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Buy Steel Authority of India: Earnings to rebound — valuations attractive
Action
Despite capacity expansion still two years away, we believe SAIL is a strong play
on increasing steel prices and improving earnings outlook. The stock has corrected
by 27.8% (vs a 7.8% fall in the Sensex) over the past three months on news of
FPO issuance and weak 3Q FY11 results. We believe the stock is trading at
attractive valuations and maintain our BUY with a revised price target of Rs212.
Catalysts
Improving steel prices along with timely execution of capacity expansion plans are
key triggers.
Anchor themes
SAIL is a play on strong domestic growth and captive iron ore. Raw material prices
remain high and integrated steelmakers are at an advantage. However, we reduce
our PT as capacity expansion has largely been pushed to FY14 and there are nearterm
earning risks on account of lower volumes and high coking coal prices.
Earnings to rebound — valuations
attractive
Earnings revised downwards, driven by lower volumes
and higher coking coal price estimates
We have revised our earnings estimates for FY11F and FY12F to
Rs12.7 and Rs15.9 from Rs16.3 and Rs19.1, respectively, primarily
on account of: 1) lower volume; 2) higher coking coal estimates; and
3) higher employee costs.
Attractive valuations – CWIP getting a negative value
On our revised estimates, FY12F core earnings are Rs14.2/share.
Therefore at 10x P/E, current capacity would be valued at
Rs142/share, and existing cash and equivalent would be Rs50/share.
This shows that market is assigning a negative value to the capital
work in progress (CWIP). The company already has spent close to
half of total capex, and commissioning of capacity should start from
FY13 in phases. Therefore, attributing a negative value to CWIP of
Rs240bn as of end 3Q FY11 (Rs100bn of the above is through longterm
debt) is not fair, in our view. We believe current valuations are
very attractive at 7.5x FY12F P/E and 4.1x EV/EBITDA (adjusted for
CWIP) and maintain a BUY on the stock with a revised price target of
Rs212 (driven by our earnings revision).
Earnings to rebound in 4Q FY11F
The stock has corrected by 6% (vs a Sensex correction of 1.8%) on
the back of weak 3Q FY11 results. We expect SAIL to clock earnings
improvement from 4Q FY11, driven by: 1) strong volumes – this
should also result in strong operating leverage for SAIL; 2) higher
steel prices – prices have gone up Rs2,000/t since December; and
3) the limited impact of higher raw material prices on account of
captive iron ore and low cost coking coal inventory.
Drilling down
Expect revival in Q4 after a weak Q3
We expected 3Q FY11 to be a tough quarter for SAIL owing to 1) limited price
increases — long products did see some price hike, but flat product prices remained
soft; 2) raw material prices remained high — despite some softening in coking coal
prices, SAIL continued to use coking coal secured at US$300/t, as per contracts of the
previous year (20% of total requirement) and stocks of the previous quarter at
US$225/t.
However, the stock corrected by 6% (Sensex off 1.8%) after 3Q FY11 results as
earnings were significantly below consensus estimates (Rs11bn vs. expectation of
Rs14bn).
However, going forward in 4Q FY11, we believe earnings should rebound given
1) steel prices have gone up by Rs1000/t each in December 2010 and January 2011;
2) the company has 1mn tonnes of coking coal inventory from last quarter at US$206/t,
which should limit the cost increases despite higher contract prices for 4Q FY11; 3) 4Q
is generally the highest volume quarter, which should result in strong operating
leverage.
SAIL’s volumes down since start of capital expenditure
SAIL’s crude steel production has softened after peaking in FY08 at 13.96mn tonnes.
A look at the chart below suggests that production started getting impacted from 1Q
FY09, when SAIL started its capex. However, the company has said that its ongoing
expansion has not affected production in any way.
Earning revised downwards – driven by lower volumes and
higher coking coal costs
We have revised down SAIL’s FY11F and FY12F earnings estimates to Rs12.7 and
Rs15.9 from Rs16.3 and Rs19.1, respectively, primarily on account of lower volumes,
higher employee costs and higher coking coal cost estimates.
