Tisco: The price rise effect

Come April, steel prices are expected to rise further. While Tisco has already announced a hike in prices by about 20% for its long-term customers, the others are expected to follow soon. However, the quantum of price hike by the other players will not be as steep as that announced by Tisco owing to the fact that they have been increasing prices periodically.

It must be recollected here that Tisco had refrained from raising steel prices in August 2004 in wake of the high inflation, which had then hovered at over 8%. In fact, it had reduced prices by Rs 2,000 per tonne to aid the noble cause of reigning in the country's inflation!

However, this did not affect the company's profitability, as the company continued on its path of costs reduction and enhancing its realisations by improving its product mix, thus helping it to absorb the impact of the price cuts announced then. These are vindicated by the fact that the operating margins of the company were at over 43% in 9mFY05 while its realisations per tonne also was higher.

It must be noted that unlike other steel companies, Tisco is in a significantly advantageous position considering that it meets all of its iron ore requirements and a bulk of its coal requirements internally. This has enabled it to insulate itself from the adverse impact of increase in input costs, in comparison with other global and domestic steel majors, who are forced to pass on the steep rise in input costs to consumers. The rise in average steel prices over the past few quarters must be considered in the backdrop that prices of steel inputs like iron ore (up around 150% YoY), coal (up around 200% YoY), coke (up around 125% YoY) and scrap (up around 230% YoY) having skyrocketed.

So, considering that Tisco has managed to increase profitability substantially in FY05 despite reducing prices, will the price hike for the new fiscal i.e. FY06 improve profitability further? Well, not exactly. This is because the price hike announced by the company is effective for its long-term contracts, which as per a company presentation made sometime back, constitutes to about 15% to 20% of the company's total sales. This is considering only the annual and half-yearly contracts of the company. Even if we consider the quarterly contracts, the price hike would cover another 8% to 10% of its contracts, taking the total to about 25% to 30%. Thus, the remaining portion of its sales would be governed largely by short-term price movements, which we are not very bullish on.

Further, it must be noted that the long-term contracts entered into by companies for assured supply of steel at an assured price (irrespective of the spot price movements), are generally made at a price lower than the spot price. Our cautious view on steel prices is also supported by our interaction with steel user-industries who have indicated that steel companies, unlike a few quarters ago, are now more willing to enter into long-term contracts. This is an indication that steel prices are nearing their peak. All these are probably the reasons that have not seen any major action in the Tisco stock despite the announcements.

However, while we will be revisiting our Tisco numbers soon (post a management meet) to incorporate the impact of increased steel prices, a back of the envelope calculations reveal that even based on optimistic assumptions (price realisations would be higher by about 10% YoY in FY06 and operating margins would hover in the vicinity of 45%), the EPS and book value per share would be around Rs 75 and Rs 195 respectively. This means that at the current levels of Rs 420, the stock is trading at a price to earnings multiple of 5.6 times our FY06 expected earnings and 2.2 times its FY06 book value.

Now, while the stock looks attractive in terms of P/E valuations, this is a typical characteristic of any commodity stock. During peaks or close to peak prices, the company's earnings are robust. But sustainability is always a question. It is therefore, pertinent for investors to look at what is in store for the sector in the year forward. With China increasingly giving indications of meeting it steel requirements internally, the threat of increased supplies and consequent pressure on steel prices is all the more evident. Further, considering our valuation parameter for steel stocks i.e. price to book value, which in the current phase of the steel cycle seems apt at 1 time to 2 times, the Tisco stock is currently trading above the upper band of the valuation parameter.

Amidst the possible upside potential in the near-term, we believe that the downside risk is more important. Since commodity cycle cannot be timed to perfection, it may not be worthwhile to extend the downside risk. To that extent, we advise caution.