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JSW Steel report: JSW Ispat Merger Expected, But Timing Surprises

Contributed by Angel Broking

JSW Steel has announced the merger of its 47%-owned associate company JSW Ispat with itself, effective 1 July 2012. The company will issue 1 equity share in lieu of 72 equity shares of JSW Ispat. We are surprised about the timing of the merger as JSW Steel maintained in the past that it would turn around JSW Ispat before merging it. But, the merger was a logical event in order to avail the benefit of accumulated tax losses. In a separate set of events, the apex court is likely to give its judgment today on resuming iron ore mining operations in Karnataka. The verdict is likely to be positive, thereby easing the current tight iron ore supply situation in Karnataka. We retain our Sell rating on JSW Steel with a revised TP of Rs600 (2% higher than our earlier TP of Rs586).

Benefit of accumulated losses at JSW Ispat: The company has indicated that JSW Ispat’s accumulated losses as per income tax calculations at the end of June 2012 stood at Rs97bn compared to Rs43bn as per reported numbers. This helps the company to achieve tax savings of Rs32bn, although it loses some of the existing Section 80IA benefits to the tune of Rs10bn in the merger process, leading to a net gain of Rs22bn. JSW Ispat’s merger was a logical move, as otherwise a portion of the accumulated losses would have lapsed and it would have taken a longer time to turn profitable at the PAT level, thereby losing the time value of money.

Transaction details: The merger would increase its equity capital from Rs2,231mn to Rs2,417mn, a dilution of 7.7% on the expanded capital. It will also issue 485mn 0.01% non- convertible cumulative preference shares in lieu of existing preference shares. As part of the merger scheme, downstream operations at Vasind and Tarapur of JSW Steel and Kalmeshwar operations of JSW Ispat would be transferred to a whollyowned subsidiary of JSW Steel in order to take the advantage of VAT benefit available to JSW Ispat.

Other highlights: JSW Steel has indicated the merger of JSW Ispat would result in substantial costs savings, to the tune of Rs3,500mn-Rs5,000mn due to economies of scale and lower interest costs as JSW Ispat’s weighted average interest costs are almost 350bps higher compared to the former. Debt-equity ratio of the combined entity would stand at 1.6x at the end of FY14 compared to 1.1x for the existing JSW Steel.

Valuation: At the beginning of the iron ore crisis, we had cut our target multiple from 5.0x to 3.5x, which was revised upwards to 4.0x last year based on the company’s strong performance. We have now upgraded our target multiple further from 4.0x to 4.5x as there is a fair amount of visibility on the iron ore supply situation easing, Nonetheless, it is still 10% lower compared to our ferrous sector universe. We have cut our FY13 EBITDA and PAT estimates by 2% and 5%, respectively, due to the new price assumptions based on the current trend, but we have raised our FY14 EBITDA and PAT estimates by 3% and 7%, respectively, as the drop in raw material price assumptions is much more when compared to steel prices.