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SAIL: The tax axe! - Views on News from Equitymaster
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SAIL: The tax axe!
Aug 2, 2005

Performance summary
Steel sector behemoth, SAIL, announced disappointing June quarter results last week. While its peer, Tisco, managed to face the steel sector 'cool off' relatively well in 1QFY06, SAIL was not upto the mark. The company declared a marginal topline growth for the quarter and this was the disappointing part. While operating margins witnessed considerable expansion, changes in the tax structure negated all the gains for the company.

(Rs m) 1QFY05 1QFY06 Change
Net Sales 52,871 53,986 2.1%
Expenditure 36,722 34,074 -7.2%
Operating Profit (EBDITA) 16,149 19,912 23.3%
EBITDA margin (%) 30.5% 36.9%  
Other income 562 1,239 120.5%
Interest 1,868 1,297 -30.6%
Depreciation 2,789 2,839 1.8%
Profit before tax 12,053 17,015 41.2%
Tax 937 5,776 516.5%
Profit after Tax/(Loss) 11,116 11,238 1.1%
Net profit margin (%) 21.0% 20.8%  
No. of Shares (m) 4,130 4,130  
Diluted earnings per share* 10.8 10.9  
Price to earnings ratio (x)   4.9  
(* annualised)      

Company profile
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. A merger with Indian Iron and Steel Company (IISCO) is also being contemplated.

What has driven performance in 1QFY06?
Inventory blues:  SAIL's topline growth was rather flat at 2% YoY. However, since the company does not provide volume sales numbers, it would be difficult for us to comment on the same. But, as per the company's management, sales volumes were hit during the quarter on the back of lower steel offtake by consumers. The saving grace for SAIL, and other steel companies alike, has however been the fact that despite the sharp fall in steel prices during the June quarter, the average YoY steel prices (spot) were higher by about 25%. This made up for the loss in volume sales. Steel production during the quarter was higher by 9% YoY for the company as it continues to operate at 104% capacity utilisation.

This quarter's topline performance of the company must be viewed in the backdrop of the fact that steel prices, globally, have been on the descent and the same has been reflected almost immediately in domestic prices, which have fallen by 20% to 25% in the past 3-4 months. The reason for this sharp correction in steel prices has been the inventory build-up in 1HCY05 that led to lower offtake globally. Moreover, anticipation of a further fall in prices led to deferment of offtake, which further pressurised realizations, thus turning into a vicious circle.

Cost break-up
(% of net sales) 1QFY05 1QFY06
(Increase)/decrease in stock-in-trade -10.1% -32.4%
Raw materials 35.5% 46.1%
Staff costs 16.5% 18.7%
Stores 7.8% 9.0%
Power & Fuel 9.9% 10.6%
Other expenditure 9.9% 11.1%

Operating margins improve, but…:  SAIL has witnessed 6.4% expansion in its 1QFY06 operating margins. However, this has largely come about on the back of an increase in stock-in-trade. If one considers the other operating heads, there has been a rise (as % of net sales) in all of these (see table above). It must be noted that while SAIL meets its iron ore requirements through captive sources, its reliance on imported coking coal has adversely affected its raw materials costing. Further, while the June 2005 quarter operating margins may be at about 37%, they are considerably lower than over 42% margins recorded in 4QFY05.

Tax axe:  A 121% YoY rise in other income owing to a sharp rise in interest income, a 31% fall in interest expense on the back of continued paring of debt and replacement of high cost debt with low cost ones and a mere 2% growth in depreciation expense, all of this led to the profit before tax registering a 41% YoY growth. However, the same is not reflected in the bottomline (up 1% YoY). This could be attributed to the fact that with profits soaring and earlier losses being wiped out, the company has come out of the Minimum Alternate Tax (MAT) ambit. This has led to a significantly higher tax incidence, which is up from about 8% in 1QFY05 to 34% in 1QFY06. Going forward, the company expects higher tax provisioning, which could keep the bottomline growth subdued.

What to expect?
At Rs 53, the stock is trading at a price to earnings multiple 3.6 times our estimated FY06 earnings and 1.4 times estimated book value. It must be noted that this valuation has been arrived at after downgrading the numbers of the company post its June quarter results and also considering the outlook for the sector over the next few quarters. We will soon incorporate this in our research report.

In the meanwhile, 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. With steel prices already having witnessed significant correction over the past few months, it is only a matter of time that the same gets reflected in the financial performance of SAIL, considering that the company has a certain portion of its volume sales being negotiated by the month. While the near term prospects for the sector and the company continues to remain favourable and a revival could not be ruled considering that the built up inventory is waning, which could prevent the stock from going out of favour, we believe that the current stock price already factors in the same.

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