SAIL: Buy

The palpable sense of urgency among top global steel makers to snap up iron ore and coking coal assets across the world has brought into spotlight India's top steel producers, several of which have captive mines. Chief among them is SAIL, India's largest domestic steel producer, and a bet worth taking in the steel space.

At Rs 155, the company trades at around 12 times trailing earnings, which is at a premium to peers such as JSW Steel, Bhushan Steel and Tata Steel. The company's current EV/tonne of around Rs 50,000 is also at a premium to peers, but appears reasonable, given the limited debt being planned for upcoming capacity and substantial iron ore mining assets the company holds.

Supporting the premium are the company’s solid financials, land bank available for expansion and iron ore mines that should lend support to its valuation. While the company appears to be reasonably valued at current levels, given expected weakness in earnings resulting from high coking coal prices, investors could use possible dips as an opportunity to buy into the stock.

BUSINESS AND NUMBERS

Through eight domestic plants, SAIL produces long and flat steel products for a variety of applications, including rail-lines, infrastructure, and automobiles among other applications. The company's product mix is skewed towards long products which account for 60 per cent of volumes.

The company's sales and net profits have grown at a compounded pace of 5.6 and 3 per cent respectively over the last three years. The lacklustre numbers are a result of the minimal capacity-additions and see-sawing steel realisations over the three-year period under consideration.

The captive iron ore mines and power, with the latter meeting 70 per cent of the company's power requirements, have enabled the company to operate on EBITDA margins of between 26 (in 2009-10) and 33 per cent over the last three fiscals.

With the addition of Chiria and two other iron ore mines to the company's existing roster of five mines, the company expects its captive iron ore operations to meet its entire requirement over the long term.

The same cannot be said of the company's coking coal requirement. About 70 per cent of the company's requirement is imported. With prices soaring over the last three quarters, a condition exacerbated by the Australian floods, the company's coking coal bill has risen. This, combined with provisioning for employee benefits, dented operating profit margins for the first nine months of FY-11 by 8 percentage points to 20.6 per cent.

Compared to the same period the year before, the first nine months of FY-11 saw net sales grow by around 8 per cent to around Rs 31,000 crore due to higher realisations. Net profits during the same period were lower by 27 per cent to Rs 3,400 crore as higher coking coal prices ate into margins.

GROWTH PLANS

The company's saleable steel production capacity is set to rise from the current 12.6 million tonnes to 23 million tonnes by the last quarter of 2013. The company's significant land resources at existing locations have rendered substantial brownfield additions a relatively simple task. The same trait has also made it an attractive partner for Kobe and Posco for small mills.

The crucial moves, however, are in the addition of new blast furnaces and increasing the proportion of steel processed through the continuous casting method at Bhilai, Bokaro, Rourkela and Durgapur. In addition to improving the quality of steel produced, the new capacity should enable the company lower the impact of coking coal prices on the overall raw material bill.

Concurrently, the company also plans to exit several ?fungible' product lines such as semis by adding rolling and value-added steel production capacity such as auto-steel and CNRO steel. Realisations, which are currently lower than peers such as Tata Steel and JSW, will improve as a result of the enhanced product mix which will lower the proportion of low-yielding long products.

STEEL OUTLOOK

A series of hikes effected over the last four months have left steel prices higher by 15-20 per cent. This has not kept pace with the spike in coal prices over the same period. India's steel production grew by 6.4 per cent to 67 million tonnes in 2010, a pace which is expected to be bettered, thanks to increased spending on infrastructure.

The pricing environment is likely to remain a difficult one for steel producers through a large part of 2011 as a not-so-transparent pricing mechanism for several raw materials, coupled with a more fickle and price-sensitive finished steel market, make for a difficult combination.

The company's current coking coal requirements are met by 70 per cent imports (a large portion from Australia), which is blended with locally procured coal (Coal India). Both components have seen substantial hikes of between 20 per cent and 30 per cent over the last four months due to supply-related issues.

A complete pass-through to final steel consumers remains unlikely, which means steel producers may have to bite into their margins for the next two quarters.

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