Bhushan Steel: Buy

Expertise in producing cold-rolled steel and improving margins as a result of higher capacities and vertical integration make the stock attractive.



Rising raw material costs and a challenging market to pass on those hikes have made for a trying environment for steel producers over the last two quarters. In such a setting, integrated producers with a premium product mix have an ace up their sleeve. A recent entrant to the integrated producer category, Bhushan Steel, appears a smart bet in the space, owing to its expertise in producing cold-rolled steel and improving margins as a result of higher capacities and vertical integration.

At the current market price, the enterprise value/tonne stands at around Rs 41,000 on its projected 2012 capacity, which is a premium to larger peers such as SAIL and JSW but just hovering below its replacement cost. This maybe justified, given the company's product mix and limited scale which may render backward integration into mining smoother. On a P/E basis, the company trades at around 7.8 times the trailing 12-month earnings, a discount to larger companies in the steel sector.

MICROSTORY

Over half of the company's 1.9 million tonnes of hot-rolled coil production capacity at Orissa is processed into cold-rolled and coated variants by units in Uttar Pradesh and Maharashtra.The company has maintained its operating margins at 28 per cent over the last two quarters, while others such as SAIL or JSW (18-20 per cent) have seen substantial margin erosion. In the first nine months of this fiscal, Bhushan Steels' net sales and net profits have grown by 25 and 26 per cent respectively as the Orissa capacity comes on-stream and producers hike prices gradually. The recent quarter saw net sales and profits rise by 36 and 23 per cent to Rs 1,900 crore and Rs 280 crore respectively.

Between 2006-07 and 2009-10, an improving product mix and capacity additions have seen the company's net sales and profits grow at a compounded pace of 14 per cent and 40 per cent respectively. Operating margins have improved from 17 to 28 per cent over the same period.

GROWTH DRIVERS

The company's ability to improve its margins and enter the coveted 30 per cent mark rests on its efforts to improve integration through higher crude steel capacity and commissioning of iron ore and coal mines. The upcoming three-million-tonne Brownfield capacity at Orissa (to be commissioned by 2012) and the operation of iron ore and coal (both coking and thermal) mines over the next four years, may be the key profit drivers for Bhushan Steel. This may catapult the company's margins closer to the 35-40 per cent mark. The Brownfield additions, coupled with the 70 per cent addition in cold rolling capability, could result in sales trebling by FY-14.

The company's 400 MW captive power capacity (including associate Bhushan Energy's capacity) should lower the power bill for company's power hungry Conarc furnace. Its 70 per cent stake in Australian miner, Bowen Energy, which has substantial coking coal mines and an offtake agreement with Resource Management for thermal coal are other measures to ensure timely and cost-effective supply of coal, in an increasingly scarce and concentrated market.



Reports indicate that the consumer durables industry grew by 12-13 per cent in 2010. Heavy steel users, including air-conditioners and home appliances, grew by 12 and 23 per cent respectively. The automobile segment saw 32 per cent growth in sales in 2010, a level which may be difficult to replicate. But even more moderate levels of growth will bode well for steel producers.

The growing consumer pies in both segments coupled with increasing levels of competition will lead to higher levels of domestic procurement of raw materials and components. This trend will work in favour of domestic steel producers which supply to these segments.

Industry outlook

With global demand remaining lukewarm and aggressive miners looking to hike iron ore and coal prices at the earliest signs of rising demand, the steel industry has been unable to match its price increases to the pace of raw material price hikes. This has resulted in a dent in the margins of steel producers, globally, over the last two quarters. High raw material costs are likely to remain a pain point for the steel sector, with few major mine additions till 2013.

Steel producers have undertaken a series of prices hikes in the 2-5 per cent range over the last three months to cope with rising costs. Floods in Australia have, however, presented a new set of challenges to steel producers, one which they may not be able to ‘price-hike' their way out of.

With pricing power firmly in the miner's corner, a surfeit of steel production capacity globally and a slow and arduous recovery in the global steel cycle, the only alibi steel producers have for hiking prices is rising raw material costs. In this scenario, being amongst the lowest cost and integrated producers appears to be the best bet to retain margins. Bhushan Steel has the potential to be among that handful of producers.

Risks

With debt equity levels of just over three, Bhushan Steel's ability to service and payback Rs 13,000 crore in debt lies in the steel prices remaining stable at the very least and the company sticking to its expansion timetable. Failure to do so will hurt profitability. Similarly, delays in commissioning mines both at home and in Australia could hurt the company's prospects of morphing into a well-hedged integrated producer. While the company's EBIT covers interest 5.7 times over, rising interest rates do pose a serious threat to the operating margins. Serious systemic shocks, as witnessed in early-2009, are another scenario which could seriously challenge the company due to its immense leverage.

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