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Tisco: On a 'hot' roll

Jan 20, 2005

Performance summary
Domestic steel major, Tisco, continued to report strong quarterly numbers. The sustenance of the steel cycle has helped the company enjoy better realisations, thus aiding its operating margins, which have registered a considerable improvement on a YoY basis. This bottomline performance of the company is impressive and is inline with our upgraded estimates post the company's 2QFY05 results.

(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Net Sales 26,320 37,313 41.8% 75,021 106,343 41.8%
Expenditure 17,516 21,597 23.3% 51,902 60,319 16.2%
Operating Profit (EBDITA) 8,805 15,716 78.5% 23,120 46,024 99.1%
EBITDA margin (%) 33.5% 42.1% 30.8% 43.3%
Other income 262 338 28.8% 1,007 1,183 17.5%
Interest 597 809 35.5% 1,932 1,774 -8.2%
Depreciation 1,479 1,495 1.1% 4,395 4,666 6.2%
Profit before tax 6,991 13,749 96.7% 17,800 40,768 129.0%
Extraordinary items (116) (22) (842) (523)
Tax 2,404 4,822 100.6% 5,784 14,590 152.2%
Profit after Tax/(Loss) 4,472 8,905 99.1% 11,173 25,656 129.6%
Net profit margin (%) 17.0% 23.9% 14.9% 24.1%
No. of Shares (m) 369.2 553.7 369.2 553.7
Diluted earnings per share* 48.5 64.3 40.4 61.8
Price to earnings ratio (x) 5.5 5.7
(* annualised)

About the company
Tata Iron and Steel Company (Tisco) is India's largest private sector steel company. The company has the distinction of being one of the lowest cost steel producers in the world at about US$ 158 per tonne for hot rolled coil. The company has a total steel capacity of 4 m tonnes with expansion plans of 1 m tonnes by September 2005. The company also intends to add another 2.4 m tonnes of capacity, which is likely to be completed by FY09 and another 6 m tonnes in phases by FY11. Tisco has been focusing on increasing contribution from value-added and branded products and derives over 1/3rd of its total revenues from these. Exports form about 15% of its revenues.

What has driven the performance in 3QFY05?
Realisations led topline growth: Tisco continues to reap the benefits of a strong steel cycle as it enjoys strong realisations for its produce. Almost the entire increase in topline during the quarter (akin to the previous few quarters) has been a factor of strong steel prices. Just to put things in perspective, the topline registered a YoY growth of 42% for the December quarter despite volume sales having grown by under 2%. It must be noted that average steel prices in the domestic markets during the quarter were higher by 34% compared to the corresponding quarter last year. Further, higher contribution from better margin product sales i.e. value-added products has also aided the topline growth. It must be noted that Tisco has constantly been making efforts at improving its product mix since the last few quarters with higher focus on branded products sales like those of Tata Shakti (corrugated galvanized sheets up 13%), Tiscon (Rebars up 15%) and Tata Steelium (cold rolled sheets up 27%).

Corresponding to the strong growth witnessed on the domestic front, the company's exports have also increased at a similar pace (40% YoY) during the quarter. The average steel prices ruled stronger by over 50% YoY in the international markets on the back of increasing input costs. Average steel prices in Europe and the US have continued to remain strong, with average prices hovering near the US$ 600 per tonne mark. While the company does not provide the details of exports, as per reports, Indian steel companies have been directing their exports to these western regions rather than China, owing to better steel realisations there.

Operating margins leapfrog: Led primarily by the rise in steel realisations, margins continued to move northwards, ultimately getting reflected on the company's bottomline (see chart below) owing to the company's high operating leverage. The operating margins leaped by 860 basis points during the quarter to over 42%. Further, though the operating expenditure witnessed a 23% YoY growth during the quarter, thanks to the stronger topline growth, operating expenses as a percentage of net sales actually declined. Control over various operating expenditure heads like staff costs and power also aided this sharp improvement in operating margins. Raw material expenses as a percentage of sales fell by 80 basis points to 13% during the quarter. This could be attributed to the fact that the company, being an integrated player, enjoys certain inherent advantages. Captive iron ore mines and meeting more than 50% of its coke requirements internally, insulates the company from the upside volatility in these input costs.

Net profits double: This was largely a factor of the strong growth witnessed at the operating level combined with a 29% growth in other income. However, while depreciation remained unchanged, interest expenses have registered a rise of 36%, which is in contrast to the trend being witnessed over the last few quarters. Its provision for taxes also doubled. Despite all of the above, the company managed to almost double its bottomline.

What to expect?
Until now, strong domestic and international demand for the metal has kept volumes as well as steel prices buoyant. At the same time however, it must be noted that China, which has been the primary driver of commodity prices over the last couple of years has displayed signs of slowing down (though marginally), which is a result of concerted efforts by Chinese authorities. This has led to softening of steel prices in that country. However, simultaneous recovery in the US and European markets has helped keep the demand for steel buoyant consequently leading to strengthening prices in the region. This could keep the exports market ticking for domestic steel companies. Further, going forward, with the demand showing little signs of cooling off and the production of the metal on the rise, the raw material shortage is likely to continue in the near future, which will prevent a significant correction in steel prices.

At Rs 352, the stock is trading at a P/E multiple of 5.7x its annualised 9mFY05 earnings. Though at this juncture, Tisco's valuations look rather appealing, investors need to understand that steel, being a cyclical industry, is expected to witness a downturn, which we believe is seemingly in the near future. This belief is further strengthened by the fact that as per reports, China has already turned a net steel exporter in the closing months of 2004 as it increasingly meets its metal demand internally. However, because of the imports in the earlier months of the year, 2004 has seen China closing a net importer of steel.

While it is difficult to time the downturn of the steel cycle, we believe that in the near term atleast, the buoyancy in prices could sustain. However, owing to increasing input costs and Tisco having opted to refrain from raising steel prices until the end of FY05, pressure on margins is likely to continue. Though the YoY picture could still remain impressive, the sequential performance of the company must be noted wherein the company's operating margins have declined from 44% in 1QFY05 to the current 42% (3QFY05). We continue to remain apprehensive about the medium term growth prospects of the sector as a whole, as we feel that the risk-return ratio is against the investor.

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