SAIL: Reduction in costs key to further gains

As volumes improve and operating leverage sets in, lower costs are necessary to boost earnings

After underperforming its larger peers in the past onethree years, the stock price of Steel Authority of India (SAIL) has been playing catch-up in the past few months; it is up 46 per cent since October. Among key reasons is the improvement in SAIL’s operating performance and a favourable business environment. The latest news regarding SAIL signing a non-binding agreement with ArcelorMittal, the world’s largest steelmaker, to set up an automotive steel joint venture, has also helped, though gains therefrom will accrue in the longer run. But, further gains for the stock will depend on how successful the company is in bringing down its operating costs.

First, the good part. After significant delays, SAIL’s capacity expansion projects are coming on stream. As most of these will be commissioned by FY19 in phases, benefits will start accruing with maximum gains seen in FY20 after stabilisation of the new capacities. So, volume growth should gradually pick up. Analysts at IIFL say that following largely flat volumes over FY06-17 at about 11-12 million tonnes, visibility has improved for 10-13 per cent compounded annual growth (CAGR) in volumes over FY17-20, as new capacities at various locations stabilise.

As volumes improve, operational leverage should also kick in. Interestingly, increased capacities for SAIL come at a time when the commodity cycle is also favourable, so the company should also benefit from price escalations, a trend already visible in the current fiscal year. But, concerns on the costs front remain. SAIL’s interest and depreciation costs have been rising with capacity expansions and impacting its bottom line. Likewise, rising coal costs have led to a volatile operating performance since FY17. While the implementation of minimum import price (MIP) in February 2016, other policy measures and improving domestic realisations helped SAIL report earnings before interest, taxes, depreciation and amortisation or Ebitda (operating profit) per tonne of ~835 in the June 2016 quarter, its operating profit deteriorated from the December 2016 quarter due to high coal prices. The decline in coal costs by about ~3,000 a tonne now (according to analysts), coupled with better product mix has helped SAIL clock an Ebitda per tonne of ~2,583 in the September 2017 quarter (Q2). Yet, analysts are cautious. If these increase again, SAIL’s profitability can come under pressure as other costs are increasing too, says an analyst with a domestic brokerage. Q2 had seen staff costs rise nine per cent, depreciation costs by 14.5 per cent and interest costs by seven per cent year-on-year; it was the 10th consecutive quarter of SAIL reporting a net loss, though the least in the past five quarters.

Analysts at Motilal Oswal Securities (MOSL), after the results, said SAIL’s cost base still remains high. It needs to cut employee costs and improve operating performance to be viable across (industry) cycles. Analysts at Elara Capital, too, said although SAIL will continue to make operational profit, high interest and depreciation costs associated with the start of its new facilities would keep net profit under pressure.

For now, expectations of lower Chinese imports into India, cut in China’s output during winter season and firm steel prices are helping all stocks of steel companies, and SAIL too has benefitted.

Analysts’ target prices in the range of ~43-71 (MOSL, Elara and IIFL), however, are lower than SAIL’s closing price of ~78.25 on Friday, signalling that the near-term positives are priced in. Thus, further upsides will depend on SAIL’s ability to surprise positively on the profitability front.