SAIL: Buy

The stock price of domestic steel producer, SAIL, has shed 57 per cent over the last one year. It has underperformed several large peers and the BSE Metal Index.

Trading at Rs 73, the share is valued at eight times the trailing 12 month earnings, which is at the lower end of its historic price-earnings multiple. The correction appears to be overdone. SAIL's current enterprise value of Rs 28,000 per tonne of steel undervalues its substantial iron ore mine leases and upcoming capacity additions.

TRYING TIMES

The first half of the year was a trying period for SAIL. Volumes remained flat at around 6.1 million tonnes. Sales during the period rose by 10 per cent to Rs 21,663 crore, driven by higher realisations, as domestic steel producers found strong support in an appreciating rupee which made steel imports more expensive. Utilisation rates remained over 100 per cent during the period. Net profits took a hard knock and dipped by 41 per cent to Rs 1334 crore.

The key culprit for the decline was Rs 520 crore of forex losses, attributable to the company's short-term foreign currency borrowings.

Two other major factors were the raw material and power bill, which rose by 13 and 25 per cent respectively, hurting operating margins; they dipped by nearly seven percentage points to 14 per cent during the first half of FY12. While cost pressures are expected to continue into the ongoing quarter, metallurgical coal prices for Q4 FY12 have settled at 17 per cent lower values than the previous quarter which bodes well for SAIL, which imports 75 per cent of its requirement. The worst in terms of cost pressure from metallurgical coal may be behind the steel sector.

EXPANSION BLUES

A major concern was the sullen pace of SAIL's expansion plans. Twenty per cent of SAIL's output comes from energy-guzzling open hearth furnaces and the company's conventional coke ovens require more imported coal than modern equipment. The company's realisations also tend to be lower because it sells 22 per cent of its steel in semi-finished form.

Fixing all of these, rolling out larger and more efficient blast furnaces and rolling mills are part of SAIL's Rs 40,000 crore investment plan, these are efforts to get more competitive. The company is increasing capacity from 13 million tonnes to 20 mt.

The benefits of expansion are expected to accrue by end-FY14. The company's debt levels have risen, but gross debt:equity ratio stands at 0.6.

Profits before interest and tax covered interest five times over, during the sombre first six months of FY12, which indicates the company does have the capacity to service more debt.

With current EV/tonne at Rs 28000 based on current capacity (a 45 per cent discount to replacement cost), investors seem to have taken an extraordinarily bearish stance on SAIL's expansion troubles.

However, at this price, factoring in the improving dynamics of large-scale integrated steel producers in the domestic market and around two billion tonnes of iron ore reserves, SAIL's assets appear to be valued at a bargain.

Scale will pay a key roll in providing the requisite buying power for raw materials whose markets are increasingly competitive.

The only cheaper asset available in the market is an ore-deficient JSW Steel, whose capacity additions from this point entail significantly higher levels of leverage and single-location risk than SAIL.

One notable risk looming is of wage-hike negotiations which are likely in January. Any hikes could result in further margin pressure until new capacity is commissioned.

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