Bhushan Steel

Investors can consider picking up shares in steel producer, Bhushan Steel, which trades at Rs 1,570 or 9.4 times the trailing 12 months earnings. The company's aggressive expansion into integrated steel production is likely to lead to better margins and pricing power. This coupled with robust demand for cold-rolled steel variants from the automotive and consumer durables sector make for good odds on this bet paying off over the next two-three years. The company's multiple is at a discount to the steel sector, which trades at 15-16 times earnings.

THE STORY

Bhushan Steel imports hot-rolled steel coils from Tata Steel, SAIL, among other sources. They then re-roll these coils into cold-rolled coils, used mainly by the automotive and consumer durables segment.

The cold-rolled coils are further processed with various coatings, included galvanising (zinc coating), colour coating and so forth. With raw material costs being volatile and the consumers price-sensitive, intermediate players such as Bhushan Steel are left vulnerable to the steel price and consumption cycle. Downturns or spikes in one or both could leave them either with healthy margins or cringing from being squeezed for the last penny.

A move to ease this pressure is Bhushan Steel's transition into a steel producer with captive iron ore and coal mines. The company is in the process of setting up a five-million tonne per annum plant in Orissa to produce hot-rolled coils, a vital input. This would neatly complement their re-rolling facilities in Khopoli, Maharasthra and Sahibabad, UP, by ensuring timely raw material supply. This means incurring a higher fixed cost on operating mines and a steel plant even during downturns in the steel cycle. But integrated producers have less to fear from both the swings in the cycle and oligopoly-ridden raw material setup within the steel sector, than standalone producers.

THE NUMBERS

The company's net sales have grown at 17 per cent annually between FY-05 and FY-09 and net profits at 29 per cent during the same period. Estimated FY-10 sales are likely to be up by 7-8 per cent while net profits may close to double compared to FY-09. The company is quite high on leverage which stood at 3.6:1 at the end of FY-09.

However, the company has seen some relief on debt, evident from the fact that interest cover improved from 3.22 times to 5.75 times for the first nine months of FY-10. Operating margins have been on the rise and peaked at 22 per cent for the first nine months of FY-10, double the average between FY-05 and FY-09. This is largely due to a favourable raw material cost scenario and buoyant demand from users. There is significant scope for upside in margins considering the company's foray into producing HR coils.

WHY THEM?

Bhushan Steel now processes over 600,000 tonnes of HRC into cold-rolled steel, with a capacity to process just over a million tonnes. It also produces rods, strips and billets. When the second phase of the Orissa plant becomes operational shortly (test runs are underway), it will produce just under two million tonnes of hot-rolled coils which should comfortably meet the in-house requirements.

Add to this mines, a captive power plant and another three-million tonnes of steel production that should become operational by FY-14, and the company appears well-positioned to capitalise on the expected growth in automobiles and consumer durables.

Another trump card is the fact that the land for the Orissa project has been secured, something which several major names are having immense trouble with in the mining belt.

Moves such as a technical tie-up with Sumitomo of Japan to produce auto-grade steel (a sought after competence) and the acquisition of the Australia-based Bowen Energy (high-quality coke) for raw material security are likely to aid margins in the long run. Also on the cards is a steel plant in West Bengal or Karnataka with Sumitomo holding a sizeable stake.

Concerns

Automobiles and consumer durables, Bhushan's key users, proved quite resilient during the recent slowdown. Automobile sales have grown 30-40 per cent in the past 11 months. Same is the case with several consumer durable segments such as refrigerators and air conditioners.

The consumer durables IIP in Apr 2009-Feb 2010 period grew by 25 per cent over a year ago; this compares to a modest 4 per cent growth over the previous year. Both demographics and macro-indicators indicate a healthy doubling or tripling of automobiles and consumer durables over the next five years; however, the growth is likely to be lumpy.

Bhushan's phased transition into a fully integrated steel producer, if successful, holds the promise of pushing up operating profit margins north of 25 per cent if the price cycle remains firm.

But until the mines are operationalised, Bhushan will have to purchase iron ore and coking coal from volatile spot markets, where current forecasts are beginning to take extreme hues with prices expected to plunge if turbulence in Europe and a slowing Chinese economy pan out.

In such a scenario, India is expected to see steel prices plunge. Alternatively, if governments continue to play the white knight to fragile economies, mining majors may continue to wield pricing power. Steel players will then reap the benefits of volume-driven growth with profits on a leash.

via BL