SAIL

Investors can consider holding on to steel major SAIL, whose massive size in terms of production capacity, raw materials and cash, coupled with low levels of debt and a robust domestic market for its products, makes for a compelling case to stay invested.

Despite SAIL's advantages within the steel space, in terms of a domestic market focus, low leverage and abundant raw material supplies, the stock trades at a valuation that is on a par with its peers at around 12.6 times FY10 earnings at Rs 206

SAIL currently produces 13.4 million tonnes of crude steel at eight locations led by units in Bhilai and Bokaro. The company's sales and profits have grown at an annual compounded rate of 10 and 13 per cent since FY06. The commodity price collapse had led most of the top ten steel producers to slip into red over the last year.

SAIL, however, was among the exceptions, managing a profit growth of 9.4 per cent with operating profit margins at 24.4 per cent for the last financial year.

Expansion plans

It owes this to two factors: A robust business model that revolves around two production facilities in proximity to huge captive iron ore mines and a domestic market whose demand remained quite tight through the crisis.

Even by 2010, 75 per cent of SAIL's expanded capacity will be located in the mining belt of Chhattisgarh, Orissa and Jharkhand in close proximity to its various captive mines. The company's expansion plans include upping brownfield capacities by 70 per cent by FY13.

Factors that work strongly in favour of SAIL are the 20,000 acres of surplus land at its Bokaro facility and abundant quality captive iron ore mines rendering it self-sufficient on that front for the long term.

The land and the mines have been a major draw for steel majors, including Tata Steel, Posco and Arcelor Mittal, all of whom are seeking to collaborate with SAIL on facilities ranging from rolling mills to integrated steel production.

The upside for SAIL from such an alliance is quick access to value-added products in cold-rolled steel which would enable it move up the value and margin chain, in addition to access to technology such as FINEX which uses non-coking coal(readily available at a lower cost domestically).

The resulting reduction in dependence on coking coal(currently SAIL imports 70 per cent of its requirement) could reduce the cost structure for SAIL. Coking coal prices are up 55-60 per cent this quarter; the shift to quarterly contracts is a source of risk for SAIL, possibly denting operating margins. A good portion of the company's product mix is dominated by semi-steel, steel plates and hot rolled coils.

The company, through a combination of brownfield expansions and rolling facilities, hopes to eliminate the lower margin semis category in addition to doubling its capacities in higher margin categories such as structurals, cold rolled coils and coated products.

This will tilt the current 60:40 flat:long mix in favour of the more lucrative flat and value-added segment. This will augur well for margins over the medium term.

SAIL is nearly fully dependent on the Indian market for sales where the outlook is mixed. Volumes have remained buoyant through the downturn and recent evidence from indicators such as IIP numbers, construction activity indicate that volumes may hold up nicely over the next year.

Steel realisations, however, do not have the same sanguine outlook. After a four-month dream run where realisations and demand rose even as costs remained low, the converse situation may now pan out. Higher prices of coking coal and lower realisations now look set to moderate margins in the latter half of this fiscal.

With China applying the brakes on lending and construction activity in the last two months, global steel realisations may be hurt for the next few months. This could mean softer prices in the domestic markets too as Indian steel prices typically do follow global trends though with a lag.

Some growth risks

There are a few medium term risks to SAIL's volume growth too. China's capacity addition binge could cause a global overhang on steel capacity that can moderate prices.

A smaller but equally potent source of near-term annoyance is the European crisis leading to choppy commodities markets.

Domestically, long-term concerns relate to disruptions to SAIL's operations from local insurgencies.

The other is long term domestic over-capacity fears with scepticism over whether Indian infrastructure will be able to make the leap on investments.

On the leverage front, the company's capex plans are being funded through a mix of debt, cash and equity. The debt component has pushed its debt:equity figure from 0.27:1 at the end of FY09 to the current 0.5:1, a very manageable number considering the EBIT covers interest 26 times over! With cash balances of about Rs 22,000 crore as of March 2010, SAIL appears well placed to fund the capex.

Plans are also on to raise equity through dilution at the time of a government planned FPO which is likely to happen around the middle of the current financial year.

The expected equity dilution of 10 per cent, when viewed in context with the expanded business, does not pose a worry for investors who are in for the long haul.

via BL