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SAIL: There it goes! - Views on News from Equitymaster

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SAIL: There it goes!
May 25, 2006

Performance summary
State-owned steel major, SAIL, announced its full year results today. While the company's topline in 4QFY06 was marginally lower, in light of a significant increase in raw material costs and decline in steel prices, operating margins have tumbled on a YoY basis. But for higher other income during the quarter, the decline in net profit would have been higher than as reported.

(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Net Sales 93,703 92,190 -1.6% 291,144 287,786 -1.2%
Expenditure 53,843 77,031 43.1% 183,043 219,312 19.8%
Operating Profit (EBDITA) 39,860 15,159 -62.0% 108,101 68,474 -36.7%
EBITDA margin (%) 42.5% 16.4%   37.1% 23.8%  
Other income 816 1,600 96.0% 2,872 5,334 85.7%
Interest 1,574 1,139 -27.6% 6,051 4,678 -22.7%
Depreciation 2,839 3,041 7.1% 11,270 12,073 7.1%
Profit before tax 36,263 12,578 -65.3% 93,654 57,057 -39.1%
Tax 9,483 1,546 -83.7% 25,484 16,928 -33.6%
Profit after Tax/(Loss) 26,780 11,032 -58.8% 68,170 40,130 -41.1%
Net profit margin (%) 28.6% 12.0%   23.4% 13.9%  
No. of Shares (m) 4,130 4,130   4,130 4,130  
Diluted earnings per share       16.5 9.7  
Price to earnings ratio (x)         8.2  
Price to book value (x) - FY06         2.6  

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 unfavorable 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 FY06?
Output higher, prices lower: Saleable steel production was higher at 12 million tones (MT), which was higher by 6.2% YoY. This was primarily achived by higher capacity utilisation i.e., 109% in FY06 as compared to 104% in FY05. We had estimated saleable steel production to increase by 8% on the back of the de-bottlenecking exercise (will increase capacity by 1 MT) and to that extent, the actual increase in production was lower. Post the merger of the IISCO steel plant, the capacity will enhance by 3 MT (this is currently under modernisation to bring it in line with SAIL's efficiency standards). Despite improved production, net sales in FY06 was lower by 1% YoY owing to a 22% decline in steel prices from its peak (in line with global trend). The decline in net sales is also attributed to the increase in excise duty during the fiscal (14% in FY06 as compared to 11% in FY05). If one were to exclude the excise duty implication, for comparison purpose, net sales has actually risen by 2% YoY in FY06.

Operating margins - Hit from both sides: The fact that steel prices have declined significantly since the peak is a known fact. The performance of SAIL in FY06 at the topline level highlights the same. However, what is also worrying is both iron ore and coke prices almost doubled in FY06. While SAIL has captive mines as far as iron ore is concerned, the rise in coke prices is reflected in raw material cost to sales touching 40% in FY06 as compared to 30% in FY05.

Interest, other income saves the day: The decline in net profit would have been greater but for higher other income and lower interest charges. SAIL reduced its total debt by Rs 1.5 bn during the year and in fact, the short-term deposits in banks exceeded borrowings, which means that the company was debt-free in FY06. Higher short-term deposits in the bank is reflected in other income increasing by 86% YoY in FY06. Our net profit estimates were higher by around 12% as compared to the actual performance, which could be attributed to steel prices.

Over the last few quarters: As is evident from the graphs above and the table below, FY06 has been a torrid year for the company. SAIL has immensely benefited from the run up in steel prices over the last two and half years, apart from its restructuring exercise. However, with the company planning aggressive capacity expansion (including de-bottlenecking), we believe that interest and depreciation charges are likely to increase substantially in the next two years. To that extent, our outlook on margins remains cautious.

Performance over the past few quarters…
(% YoY change) 1QFY05 2QFY05 3QFY05 4QFY05 1QFY06 2QFY06 3QFY06 4QFY06
Net sales growth 23.3% 31.8% 31.9% 38.2% 2.1% 4.7% -18.5% -1.6%
Net profit growth 336.4% 199.5% 105.2% 164.0% 1.4% -25.5% -54.8% -58.8%

What to expect?
At Rs 80, the stock is trading at 2.6 times its FY06 book value. While steel prices continue to remain volatile in the global markets (rose in 1QFY07 as compared to 4QFY06 and again weakening in the last month), it is not clear whether the dream run is over as far as steel prices are concerned. Demand in China is expected to grow at 13% YoY in FY07 (though lower than 17% in FY06), supply scenario is a cause of concern (production in China increased by 27% YoY in FY06). If one compares the performance of SAIL and Tisco in FY06, undoubtedly, Tisco has outperformed on all parameters. The reason for the comparison stems from the fact that when it comes to commodity stocks, choose the lowest cost producer in the world (if one is interested in investing in steel stocks now). This will atleast reduce the magnitude of risk.

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