Bhushan Steel: Hold

Investors with a long-term perspective can adopt a ‘wait-and-watch' approach on their holdings in steel-maker Bhushan Steel. Despite the stock having run-up by 32 per cent over the last six months, the company's fundamental strengths, including a growing and lucrative product mix, increasing levels of integration and proximity to iron ore mines inspire confidence.

On the other hand, expected increase in competition and the strain on the company's profitability in the near-term due to rising interest and depreciation cost warrants caution. At Rs 424, the stock trades at around 9 times trailing 12-month earnings. This is at a slight discount to peers.

Bhushan Steel operates a two-million-tonne per annum steel plant in Odisha which produces hot rolled coils, one of its key inputs. This backward integration has bolstered Bhushan Steel's margins to around 30 per cent currently from 15-19 per cent a few years ago.

Expanding capacity

Over the last five years, Bhushan Steel has also added capacity in the value-added segment. The company has doubled its capacity to produce precision tubes and colour-coated galvanised steel. It has introduced more value-add products that enjoy higher realisations than hot-rolled coils.

Bhushan Steel's sales between 2007 and 2011 grew at a compounded pace of 17 per cent. Operating profits grew at double that pace. The company has been among the best performers in the steel space in terms of executing its expansion plans. Also, its EV/tonne premium over peers has rested on its superior product mix and higher realisations.

The company plans to up its steel-making capacity from the current two million tonnes to 4.7 million over the next two years. Currently, utilisation rate on the two-million tonne steel plant is at around 70 per cent.

Benefits in terms of increased sales volumes from the additional capacity are expected to reflect in FY2013-14. The company also plans to commission captive iron ore and coal mines in Odisha by 2014-15. Expansion plans are predicated on expectations of robust demand growth by the automobile and consumable durables sectors.

While demand in the last year has taken a hit primarily due to unfavourable macro-economic conditions, the company has managed to put up a good show. The nine months ended December 2011 saw sales grow by 41 per cent to Rs 7,700 crore on account of ramping up steel production and higher blended realisations.

Also, despite a sharply higher raw material bill, the backward integration paid off as the company maintained its 30 per cent operating margin when most peers saw margins dip sharply.

Net profits, though, slipped on account of a near three-fold increase in both depreciation and interest expenses which came with the freshly commissioned capacity. Net profits for the nine month period were down 7 per cent to Rs 693 crore.

Increasing Competition

Between 2008 and 2011, Bhushan Steel was among the few players that was on an aggressive expansion mode. Other majors such as SAIL, Tata Steel, RINL and Essar Steel were going slow in capacity additions.

However, the situation is different now, with most players adding capacity. It is expected that over the next two years, the Indian steel sector may add 15-20 million tonnes of capacity. A sizable portion of these additions is directed at the more lucrative flat steel market. This could translate into higher competitive intensity among domestic producers. In this context, ramping up captive mines will be crucial for Bhushan Steel to maintain high margins.

Risks

Bhushan Steel's ascent to the top of the steel value-chain has been on the back of debt. The company's gross debt-to-equity ratio stands at close to 3.

In the nine months ended December 2011, earning before interest and taxes covered interest cost just two times over. For Bhushan Steel to work out as a rewarding investment hereon, the key will be how quickly the company ramps up output and manages to grow revenue and profits faster than the expected increase in depreciation and interest costs.

While Bhushan Steel does have a solid execution track record, any slip-ups on this front may prove costly.

Other risks include a weakening rupee which will increase both the company's coking coal bill and interest payouts on the forex component of borrowings. Besides, a sustained bounce-back in demand for steel circa pre-2011 is important.

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