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Steel: Tata Steel vs. SAIL

Mar 14, 2007

Steel being a capital-intensive industry, huge investment is required for expansion and modernization of plants. Given that in a cyclical industry operating leverage counts, to increase their share in volume, companies need to scale up their capacities and operations. Though steel being a commodity is a volume game, efficiency along with scale results into long-term business viability. In this article we have made a comparison between Tata Steel and SAIL, the two largest steel manufacturers in the country that incurred the highest capex in the industry over the last 5 years, to gauge the impact of the same on their respective performances.

Capacity and capacity utilization: SAIL’s capacity utilization went up from 91% in FY01 to almost 105% in FY06. The slack performance by the company was on account of low productivity and inefficient operational efficiency. The company’s production has grown at CAGR of 5.8% over a period of 5 years. With the upswing in steel cycle and overall improvement in the physical performance of the company, SAIL turned around in FY04. On the other hand, Tata Steel’s capacity utilisation has gone down from 103% in FY01 to 95% in FY06. During FY05, the company planned to upgrade G blast furnace and has outlined 6 MT capacity expansion by FY09 in 2 phases. The new capacity is being built up and not being operated at 100% utilisation level resulted in lower capacity utilisation in FY06 compared to previous years. The company has built up capacity at CAGR of almost 8% over a period of 5 years (SAIL merely 2% during the period under review) and ramped up production by almost 6% for the period under consideration. Both the companies are building up capacity to cater to increasing demand and benefit from economies of scale.

    FY01 FY06
Particulars Unit Tata Steel SAIL Tata Steel SAIL
Saleable Steel Capacity MT 3.3 10.6 4.8 11.4
Capacity Utilisation % 103.0% 91.3% 94.7% 105.0%
EBITDA margin % 33.8% 10.9% 38.4% 22.1%

If compared in terms of size, SAIL is almost 3 times that of Tata Steel. However, on account of higher utilization level, the latter was able to sustain margins when majority steel companies were referred to BIFR. Tata Steel, on account of its ability to effectively utilize available resources, has historically enjoyed almost 2,000 basis points premium over its peer SAIL in terms of EBITDA. Thus in case of commodities, operational efficiency and level of utilisation translates into higher profits, as there is little or no brand distinction.

Operating leverage: Though large capacities help, operating efficiencies decide whether the business is viable in the long run. In fundamental terms, the performance of both the steel majors have improved, but when compared, it is clear that Tata Steel’s performance has always been better as compared to SAIL.

    FY01 FY06
Particulars Unit Tata Steel SAIL Tata Steel SAIL
Net margin % 18.9% -5.1% 22.8% 14.2%
Current ratio x 1.1 1.2 0.8 1.4
Debt to Equity ratio x 1.2 3.4 0.3 0.3
Interest Coverage ratio x 5.0 0.6 45.2 13.2
RONW % 38.3% -17.5% 42.9% 32.4%
EV/EBITDA x 3.1 10.4 3.1 7.2
P/BV x 1.2 0.7 2.5 3.3

On account of lower operational costs, Tata Steel could withstand cost pressures during the cyclical downturn. Tata Steel owns captive iron ore and coal mines, which entirely satisfies its requirement, while SAIL partially imports coal that increases its exposure to international coal price volatility leading to increased costs. Moreover, SAIL, in the past, incurred huge expenses in terms high manpower, high coke consumption rate, high interest outgo costs due to high leverage etc. The measures like reduction in manpower, usage of alternative fuels like tar and coal dust and increasing usage of sponge iron and scrap helped to reduce costs. The company also gave impetus on cost reduction and productivity improvement through systematic application of new technology. The upturn in steel cycle and better operational efficiency resulted into increased cash flows that enabled SAIL to reduce its debt to equity ratio below 1 time. The effects of improved cash flows and productivity is also being reflected in considerably higher return ratios. Having generated negative returns during slack period, SAIL was able to deliver 32% RONW with upturn in cycle and on account of business and financial restructuring. Control over various operating expenditure heads like staff costs and power also aided this improvement in operating margins.

To conclude…
Tata Steel could be termed as proactive as it improved its product mix, relied on captive ore, and has lately also started branding its products and opened retail outlets to reach the end consumers. The company is also scaling up its capacity through the inorganic (acquisition) route to venture into international markets, increase market share and develop a huge customer base. Meanwhile, SAIL has also lined up modernisation and expansion plans to further improve productivity and cater to increasing demand.

However, considering the way the steel companies have outlined expansion plans, the debt burden is bound to increase leading to increased finance charges. Though steel demand seems to be robust and not expected to cool off soon, commodities have their own cycles. With steel capacities on the rise across the globe, there are fears that it could lead to over capacity a few years down the line leading to softening of steel prices. If this happens companies might witness pressure on margins. Even if prices remain firm, rising costs are a concern. Companies that are able to source raw material at cheaper rate will benefit. Hence, companies are racing to acquire mines abroad and in India, to reduce costs.

At the current levels, the stock of Tata Steel appears relatively attractive compared to its peer SAIL in terms of Price to book value. Between the two, risks outweigh rewards for SAIL compared to Tata Steel on account of the latter being a globally cost competitive player and has high operating leverage. Having said that cyclicality risk poses a significant downside to our assumptions.

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