Like most other steel companies,Steel's operating performance has been weaker than our expectation. The company's consolidated EBITDA margin contracted to about 10.5% for the nine months ended Dec. 31, 2011, from about 14% in the same period in 2010. The decline in global steel capacity utilization, weak European operating environment, and high raw material prices caused the contraction.
We believeSteel's performance in the quarter ended March 31, 2012, will be better than in the previous quarter because of lower raw material costs and re-stocking in Europe resulting in a moderate increase in steel prices. But this improvement is likely to be temporary. Despite our negative outlook on the steel sector, we expect the company's performance to improve in the fiscal year ending March 31, 2013, with the soon-to-be commissioned 2.9 million tons per annum brownfield expansion in Jamshedpur.
We assess Tata Steel's business risk profile as "fair". The company has a good market position, in our view; it is the second-largest steel producer in Europe and the third-largest in India. Tata Steel also has a 50% market share in terms of sales volumes in the U.K. The company's product mix is good, with a large proportion of value-added products.
We assess Tata Steel's financial risk profile as "significant". The company's financial performance was weaker than we expected during the 12 months ended Dec. 31, 2011. The ratio of debt to EBITDA remained about 3.9x despite cash proceeds of about US$1.35 billion, largely for a part sale of Riversdale Mining Ltd.
We expect Tata Steel's cash flow protection measures to remain constrained in fiscals 2012 and 2013. The company's free operating cash flow (FOCF) is likely to remain negative because of capital expenditure of about US$2.5 billion annually in these two fiscals. We now expect Tata Steel's ratio of debt to EBITDA to remain about 4x-4.3x in fiscals 2012 and 2013.
We believe Tata Steel has "strong" liquidity, as defined in our criteria. We expect the company's sources of liquidity to exceed uses by more than 1.5x in the 12 months ending Dec. 31, 2012, and more than 1x in the subsequent 12 months. We anticipate that the company's net sources of liquidity will remain positive even if EBITDA declines 30%. Our liquidity assessment is based on the following factors and assumptions:
-- Tata Steel's liquidity sources include a cash balance of Indian rupee (INR) 156 billion and unused credit facilities of INR52 billion as of Dec. 31, 2011. The company is likely to primarily use the credit facility to fund its capital expenditure in India.
-- Liquidity sources also include our projection of funds from operations (FFO) of about INR80 billion in the next 12 months, INR15 billion from a recent 10-year rupee bond sale, and INR6 billion proceeds from a warrant conversion by Tata Steel's largest shareholder Tata Sons Ltd. (not rated).
-- Tata Steel's uses of liquidity include capital expenditure of about INR125 billion in the next 12 months, debt maturities of about INR45 billion, and dividend of about INR7 billion.
We believe the company has strong financial flexibility, with good access to domestic capital markets, strong banking relationships, and potential to sell investments in group companies such Tata Motors Ltd. (BB-/Stable/--). In addition, Tata Steel has significant headroom under its financial covenants.
The stable outlook on Tata Steel reflects our expectation that the company's operating performance will improve over the next 18 to 24 months.
We may raise the rating if we expect Tata Steel's financial strength to improve further, such that the ratio of debt to EBITDA falls to less than 3.0x or the ratio of FFO to debt increases to more than 25%. Such an improvement could be due to: (1) higher cash flows from Tata Steel's Indian operations after it ramps up production at its brownfield expansion; (2) a significant improvement in demand, particularly in Europe, though we consider this less likely; or (3) the company's strategic measures, such as raising fresh equity or monetizing some investments, to reduce debt.
We may lower the rating if Tata Steel is unable to sustain the improvement in its operating performance or the commissioning of its brownfield expansion is significantly delayed, resulting in a weaker financial performance. Downward rating triggers are the ratio of debt to EBITDA rising above 4.0x or the ratio of FFO to debt falling to less than 15%.