Bhushan Steel

Higher demand for flat products and expansion in operating margin will benefit Bhushan Steel in the near term

THE recent recovery in Indian economy has once again increased the demand for steel products. There has been significant rise in auto sales and other consumer goods in last few months. All these factors have led to a rise in sales of flat steel products. Bhushan Steel, a leading producer of flat products, is set to benefit from all these. The gains will be driven by faster topline growth coupled with backward integration, which will lead to significant improvement in operating margins. Investors with a mid-term horizon of 2-3 years can add this stock to their portfolio kitty.

BUSINESS :

Bhushan Steel is a secondary steel producer and mainly produces value added flat products. It gets more than twothird of its revenue from cold rolled and galvanized steel products. Bulk of its revenue comes from the automobile and white goods sector, which uses the flat products predominantly. It has three plants, located strategically in different parts of the country. The Dhenkanal plant in Orissa is close to the raw material source and manufacturers sponge iron and billets, the primary steel products. The Khopoli plant in Maharashtra and Sahibabad plant in Uttar Pradesh are close to the two auto hubs in India namely Pune and Gurgaon. These two plants primarily manufacture cold rolled and galvanized products used by the auto companies. It has a close to one million ton capacity for cold rolled products, which is used as a key input for other value added products.

FINANCIALS:

The company's topline has almost doubled in last four years to Rs 5,000 crore in FY 2008-09. The net profit, however, grew at a faster rate during the same time period.

For last four years, the company has been making significant capex to link its operations backwards and to become more integrated. Bulk of this capex program is being financed through debt. As a result, its debt-equity ratio has increased close to four, from the two earlier. This is not a major concern given its higher interest coverage ratio (more than 5). The company has expanded its operating margin by around 500 basis points over last two years to 20.4% in FY 2008-09. In fact, its operating margin in September 2009 quarter increased to around 26%, thus reflecting the partial impact of backward integration. Its return on capital employed (ROCE) of 10% for last several years appear to be lower. But this is a result of higher capital expenditure made during the same time period.

GROWTH DRIVERS:

The company plans to make a structural change in its business model to become an integrated steel company. The management feels that at a time when primary steel producers are planning to produce more value added products, it is imperative for the company to integrate itself backwards to remain competitive in secondary market. The integration process itself will be completed in two steps. In first step, the company will set up around 2 million tons of hot rolled coil (HRC) and 0.3 million tons of slab capacity by this year-end. The HRC capacity will be further augmented to 5 million tons by FY '13. In second step, the company will start mining iron ore and coal from the mines allocated to it. This process will take around 4-5 years. Hence, the full impact of integration, from mining to value added steel products, can be seen from FY '14 onwards. The company has already spent 50% of total capex required for all these expansion programs.

VALUATION:

The full impact of first phase of expansion will start flowing into the financials of the company from FY '11 onwards. As a result of this backward integration, its net profit margin is expected to rise to 15-16%, from the current 9%. This will also boost the company's operating cash flow significantly.

The earning per share (EPS) for FY '10 and FY '11 is estimated to be Rs 171 and Rs 243 respectively. At the current price level, the forward price-earning multiple works out to be 7.9x and 5.6x for FY '10 and FY '11 respectively. The company's scrip has always traded at a P/E multiple in the range of 13-17 during good times. This provides significant upside potential for investors with a horizon of 2-3 years.