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Commodities: Shedding excess flab

Aug 26, 2004

Prudent financial management is key to the success of any business organisation. More so in the case of capital-intensive industries whose fund requirements for both, running the day-to-day operations as well as creating new assets are huge. Since, it is almost impossible to fund an entire project through equity, it becomes imperative for companies to resort to debt funding. However, this very source of funding can prove to be a double edged sword. While in times of economic prosperity, (when demand is growing and capacity utilizations are at their peak) it can improve shareholders returns to a good extent; the damage may be even more severe during times of economic slowdown. Indian companies, especially from the commodity sectors of steel and cement have been guilty of carrying excessive debt on their books. However, in the recent past, these companies have been able to retire a substantial amount of debt and have thus become, leaner and stronger organizations. Let us try and find out what led to this phenomenon and the benefits that are likely to accrue from it going forward:

In case of steel industry, year 2000 and 2001 were one of the worst in terms of demand and realisations. The prices of steel were at all time lows and debt burdens were at all time highs. So, it was sort of a double whammy. But things have improved since then. Steel prices are near all time highs in recent times. On the other hand, the soft interest rate regime has helped companies restructure their debt. As can be seen in the graph above, the leverage (D/E ratio) for all the companies under consideration has come down in recent years. The major reason for this in case of steel industry is that the companies after achieving record profits in last year have reduced their high cost debt. Take for example steel major SAIL, it has reduced its debt by almost 50% in FY04. Government support also helped SAIL's case. The continued upturn in the cycle proved to be a boon for the steel industry and companies have improved their balance sheets in the last financial year. In case of cement companies, they focused on reducing high cost debt from their books, even though the growth in revenues and profits were not as high as that of their steel counterparts. It was more a case of prudent financial management helped by the soft rates.

These companies converted their high cost loans to low cost ones, improving their cash flows in the last three years. As can be seen from the graph below, the interest cost as a percentage of sales for the top commodity companies in India has come down in last five years. Average cost of debt for companies like Gujarat Ambuja has come down to from 12.6% in FY00 to 5.5% in FY04. Similarly, in case of ACC it has come down for 12% in FY00 to 7% in FY04. This has a huge impact on the net profit margins of the companies.

How does low debt on books help companies? Firstly, low debt equity ratio helps companies to improve their credit rating, which in turn helps them to access low cost debt. Secondly, it also gives companies financial freedom to raise debt when there is a need (such as capacity expansion). This enhances the shareholders value too, as the companies with lower leverage gets higher valuation and in case of any acquisition or merger these companies have higher bargaining power.

Lower debt leads to lower interest outflow, which in turn increases the cash flow to the shareholders. Higher cash flow for shareholders means higher returns in form of dividends or higher value of stock in the market, as commodity stocks are also valued on P/BV (price to book value) basis.

However, we have seen interest rates hardening since the beginning of the year and the interest rates are about 130 basis points higher than what they were in the beginning of the year. This increase, if continued, may not be good news for the companies in the commodity sector. While companies in the steel sector are planning to increase their capacity, higher debt cost can be a deterrent for these companies going forward. Investors must take a cautious view on the stocks from these sectors that have higher capex plans, as rising interest rates have a two-pronged effect on these companies. Rising interest rates will reduce demand for the product, as well as impact the bottomline of the companies due to higher interest outgo.

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