (INR mn) 2,002 Value (INR mn) 209,774 No. of shares (mn) 242 Value per share (INR) 868 Source: Edelweiss research 4 Edelweiss Securities Limited

5 Company Description JSW Steel JSW, part of the USD 8 bn O.P. Jindal Group, was incorporated as Jindal Vijaynagar Steel (JVSL). It began operations in 1999 with the commissioning of the first Corex-2000 module in India (third in the world after Posco in South Korea and Isicor in South Africa), with a capacity to produce 0.8 mn tonnes of hot metal. In FY05, the company merged group company JISCO (Jindal Iron and Steel Company), which had a strong presence in downstream products such as CR and GP/GC products. In FY06, the company merged Euro Ikon, Euro Coke, and JSW Power and was renamed JSW Steel, transforming into an integrated steel manufacturer. The current steel capacity of JSW Steel is 11 mtpa, which includes 10 mtpa capacity at Vijaynagar and 1 mtpa capacity at Salem that caters exclusively to the long product segment. Investment Theme Global steel demand is showing mixed signals with strong growth in China and weakening demand in the developed world. Steel prices are expected to be range bound with steel margins expanding led by declining raw material cost. JSW has expanded rapidly to emerge as India s second largest steel producer in terms of capacity and has added 3.2 mtpa capacity in Q2FY12. It continues to focus on the domestic market and increasing its penetration in semi-rural and rural areas by opening retail outlets. Key Risks No partial restart of private iron ore mining in Karnataka. Weakness in global steel demand leading to lower international prices. 5 Edelweiss Securities Limited

6 Metals and Mining Financial Statements Key assumption FY11 FY12 FY13E FY14E Macro GDP (YoY%) Inflation (Avg) Repo rate (exit rate) USD/INR (Avg) Ferrous sector HRC price - India (net, INR '000/t) Hard coking coal price (FOB, USD/t) India steel demand growth (%) JSW Steel - India Crude steel production (mt) Net blended realisation (USD/tonne) EBITDA (USD/tonne) Income statement (INR mn) Year to March FY11 FY12 FY13E FY14E Net revenue 239, , , ,695 Raw material costs 154, , , ,309 Employee expenses 6,368 8,464 6,880 8,342 SGA and other expenses 26,888 37,399 37,600 45,590 EBITDA 46,627 61,019 67,388 79,994 Depreciation and amortisation 15,597 19,332 21,524 22,486 EBIT 31,030 41,687 45,864 57,508 Interest expenses 9,454 14,273 19,175 20,531 Other income 2, ,948 3,829 Profit before tax 24,417 28,183 29,637 40,806 Provision for tax 7,823 5,002 9,992 13,663 Core profit 16,594 23,181 19,645 27,143 Profit after minority interest 17,540 5,377 18,387 26,831 Adjusted PAT 16,751 13,399 18,127 26,831 Basic shares outstanding (mn) Diluted shares (mn) Diluted EPS Dividend per share (INR) Dividend payout (%) Tax rate (%) Common size metrics- as % of net revenues Year to March FY11 FY12 FY13E FY14E EBITDA margins Net profit margins Growth metrics (%) Year to March FY11 FY12 FY13E FY14E Revenues (5.5) 18.5 EBITDA Net profit 6.8 (10.0) Edelweiss Securities Limited

7 JSW Steel Balance sheet (INR mn) As on 31st March FY11 FY12E FY13E FY14E Equity capital- Voting shares 2,842 2,842 2,841 2,841 Preference shares 2,790 2,790 2,790 2,790 Reserves & surplus 159, , , ,210 Shareholders funds 165, , , ,842 Secured loans 121, , , ,308 Unsecured loans 43,016 13,758 29,349 28,560 Borrowings 164, , , ,868 Minority interest 2,358 2,177 2,002 1,849 Deferred tax liability 23,256 30,412 30,412 30,412 Sources of funds 355, , , ,971 Gross block 326, , , ,455 Depreciation 68,732 88, , ,784 Net block 258, , , ,671 CWIP 65,077 28,317 44,502 74,502 Total fixed assets 323, , , ,173 Investments 29,138 20,896 19,463 18,998 Deferred tax asset 2,762 3,162 3,162 3,162 Goodwill 10,932 12,440 12,440 12,440 Loans and advances 21,568 47,900 47,900 47,900 Inventories 44,097 57,893 62,702 71,062 Sundry debtors 9,333 15,394 11,561 13,701 Cash and equivalents 20,480 30,470 57,336 78,246 Total current assets 95, , , ,909 Sundry creditors and others 102, , , ,590 Provisions 3,995 2,308 4,323 5,123 Total CL & provisions 106, , , ,713 Net current assets (10,365) (42,690) (11,708) 2,196 Uses of funds 355, , , ,971 Book value per share (BV) (INR) Free cash flow metrics (INR mn) Year to March FY11 FY12E FY13E FY14E Net profit 17,540 5,377 18,387 26,831 Depreciation 15,597 19,332 21,524 22,486 Others 8,302 13,305 20,433 20,843 Gross cash flow 41,439 45,746 60,343 70,160 Less: Changes in W. C. 13,137 10,622 4,116 (7,006) Operating cash flow 28,302 35,124 56,227 77,166 Less: Capex 55,181 40,802 41,185 40,000 Free cash flow (26,879) (5,678) 15,042 37,166 Cash flow statement Year to March FY11 FY12E FY13E FY14E Operating cash flow 28,302 35,124 56,227 77,166 Financing cash flow 50,961 6,978 11,824 (16,256) Investing cash flow (76,331) (41,006) (41,185) (40,000) Net cash flow 17,450 1,096 26,867 20,910 Capex (55,181) (40,802) (41,185) (40,000) Dividends paid (2,397) (3,501) (2,937) (2,937) 7 Edelweiss Securities Limited

