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SAIL: When the tide turns… - Views on News from Equitymaster
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SAIL: When the tide turns…
Oct 27, 2005

Performance Summary
Steel sector behemoth, SAIL announced its September quarter results just a short while ago and the company has delivered yet another quarter of disappointing performance. It must be noted that SAIL’s performance in 1QFY06 was also poor. Now, in 2QFY06, the performance has further deteriorated, with the company reporting a decline in operating profits and the bottomline registering a much sharper fall, primarily owing to a much higher tax incidence.

(Rs m) 2QFY05 2QFY06 Change 1HFY05 1HFY06 Change
Net Sales 67,041 70,178 4.7% 119,912 124,164 3.5%
Expenditure 46,037 50,551 9.8% 82,759 84,624 2.3%
Operating Profit (EBDITA) 21,004 19,627 -6.6% 37,153 39,539 6.4%
EBITDA margin (%) 31.3% 28.0%   31.0% 31.8%  
Other income 853 1,385 62.4% 1,415 2,624 85.5%
Interest 852 1,145 34.4% 2,721 2,443 -10.2%
Depreciation 2,773 2,802 1.0% 5,563 5,641 1.4%
Profit before tax 18,231 17,065 -6.4% 30,284 34,080 12.5%
Tax 3,100 5,798 87.0% 4,037 11,574 186.7%
Profit after Tax/(Loss) 15,132 11,268 -25.5% 26,247 22,506 -14.3%
Net profit margin (%) 22.6% 16.1%   21.9% 18.1%  
No. of Shares (m) 4,130 4,130   4,130 4,130  
Diluted earnings per share* 14.7 10.9   12.7 10.9  
Price to earnings ratio (x)         4.6  
(* annualised)            

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 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.

What has driven performance in 2QFY06?
Realisation blues: The topline of the company continued to remain muted for the second consecutive quarter. Net sales in 2QFY06 were higher by about only 5% over the corresponding quarter of the previous fiscal. While it will be difficult to comment on the volume sales of the company during the quarter, since the company does not provide any details of the same, considering that average steel prices ruled higher by about 4% to 5% YoY during the quarter, it is safe to assume that volume sales would be rather flat. 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 deferment of offtake, leading to inventory build-up in 1HCY05. Moreover, anticipation of a further fall in prices has led to further deferment of offtake, which further pressurised realizations, thus turning into a vicious circle.

Cost break-up
(% of net sales) 2QFY05 2QFY06 1HFY05 1HFY06
(Increase)/decrease in stock-in-trade -1.3% -0.9% -5.2% -14.6%
Raw materials 31.5% 35.1% 33.2% 39.9%
Staff costs 16.4% 13.9% 16.4% 16.0%
Stores 6.8% 8.0% 7.2% 8.4%
Power & Fuel 8.2% 8.5% 8.9% 9.4%
Other expenditure 7.1% 7.4% 8.3% 9.1%
Total 68.7% 72.0% 69.0% 68.2%

Operating margins collapse: Operating margins of the company have tumbled for the second consecutive quarter and currently hover at 28%. While on a YoY basis, this may seem a mere 330 basis points, if one compares this to the previous quarter (1QFY06), operating margins have fallen by almost 900 basis points and this fall has been much more drastic compared to the 4QFY05 margins of 42.5% (see adjoining chart)! Further, while most of the operating heads have been largely under control, raw material costs, which form almost 50% of the total operating expenses of the company, have registered an absolute growth of 17% YoY, mainly because of an increase in the price of indigenous and imported coal, which led to the 360 basis points increase as a % of net sales (see table above). Stores and spares also contributed its bit in denting operating margins.

Taxing times: While the rise in interest expense by 34% YoY was fully offset by the 62% YoY increase in other income, thus leading to a ‘mere’ 6% YoY fall in profits at the PBT level, it was the high tax burden that eroded the company’s bottomline. To put this in perspective, the effective tax rate (as % of PBT) doubled from 17% in 2QFY05 to 34% in 2QFY06. It must be noted that in the previous year, in view of brought forward losses, unabsorbed depreciation and other relief available under the Income Tax Act, the company did not have taxable income and only minimum tax on book profits was provided under the Income Tax Act. The company is, however, now providing regular tax liability.

What to expect?
At Rs 50, the stock is trading at a price to earnings multiple of 5.3x our estimated FY08 earnings and price to book value (P/BV) of 0.9x. The company has underperformed our estimates for the second consecutive quarter and thus, we would be revisiting our numbers, as we believe that the company is unlikely to achieve our full year estimates, wherein we had estimated a 6% rise in bottomline for FY06 after accounting for regular tax liability. 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 starts to get reflected in the financial performance of steel companies in a much larger manner.

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