Uncommon steel

PENNY WISE

Enhanced capacities and backward integration will help Usha Martin report higher sales and profitability.

Usha Martin, which is the second largest steel wire rope manufacturer in the world, operates in the value-added steel products space that find applications across various sectors. Notably, these products typically enjoy high margins and competition is relatively low.

For Usha Martin, the company is expected to be among the key beneficiaries of the ongoing investments being made by user industries such as mining, drilling, elevators, cranes, air cargo and track installations among many others.

It also manufactures structural ropes, which are used in infrastructure projects and construction of high-rise buildings. What adds further confidence is the fact that the company is also active in the export markets, which contribute about 34 per cent to its total revenues.

It has distribution networks in the countries like USA, UK, Thailand, Africa, Middle East, South East Asia and Australia, besides manufacturing activities in a few of them.

But, the equation may change in favour of the domestic market, going forward. Says P Bhattacharya, joint managing director, "Though till recently, exports has been a focus area, the domestic market is opening up and offers huge potential for the value-added steel products, due to the growing investment in the industrial and infrastructure sectors."

To be a leader with a range of products is one thing and, sustaining leadership is yet another. In a bid to sustain its dominant position and also to grow its specialty and value added steel products business, which currently contributes about 70 per cent to consolidated revenues, the company has undertaken a significant expansion-cum-backward integration programme.

Capacity expansion
Over a three year period starting FY07, the company plans to spend Rs 2,100 crore towards capital expenditure (capex). Of this, about Rs 600 crore will be spent during the current year, and the rest of the amount in the phased manner over the next two years.

The plans include expanding its specialty steel capacity from 400,000 tonnes per annum currently to 900,000 tonnes per annum by FY09 and, by another 100,000 tonnes to 10,00,000 tonnes per annum by FY10.

Margin improvement
Apart from the expansions, Usha Martin is undertaking various steps to backward integrate as well as reduce production costs. Till some time back, the company's EBIDTA (earnings before interest, depreciation and amortisation) margins were under pressure on account of the rising raw material (including coal) prices and high power costs.

The EBIDTA margins in the past have hovered between 17-22 per cent. But, these are set to improve going forward considering that the company has now (from September 2007) fully integrated its captive iron ore mines, which have an estimated reserve of about 70 million tonnes.

The company currently consumes about 700,000 tonnes of iron ore to produce steel equivalent to 400,000 tonne annually. But, the requirement for the iron ore is estimated to rise to 20,00,000 (or 2 million) tonnes once the planned expansions go on stream. Now consider this. The company procures part of its iron ore requirements at a cost of about Rs 3,000-3,500 per tonne from external sources.

On the other hand, the cost of iron ore from its own captive source is just about Rs 800-850 per tonne. Given that it now has integrated its mines, new capacities will have the advantage of captive iron ore, thus leading to lower costs. 
 

SOLID STEEL
	FY07	Estimates
		FY08	FY09	FY10
Net sales	1,964.70	2,200.00	2,425.00	4,500.00
EBITDA (%)	17.40	18.20	23.50	23.50
Net profit	129.00	176.00	254.63	495.00
NPM (%)	6.60	8.00	10.50	11.00
EPS (Rs)	5.16	7.03	10.18	19.78
PE (times)	28.10	20.60	14.20	7.30

Power cost savings
Likewise, integration of its coal mines, which have about 40 million tonne of high grade reserves, will have a positive impact on margins. Currently, the company is procuring high grade coal from international markets at about Rs 5,000-5,500 per tonne.

The company currently consumes about 500,000 tonne of coal, which also includes some amount of low grade coal, which is procured at about Rs 1,100-2,000 per tonne. On expanded capacities, the company expects its coal requirement to rise to about 600,000 tonne of high grade coal.

Once the coal mines are integrated, the cost of coal is expected to decline to about Rs 3,000 per tonne thus, providing a saving of about Rs 1,500 per tonne. This works to an additional saving of Rs 90 crore per year.

On the flip side, if one may say so, the backward integration will happen in a phased manner as these coal mines are yet to get the approval of environment authorities.

Notably, these moves will not only improve its margins, but they will help in providing security with respect to future demand for coal and iron ore, thus insulating the company from vagaries of movement in the price of inputs.

Another positive trigger is the saving that would accrue from the addition of new power generation capacity, which is expected to increase from the current 43 MW to 118 MW by the end of FY10. This additional power will be used for captive consumption and is part of overall capex plan.

Investment rationale
To sum up, the move towards expanding capacities of its value-added steel products and power generation assets as well as backward integration into iron ore and coal mining are certainly in the right direction.

The benefits are expected to start accruing in a phased manner from FY09. This will not only help sustaining topline growth, but also lead to increase in margins (by about 5-7 percentage points to 22 per cent) and hence, faster growth in profits. Notably, analysts estimate the standalone value of iron ore mines at over Rs 400 per share, which provides some amount of cushion.

On the flip side though, an equity dilution looks imminent given the size of expansions undertaken and the debt to equity ratio of slightly over one time. Nevertheless, at Rs 145, the stock trades at 14 times its FY09 estimated earnings and can deliver good returns.