8 Metals and Mining Ratios Year to March FY11 FY12E FY13E FY14E ROAE (%) ROACE (%) Inventory (days) Debtors (days) Payable (days) Cash conversion cycle (days) (121) (147) (223) (189) Debt/EBITDA Current ratio Debt/ Equity Adjusted debt/equity Turnover Year to March FY11 FY12E FY13E FY14E Fixed assets turnover (x) Total asset turnover (x) Equity turnover (x) Valuation parameters Year to March FY11 FY12E FY13E FY14E Diluted EPS (INR) Y-o-Y growth (%) (7.6) (20.0) CEPS (INR) Diluted P/E (x) Price/BV(x) Market cap/sales (x) EV/Sales (x) EV/EBITDA (x) Dividend yield (%) Peer comparison valuation Price Market Cap PE (x) EV/EBITDA(x) ROE(%) (USD) (USD bn) 2013E 2014E 2013E 2014E 2013E 2014E Global steel Companies POSCO ArcelorMittal Sid Nacional JFE Thyssenkrupp Hyundai Steel Average Indian Steel Companies Tata Steel SAIL JSW Steel JSPL Bhushan Steel Usha Martin Average Source: Bloomberg, Edelweiss research 8 Edelweiss Securities Limited

9 RATING & INTERPRETATION Company Absolute reco Relative reco Relative risk Company Absolute reco Relative reco Relative Risk Bhushan Steel REDUCE SU M Coal India BUY SO M Hindalco Industries BUY SO M Hindustan Zinc BUY SP L Jindal Steel & Power BUY SP M JSW Steel BUY SO M National Aluminium Company REDUCE SU M Sesa Goa HOLD SP M Steel Authority of India HOLD SU L Sterlite Industries (India) BUY SO M Tata Steel BUY SO M Usha Martin HOLD SU M ABSOLUTE RATING Ratings Expected absolute returns over 12 months Buy More than 15% Hold Between 15% and - 5% Reduce Less than -5% RELATIVE RETURNS RATING Ratings Sector Outperformer (SO) Sector Performer (SP) Criteria Stock return > 1.25 x Sector return Stock return > 0.75 x Sector return Stock return < 1.25 x Sector return Sector Underperformer (SU) Stock return < 0.75 x Sector return Sector return is market cap weighted average return for the coverage universe within the sector RELATIVE RISK RATING Ratings Low (L) Medium (M) High (H) Criteria Bottom 1/3rd percentile in the sector Middle 1/3rd percentile in the sector Top 1/3rd percentile in the sector Risk ratings are based on Edelweiss risk model SECTOR RATING Ratings Overweight (OW) Equalweight (EW) Criteria Sector return > 1.25 x Nifty return Sector return > 0.75 x Nifty return Sector return < 1.25 x Nifty return Underweight (UW) Sector return < 0.75 x Nifty return 9 Edelweiss Securities Limited

10 Metals and Mining Edelweiss Securities Limited, Edelweiss House, off C.S.T. Road, Kalina, Mumbai Board: (91-22) , Vikas Khemani Head Institutional Equities Nischal Maheshwari Co-Head Institutional Equities & Head Research Nirav Sheth Head Sales Coverage group(s) of stocks by primary analyst(s): Metals and Mining Bhushan Steel, Coal India, Hindalco Industries, Hindustan Zinc, Jindal Steel & Power, JSW Steel, National Aluminium Company, Steel Authority of India, Sesa Goa, Sterlite Industries (India), Tata Steel, Usha Martin Recent Research Date Company Title Price (INR) Recos 17-Aug-12 Metals and Mining 16-Aug Aug-12 National Aluminium Company Hindalco Industries Coal gate: CAG castigates government; Sector Update Waiting for sunshine; Company Update Near term head-winds; Result Update 54 Reduce 117 Buy Distribution of Ratings / Market Cap Edelweiss Research Coverage Universe Buy Hold Reduce Total Rating Interpretation Rating Expected to Rating Distribution* * 1 stocks under review > 50bn Between 10bn and 50 bn < 10bn Market Cap (INR) Buy Hold Reduce appreciate more than 15% over a 12-month period appreciate up to 15% over a 12-month period depreciate more than 5% over a 12-month period 10 Edelweiss Securities Limited

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