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Steel: Do Valuations factor in "Coalgate"? - Views on News from Equitymaster
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  • Sep 27, 2012

    Steel: Do Valuations factor in "Coalgate"?

    This is the second article in our series that analyzes some expensive stocks in specific sectors to understand if their valuations or "high PE" (price to earnings) multiples are justified.

    In this second article we focus on steel stocks with high PEs. In the first one we looked at high PE food stocks.

    The Steel industry tracks the overall long term economic health of the country. This is evident from the fact that the fortunes of steel companies are closely connected with that of the construction, infrastructure, automobile and consumer durables goods sectors. This also explains why steel is one of the highest consumed items in the world's wealthiest countries.

    With India's GDP expected to grow over 7-8%, steel consumption is expected to correspondingly grow at over 8%.

    However, due to the recent Coalgate turmoil, some of these steel companies lost their coal blocks. We examine how this "Coalgate" has impacted the PEs of steel industry stocks.

    We first shortlisted steel companies with a 10 year track record of profitability, and a return on equity of 10% in each of these past 10 years.

    Of these shortlisted, companies with the highest PEs, (in descending PE order) are Jindal Steel and Power Limited (JSPL) ... 11.6, Bhushan Steel Limited ... 9.8 and Maharashtra Seamless Limited (Mah. Seam.) ..7.5.

    Let's look more closely at the reasons for the relatively strong PEs of these companies.

    Key financial parameters for 3 highest PE Steel companies
      JSPL Bhushan Steel Mah. Seam.
    TTM PE 11.6 9.8 7.5
    Average growth (in %)      
    Sales 44.4 26.3 20.8
    Net profits 48.6 39.3 23.6
    Average Profit Margins (in %)      
    Operating Profit 36.7 19.5 21.7
    Net Profit 20.0 8.1 13.7
    RoE (in%) 37.4 21.3 27.0
    Average debt to equity (x) 1.3 2.6 0.3
    Average dividend payout (%) 6.6 3.3 15.3
    Note: Numbers are for last 10 years except TTM PE.
    TTM: Trailing Twelve Month
    RoE: Return on Equity

    Jindal Power and Steel Limited (JSPL) is one of India's major steel producers with a significant presence in sectors such as mining, power generation and infrastructure. The company produces a wide variety of steel products including hot rolled plates, billets, parallel flange beams, channels/ columns, pellets and hot rolled coils. It operates in the power space through its subsidiary Jindal Power Limited.

    The rising demand for steel (and power) in a growing Indian economy is reflected in JSPL's average sales and net profit growth of 44% and 48% respectively during the last 10 years. Operating and net profit margins too were a strong 37% and 20% respectively. JSPL's average RoE has been nearly 37% with a 6% and dividend payout. Overall, the JSPL has shown stellar results over the past decade.

    However, recently the company was named in the "Coalgate" scam, following which a couple of its coal blocks have been cancelled. Despite all this, the company is still trading at a high price multiple of 11.6.

    Bhushan Steel has also been named in the "Coalgate" scam, and some of its coal mines have been de-allocated. The company manufactures products used in automobiles and home appliances. Its list of clients includes well-known names such as General Motors, Hyundai Motors, Ford Motors in the auto segment, and Videocon, Daikin, Samsung, Godrej and Voltas amongst others. In terms of financials, Bhushan Steel does not boast of an extra ordinary past performance Although sales grew by 26% on an average in last 10 years and net profits by 39%, the company's average operating profit margin and net profit margin were relatively low at 19% and 8% respectively. RoE has been close to 21%, and dividend payout, 3%. However, a high debt equity ratio of 2.6 times is a cause of concern. In our opinion, the company's fundamentals do not warrant such a high 9.8 times price multiple in such turbulent times.

    Maharashtra Seamless (Mah. Seam) is yet another steel company named in the "Coalgate" scam. Mah. Seam. Makes seamless pipes and tubes used mainly in the Oil and gas sector. It is the largest manufacturer of seamless pipes in India. The growth prospects of the oil and gas sector are strongly dependent on the growth in Exploration and Production (E&P) activities in both domestic and international markets. Mah. Seam too has demonstrated impressive financial performance. Net sales grew by 21% on an average in past 10 years and net profit by 24%. The company has decent operating and net profit margins at 22% and 14% respectively. Mah. Seam. has an RoE of 27% and dividend payout of 15%. Another parameter that reflects well is the low debt equity of 0.27 times on average, highest being 1.2 in last 10 years. Its TTM PE trades at a high multiple of 7.5


    Overall, we see that all these companies have sound fundamentals and have grown fast over the past decade.

    However, the alleged involvement of these companies in the "Coalgate" scam has negatively impacted their stock prices and therefore their PEs and valuations.

    This highlights the fact that investors should not just look for sound fundamentals and financial performances, but are also be concerned about the quality of management and corporate governance practices adopted by them. Since trust worthiness of management is an important criterion for investors, in the wake of coal block troubles, we believe that the stock prices may see further decline.



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