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SAIL: Back to square one… - Views on News from Equitymaster
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SAIL: Back to square one…
Jan 27, 2006

Performance summary
Steel sector behemoth, SAIL, has announced results for the third quarter and nine-month period ended December 2005. Though not surprising, the performance has further deteriorated during the quarter. Not only has the bottomline registered a decline, the operating margins have halved from what they were in 3QFY05 and this has severely impacted the company’s bottomline, which too has fallen more than 50% YoY. The company has announced an interim dividend of Rs 1.25 per share (dividend yield of 2.4%).

(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net Sales 77,691 63,345 -18.5% 197,603 187,509 -5.1%
Expenditure 46,603 49,620 6.5% 129,362 134,244 3.8%
Operating Profit (EBDITA) 31,088 13,726 -55.9% 68,241 53,265 -21.9%
EBITDA margin (%) 40.0% 21.7%   34.5% 28.4%  
Other income 642 1,089 69.7% 2,056 3,713 80.5%
Interest 1,756 1,056 -39.8% 4,476 3,499 -21.8%
Depreciation 2,868 3,112 8.5% 8,431 8,753 3.8%
Profit before tax 27,106 10,646 -60.7% 57,391 44,726 -22.1%
Tax 11,964 3,800 -68.2% 16,001 15,374 -3.9%
Profit after Tax/(Loss) 15,142 6,846 -54.8% 41,390 29,352 -29.1%
Net profit margin (%) 19.5% 10.8%   20.9% 15.7%  
No. of Shares (m) 4,130 4,130   4,130 4,130  
Diluted earnings per share*       20.0 13.6  
Price to earnings ratio (x)         4.3  
(* trailing 12-month earnings)            

What is the company’s business?
Steel Authority of India Ltd. (SAIL) is India’s largest and world’s 15th largest steel producer. The company commands almost 1/3rd of the domestic market share with its 13 MTPA capacity. It operates 4 integrated steel plants and 2 specialty steel plants. After bleeding at the net profit level during the period FY99 to FY03 owing to an unfavourable steel cycle, the company turned around in FY04 and reported an astounding performance in FY05. Further, the company has embarked on a massive expansion plan (split into two phases), which will take its steel production capacity to 20 MTPA by FY12.

What has driven performance in 3QFY06?
Disappointing topline: The company has been severely hit at the topline level with net revenues declining by 19% YoY. This could be attributed to weak steel prices that ruled during the quarter, which were lower by about 6% to 7% YoY. However, while the company does not disclose its volume numbers, it has seemingly also been affected by substantially lower volume sales for the 19% YoY fall in sales to come about. It must be noted that steel prices, globally, have been treading lower. The same has been reflected in domestic steel prices, which have fallen by 20% to 30% in the last 8 to 9 months compared to their peak in early FY06. The reason for this sharp correction in steel prices has been the excess supply of the metal in international markets with China increasingly meeting its demand from internal capacities.

Cost break-up (as % of net sales)
  3QFY05 3QFY06 9mFY05 9mFY06
(Increase)/decrease in stock-in-trade -2.2% -9.4% -4.0% -12.8%
Raw materials 30.4% 46.1% 32.1% 42.0%
Staff costs 12.2% 13.9% 14.8% 15.3%
Stores 6.6% 8.8% 7.0% 8.6%
Power & Fuel 7.1% 9.6% 8.2% 9.4%
Other expenditure 5.8% 9.4% 7.4% 9.2%
Total 60.0% 78.3% 65.5% 71.6%

Operating margins tumble: Operating margins during the quarter have nearly halved from 40% in 3QFY05 to 22% in 3QFY06. A sharp rise in raw material costs in particular did the damage. It must be noted that raw materials contributed to about 60% of SAIL’s total operating expenditure in 3QFY06. However, there was a rise witnessed across operating heads as percentage of net sales as can be seen in the table above.

Bottomline trips: The effect of lower revenues and an exceptionally poor operating level performance led to the 55% YoY fall in bottomline. The performance would had been worse but for a 70% YoY growth in other income, 40% YoY decline in depreciation charges and lower tax incidence (36% in 3QFY06 as compared to 44% in 3QFY05).

Performance over the past few quarters…
  1QFY05 2QFY05 3QFY05 4QFY05 1QFY06 2QFY06 3QFY06
Net sales growth (YoY, %) 23.3% 31.8% 31.9% 38.2% 2.1% 4.7% -18.5%
Net profit growth (YoY, %) 336.4% 199.5% 105.2% 164.0% 1.4% -25.5% -54.8%
Operating margins (%) 30.6% 31.3% 40.0% 42.5% 36.9% 28.0% 21.7%

What to expect?
At Rs 58, the stock is trading at a price to earnings multiple of 8.3 times our estimated FY08 earnings and price to book value (P/BV) of 1.2 times. The company has underperformed our estimates for the third consecutive quarter and thus, we would be revising our numbers downwards. While the current valuations of the stock may look attractive, investors must carefully assess the risks associated with investing in steel sector stocks (including SAIL) at the current juncture, which we believe are rather high.

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