We review SAIL’s status within the volatility of the steel market. SAIL’s stock price has run up significantly, while its inability to renegotiate coking coal costs means depressed earnings will continue over the next two quarters.
Coking coal accounts for 48% of SAIL’s total cost and is key to its profitability. SAIL has been trying to renegotiate its existing contracts, but its main supplier BHP Billiton has until now not been amenable.
According to industry sources, the company plans to lift only 130kt in January 2009, compared with 830kt in December 2008; it has also floated a tender to buy coking coal in spot market for April and May deliveries, but the benefit of lower spot coal will be fully seen only by May or June.
Since HRC prices have seen a $100/t decline in December, and costs for SAIL are not falling, we think SAIL’s margins could be severely affected in 4Q.
The Ministry of Steel is pushing SAIL to continue with its $11 billion expansion plan at fast pace (in view of upcoming elections). We believe this could cause SAIL to turn from a net cash position of $3.5 billion to debt of $4bn in 2–3 years’ time.
The unusually high profitability of its Bhilai unit as compared to other units is understood to be due to the presence of high-priced government orders for rail and plates. New contract prices from April could be sharply lower in view of the meltdown.
SAIL has outperformed its peers due to the perceived safety of its net cash balance sheet. However, under current conditions, with margins under squeeze and a high cost structure due to significant manpower costs, SAIL is likely to be uncompetitive.
The stock is now trading at 8x PER and 1.2x P/BV, which we think is fair value, leading to our downgrade to Neutral. 12-month price target: Rs90 based on a PER methodology. We therefore downgrade SAIL to NEUTRAL.