Jindal Steel and Power

Shareholders can consider holding on to the stock of Jindal Steel and Power, now trading at 15 times trailing 12-month earnings, despite the run-up in stock price.

While this is at a stiff premium to peers in the steel sector, it is at a discount to power majors such as NTPC and Tata Power, which are at 20 and 19 times trailing earnings respectively.

The premium valuations can be justified by the company’s major expansion plans for both its steel and power holdings, backed by a solid execution track record.

The company’s raw material linkages and high operating margins for its steel business and high realisations and captive fuel for the power business, make the stock a good exposure to both the sectors.
Conditional promise

Jindal Steel and Power (JSPL) has gradually added capacity over the past three years to produce three million tonnes of steel at its Chhattisgarh plant, with the product line comprised mainly of ‘long’ products.

These products cater mainly to the infrastructure segment, including Railways and structural products for real estate, bridges, and so on.

JSPL’s raw materials and power requirements for steel are largely met by captive sources. The company’s operating margins, averaging an impressive 38 per cent since 2005 and at 33.4 per cent for FY-09, are higher than peers such as SAIL and JSW, mainly due to this backward integration.

Sales have grown at a compounded average of 44 per cent annually during the same period. The company has plans to add 2.2 million tonnes of capacity at Jharkhand and Chhattisgarh by 2010 and another 7.8 million tonnes at Orissa and existing locations by 2012-13, quadrupling its output over three-four years.

Sober estimates point to a total domestic capacity of 80-85 million tonnes by 2014, of which JSPL’s share is small. Keeping in mind the long overdue push in infrastructure development, these volumes should be easily absorbed by the market. .

With lower debt on its balance sheet than peers giving it a debt:equity ratio of 0.95:1; JSPL enjoys a comfortable interest cover of eight times, with a healthy net profit margin of 28 per cent in 2008-09.

Excluding the value of JSPL’s power subsidiary (valued at about Rs 28,000 crore), the residual market capitalisation for JSPL’s steel business is about Rs 23,700 crore.

That suggests that the steel business is valued at 15 times the 2008-09 earnings. Assuming the company produces 5.2-5.5 million tonnes of steel by 2010-11, the PE multiple would amount to 10 times on forward earnings. However, it is the power business with its high margins and increased capacity that is the company’s trump card.

The power business contributed to a third of the company’s sales and slightly more than half the operating profits in 2008-09.
POWERFUL SUBSIDIARY

Despite being an early mover in the private sector power generation, JSPL has conservative capacity-addition targets compared to many new entrants. The company now has a total capacity of 340 MW on its books and 1,000 MW in its subsidiary, Jindal Power (JPL). JPL plans to add 2,400 MW (brownfield expansion) in Tamnar, Chhattisgarh and JSPL targets 2690 MW captive addition for its steel requirement over the next four years.

In addition, JSPL has entered into an MoU with the Arunachal Pradesh Government to set up 4500 MW of hydro projects. Captive coal mines allotted to the company for the 1000 MW power project minimise fuel risks and reduce input and transportation costs. The fact that JSPL’s sales are pegged entirely to merchant power tariffs offers scope for higher realisations than other power generation companies that are subject to regulated tariffs.

The company’s costs are also low, thanks to its fuel linkages. Captive transmission lines (400 KV, 254 km line) connected to the national grid put the company at an advantage to wheel its power for merchant use.

The company will continue to enjoy high realisations, helped by merchant power, given that the demand-supply mismatch is likely to persist over the next three-four years. Surplus capacity from the captive power plant with JSPL is currently being sold on a merchant basis.

With the company adding to captive capacity, surplus generation from these projects may also contribute to revenues over the next couple of years.

Last year, 1125 million units (MU) were sold on a merchant basis from the captive power plant, besides the 6369 MU sold by the power subsidiary. Revenue contributions from the Tamnar project are likely to increase in the current year as the project operates at its full capacity.

JSPL has plans to unlock value in its power subsidiary by listing it early next year. Investors can expect higher earnings growth from the company’s power segment even if average realisations moderate with the demand-supply gap narrowing.

With a good portion of the upcoming power capacity to reflect in JSPL’s own books, the listing of the power subsidiary may only unlock partial value from the power business. Of the total 5090 MW thermal capacity to be added in the next four years, only 2400 MW is being developed by Jindal Power.

Assuming a conservative PE multiple of 15 times the 2010-11 earnings for the power subsidiary, the market capitalisation for this business works out to about Rs 28,000 crore (Rs 363 per share).

We have assumed revenues from the present power capacity of 1000 MW project alone. A proven track record in executing and operating power projects and assured fuel and distribution linkages may make Jindal Power a preferred exposure to the power generation sector.