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Steel: Not without reason

Nov 17, 2003

One sector that has outperformed the benchmark indices by a huge margin in the current rally has been the steel sector. Steel stocks, of the likes of Tisco, Steel Authority of India (SAIL), Jindal Iron & Steel (Jisco) and Ispat Industries, have been significantly in favour on the bourses during FY04. The rally in steel stocks continued during the second quarter of the current fiscal also.Just to put things in perspective, Rs 100 invested in the BSE-Sensex at the end of the March quarter would have yielded Rs 136 by now. However, if the same amount had been invested in the above four stocks each, the amount would have now more than doubled in case of Tisco and Sail, while it would have increased to Rs 182 in the case of Jisco. However, the case is not the same with Ispat Industries (Rs 114), which actually underperformed the Sensex (see chart below). But all this is not without reason!

The performance of the stock price of a company is dependant to a large extent on the performance of the company. And this is precisely the reason for the euphoria seen towards steel stocks. The table below shows the YoY effect of the consolidated September quarter results of the four companies under consideration here. The table below shows a very impressive and encouraging scenario of the steel sector prevalent during the September quarter of the current fiscal. Let us look analyse the same in brief.

Steel: Quantum leap
(Rs m)2QFY032QFY04% Change
Net Sales65,81790,45637%
Other Income8971,06919%
Expenditure55,08870,73728%
Operating Profit (EBDIT)10,72919,71884%
OPM (%)16.3%21.8%
Interest5,3293,908-27%
Depreciation4,8224,9032%
Profit before Tax1,47511,978712%
Tax2782,637848%
Extraordinary items(842)(16)
Profit after Tax/(Loss)3559,3252528%
Net profit margin (%)0.5%10.3%
Note: The companies under consideration are Tisco, Sail, Jisco and Ispat
Source: bseindia.com

The consolidated topline showed a 37% increase for the September quarter 2004 over the corresponding quarter last year. This strong growth can be attributed to two factors – volume and prices. The continuance of demand for steel, both domestic and international, has been driving up the volume sales of steel companies. Coupled with this, the strong upsurge in steel prices further augmented the topline of these companies. The average domestic steel prices were higher by about 10% YoY during the September quarter (see chart below).

Despite a strong surge in sales, effective cost control measures helped keep expenditure under control thus preventing it from rising in proportion to sales. Significant control over expenditure heads like raw material consumption, power consumption and staff costs helped bring down the costs for these companies. As a result of this, total expenditure as a percentage of sales has decreased by almost 600 basis points from 84% of net sales to 78% YoY. The benefit of this is visible is the huge improvement in operating margins from 16% to 22%. This consequently led to the 84% jump in operating revenues.

Moving further down the table is another important factor - interest (payments), which played a vital role in improving the bottomline of not just the steel companies, but of practically all of the manufacturing industry. All companies, where debt had an important role to play, benefited from the fall in interest rates over the last couple of years. Steel, is one of the industries, which is highly leveraged. Thus, as a result of the lower interest rates, companies were able to re-shuffle their debts to a large extent by substituting high costs debts with lower interest bearing debt. The cyclical upturn in the industry, which in turn improved cash flows, also helped companies to pare their debts significantly. Further, assistance from financial institutions and the government in terms of debt restructuring came as a boon for the ailing steel industry and this development further helped companies to turnaround their fortunes and come out of the trough.

Consolidated depreciation remained almost flat during the quarter as compared to the same period last year. Further, the extraordinary item above is a part of Tisco’s results. The company had incurred extraordinary expenses (Rs 842 m) on account of employee separation costs. In the current quarter, the company has incurred much lower expenses (Rs 16 m) under this head on account of some changes pertaining to the method of charging Employee Separation Compensation costs.

All of the above ultimately led to the net profit margins leapfrogging from under 1% to over 10%, the effect of which is visible in the bottomline growth of over 2,500%! Now, considering the stock price angle of the same, barring Ispat Industries, all the others continued to outperform the benchmark index owing to continuous ‘substantial’ improvement in bottomline. If we look at the individual numbers of the above companies, the reason becomes clear. While Tisco doubled its bottomline for the quarter, Jisco trebled it and Sail managed to post Rs 5 bn profit as compared to Rs 1.5 bn loss. However, Ispat industries managed to reduce its losses by only 14%. While part of this could be attributed to the higher tax outgo for the company, the fact that the company’s operating margins actually fell during the quarter did not augur well for the stock price.

To conclude, having provided extra-ordinary returns to investors over the last 7-8 months and much of the future performance of many of the companies already factored into their stock prices, it is now advisable to exercise utmost caution towards steel stocks and beware of any signs of a turn in the steel cycle.

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