The Hindu Business Line : Essar Steel: Hold

SHAREHOLDERS can consider retaining their exposure in the Essar Steel stock. Positive outlook for steel prices, higher demand and growing share of value-added products are likely to drive revenue growth in the medium term. At its current price, the stock trades at a multiple of about seven times its FY 05 earnings on a fully diluted basis. Although this appears stiff when compared to the likes of Tata Steel and SAIL, we believe that going forward, earnings growth is likely to support current valuations.

With an intent to reduce its huge level of debt ( debt to equity ratio of over 12) and improve profitability,the company went in for Corporate Debt Restructuring (CDR) in 2002.Post CDR,there has been a substantial reduction in cost of funds.Interest as a percentage of sales has declined from about 22 per cent in 2002 to about 9 per cent in 2005.Revenues over the past 12 quarters have grown at a CAGR of about 1.5 per cent while earnings growth has been tepid at about 5.5 per cent. For 2004-05, the company's performance has been noteworthy. While the revenues were up 62.3 per cent to Rs 6,533 crore, earnings increased ten-fold to Rs 590 crore. This was primarily on account of higher volumes and better realisations. The share of value-added products rose substantially to over 35 per cent of sales volumes against 20 per cent last year.

The numbers for the first quarter were impressive. The revenues grew 24.5 per cent on a YoY basis, while the post-tax earnings were up 300 per cent.

However, on a sequential basis, while the revenues fell 12.5 per cent, earnings dipped 23 per cent. This can be seen as an impact of lower volumes on account of slowdown in demand. However, the interest cost came down by about 25 per cent.

The company recently completed the acquisitions of Hy Grade Pellets Ltd (HGPL) and Steel Corporation of Gujarat Ltd (SCGL) from Stemcor, UK. Acquisition of HGPL, which operates a four-million-tonne per annum pellet (major raw material) plant at Visakhapatnam, should give Essar Steel better control over supply and costs of inputs. Acquisition of SCGL, which has 1.2 million tonnes of cold rolling capacity, is expected to add greater value across the value chain.

Essar Steel has a wide product mix consisting of hot rolled and cold rolled coils, sheets, plates and galvanized products.

To tap the niche market, the company last year launched hot-rolled dual phase steel, which finds application among auto components and precision tubes manufacturers. It has entered into a supply agreement with Delphi automotive systems to supply new grade steel-based auto components to General Motors in the US. Currently, the $1-billion domestic auto component industry, seen as one of the largest consumers of this material, imports a greater part of its dual-phase steel requirements.

The industry, which is expected to touch the $5-billion mark by 2008, offers an attractive opportunity for the company to grow, thereby reducing its dependence on exports. Although in terms of domestic market size, there appears to be huge potential, the confidence level of component manufacturers in sourcing from domestic steel players remains to be seen. Its augmentation of hot rolling capacity (from 3 mtpa to 4.6 mtpa), which is expected to be completed by September 2005 at Hazira, is likely to add further impetus to its volume growth.

The company's products find acceptance among a large number of customers. In the domestic market, its clients include Ashok Leyland, ABG Shipyard, Indian Railways and Hero Cycles, among others. On the export front, it has clients such as LG, Hyundai and General Motors.

The demand from user industries — automobiles and auto components, structural engineering, construction and ship-building — is expected to grow at a healthy 5-10 per cent over the next two-three years. Volumes may grow 5-6 per cent and the average realisations 0-5 per cent over the next two-three quarters leaving room for expansion in earnings.

However, slower-than-expected growth in demand and a further expansion in equity remain principal risks to the company's business and, hence, to our recommendation.

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