We expect FOB HR coil global export prices of around US$650/t for FY11F and
US$700/t for FY12F. However we increase our coking coal price estimates from
US$241/t earlier to US$255/t for FY12F, as we expect 1Q FY12 to see very high
coking coal prices due to disruption of supply on account of the Queensland floods.
We have revised down our sales volume expectations since the majority of the
expansion has been pushed back to FY14 and near-term volume has also been
impacted. We expect sales volume of 12.36mn tonnes and 12.82mn tonnes in FY11F
and FY12F, respectively, from 13mn tonnes and 13.5mn tonnes earlier. We believe
the pace of commissioning of capacities will be slower and meaningful production from
expansion will start from FY13 only and will largely be bunched up in FY14.
Employee costs remain high – rationalisation of costs only after
full expansion
SAIL’s employee costs remain high at Rs5,400/t as against Rs4,000/t for TATA Steel
and Rs811/t for JSW Steel. While JSW’s lower cost is because it does not have iron
ore mines, SAIL’s employee costs are higher even compared to TATA Steel, which
has better raw material integration.
SAIL plans to improve employee productivity not only through reduction in the number
of employees, but also by increasing production. SAIL plans to reduce the number of
employees to 100,000 in the next two to years, which along with higher capacity
should rationalise employee productivity.
SAIL’s EBITDA is largely from iron ore — inefficient
steelmaking a drag
SAIL’s current EBITDA/t of Rs5,000-6,000/t is largely from its captive iron ore. Its
steelmaking operations hardly generate any EBITDA. While TATA Steel and JSW
generate EBITDA of US$ 80-100/t from steelmaking operations, SAIL’s contribution is
negligible. This is the key reason for the profitability gap between TATA Steel and
SAIL, despite both having captive iron ore.
SAIL’s modernisation plan is key for improved profitability
going forward
Factors such as 1) high employee costs; 2) low yield of blast furnace and casters;
3) poor product mix; and 4) high coke rate/energy consumption have weighed on
SAIL’s steelmaking operations. The key improvements that could make a difference, in
our view, are:
employee cost/t rationalisation once full expansion is complete
higher yields, with the commissioning of new blast furnaces and modernisation of
older furnaces together with sinter plant and 100% continuous casting (from 66%
currently)
removal of semis from its product mix. Currently SAIL has close to 15% semis in its
product mix, which will be rolled in value-added products. This will add to the
profitability
reduction in the coke rate and energy cost, by using 1) higher pulverised coal
injection (PCI) – this will reduce coke requirement in blast furnace; and 2)
continuous casting, which will reduce energy loss. This should help SAIL reduce
coke rate from current levels of 520kg/t to 450kg/t, on our estimates.
All these initiatives together can increase EBITDA/t from steelmaking operations by
US$70-80/t, in our view.
Expansion to come in phases — significant part back ended
SAIL plans to double its capacity to 25mn tonnes of hot metal in the next 2-3 years. It
has undertaken various brownfield expansions at all its locations, and these will come
on line in phases. However, most of the expansion is back ended, and we only see a
significant jump in production from FY14.
Government divestment / dilution by company to be completed
in the near term
The Government of India plans to divest a 10% stake in the open market, with the
company also planning to come out with a follow-on offer for equity dilution of 10%.
This will be done in two tranches of 5% each.
The company has indicated that it will be filing a red herring prospectus soon for the
first phase of the issue, and expects the issue could come to market in the near term.
Valuations
Maintain BUY – revising our price target to Rs212
We value SAIL at 10x FY12F core earnings (unchanged) and add total capex done
through FY12F at face value to arrive at our price target of Rs212. While core business
contributes Rs142/share, Rs89/share comes from capex done. We have subtracted
Rs79bn of net debt from the above, which is Rs19/share. Our methodology is
unchanged, with the revision driven by our revised earnings estimates
Sensitivity analysis
SAIL earnings are driven by steel prices, as well as coking coal prices. Owing to
captive iron ore, the company is not impacted by fluctuation in iron ore prices. In the
table below, we present our calculations for SAIL’s sensitivity to steel prices and
coking coal prices.
Key risks
Coking coal prices higher than our estimates
Government divests its stake at significant discount to market price
Further delay in expansion plan
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