SAIL - Takeaways from management meeting - Ambit

Our recent meeting with SAIL's management highlighted business conditions have remain unchanged with sluggish demand, strong import pressure resulting in domestic steel pricing at discount to landed prices. Steel demand remains sluggish, especially in the flat segment, which accounts for about 58% of SAIL's overall volumes. The management expects profitability to improve owing to volume leverage (incremental volumes of 1.1mt in FY14 over FY13, in line with our expectations) and cost savings. The company expects to sell half of the incremental volumes in the export market. While the management believes increased exports to be margin neutral, we see export parity pricing diluting some of the operating leverage from higher volumes. Further, the management's strategy to secure iron ore from the Rowghat mines with the help of CRPF security not only increases costs but may also not be a sustainable solution. We retain our SELL stance.

Key takeaways from the meeting:

- Incremental volumes of 1.1mt in FY14: The management expects incremental volumes of ~1.1mt in FY14 over FY13. This is in line with our expectations because our estimates factor in steel sales volume of 12.1mt for FY14 vs 11.1mt reported in FY13. After the inventory build-up of ~1.2mt-1.3mt in FY13, whether the company would be able to push through incremental volumes has been a cause for concern. The management highlighted that half of the incremental 1.1mt volumes would be exported.

Although the rise in exposure towards exports is a positive from the perspective of geographical diversification, we believe this could create a pressure on realisations. At present, domestic realisations are based on an import parity basis, which include freight costs and import duties over the FoB prices. Our discussions with industry sources have always highlighted that realisations from exports are lower than those in the domestic business due to freight costs and import duties. Hence, we expect some pressure on SAIL's realisations in the event of a rise in the share of exports.

- Cost savings likely to flow through: The management highlighted that the company faced multiple cost pressures in the form of higher coke and pellet purchases, other manufacturing disruptions, etc., in FY13. A large part of these operational inefficiencies are likely to subside in FY14. The management expects EBITDA/tonne to increase by ~US$80-100/tonne on account of these cost savings. However, we remain skeptical about the extent of margin benefits, as the cost savings would be partially offset by lower realisations (due to rising exports). We build in an EBITDA of ~Rs4,000/tonne in FY14 vs ~Rs2,850/tonne reported by SAIL in 4QFY13.

- Inventory levels marginally higher: SAIL currently carries an inventory of ~1.2mt-1.3mt, higher than its normal inventory levels of ~0.8mt-0.9mt. Over 9MFY13, SAIL's inventory increased by ~1.5mt-1.7mt. The management claims that the price discounting in the market by other players was not undertaken by SAIL. However, SAIL offered discounts in 4QFY13 which helped it liquidate inventory by ~0.3mt-0.4mt.

- Demand remains sluggish: The management highlighted that steel demand remains muted and there have not been any signs of recovery. Demand and prices in the long segment are still holding up, but that of the flat segment have been under significant pressure. This negatively impacts SAIL, because it has a product mix which is skewed in favour of the flat segment (58% of FY13 volumes).

- Risks to raw material integration: SAIL is developing the Rowghat mine which is likely to have a capacity of 12mt p.a. Naxalite activities in the area have delayed the commissioning of the Rowghat mines. SAIL is looking for security from the government to help develop this mine and has requested for five battalions of CRPF (Central Reserve Police Force), the cost of which would be borne by SAIL. In our view, this not only increases the cost structure for SAIL but is also not a sustainable solution.

Where do we go from here? Our SELL stance on SAIL is based on: (a) SAIL's poor margin profile, (b) material capacity expansion benefits which are unlikely before FY15, and (c) rising risks to raw material integration. We maintain our earnings estimates and TP of Rs55 (3% upside) and reiterate our SELL stance. The stock is currently trading at FY14 EV/EBITDA of 8.2x and FY14 P/B of 0.5x.

Source : Equity Bulls

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