Dissappointing show

Due to its captive iron ore operations,SAIL would not get incremental benefit from falling iron ore prices.

Poor operational performance in a weak-performing sector

We downgrade Steel Authority of India (SAIL) to In-Line from Outperform because of: (i) larger-than-expected capital expenditure; (ii) further delay in the expansion plan; (iii) weak steel sector outlook; and (iv) poor operational performance. We expect subdued pricing and demand outlook for the next two-three years.

Due to its captive iron ore operations,SAIL would not get incremental benefit from falling iron ore prices. SAIL plans an additional capex of R65 bn until FY17,in addition to R40 bn in the 11th Five-year Plan (FY07-12). Over the past five quarters,operational performance has been worse than that of competitors. We cut our FY13e/14e EPS (earnings per share) by 35%/51% to R9.1/R8.9 and also cut our price target to R95 from R146.

Increased capex to worsen balance sheet: The company has increased its capex guidance for FY12-17 by more than 40% to R650 bn (vs. R450 bn earlier).

We were expecting the balance sheet to gain strength once the current capex (capital expenditure) plan is over. However,because of the increased capex guidance,the company should report negative free cash flow (FCF) till FY17,in our view.

As a result,we expect the net debt of the company to increase to R428 bn in FY17 from R99 bn in FY12.

Delay in current expansion/modernisation: We were expecting SAILs capacity to rise to 16 mtpa by mid-FY13. However,it seems to have been delayed further by a year. We expect all the projects to be further delayed by 6-12 months from the time line given by management earlier.

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Weak operating performance compared with peers: Despite having captive iron ore operations,the company has been performing poorly compared with peers. Over the past five quarters,the company has reported Ebitda/tonne of Rs.4,000-R5,500. In comparison,Tata Steels domestic operations reported Ebitda/tonne of R15,500-R19,000 and JSW Steel,in spite of being a totally non-integrated player,reported Ebitda/tonne of R6,500-R 8,400.

Valuation: We valued the company at two-year forward EV(enterprise value)/Ebitda multiple of 5.5x (times). Previously,we valued SAIL taking two components of its valuation: (i) We valued base business at R90/share,taking no-growth operating cash flow. (ii) We also added 75% of the book value of the capital work in progress (CWIP) to account for significant investment in capacity expansion and the high probability that it could deliver $160/tonne of Ebitda/tonne.

At our base business value of R90/share,we had effectively valued the base business at one year forward EV/Ebitda multiple of 5.4x. We have not valued the CWIP,since we have already taken major benefits of the current expansion/modernisation plan in FY15 such as volume growth of 42% in FY12-15. 2.

Major benefit of modernisation (R2,000/tonne) has been accrued to our Ebitda (earnings before interest,taxes,depreciation,and amortisation) numbers in FY15.

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Even after FY15,the volume growth would continue to accrue to the company. However,we have not given significant premium on EV/Ebitda multiple because: (i) Ebitda growth at 10% CAGR (during FY15-17) is not very high to warrant significant premium over the relative valuation. (ii) The balance sheet would continue to worsen even after FY15. We expect net debt to increase to R428 bn in FY17 from R330 bn in FY15.

However,key risk to our valuation is earlier-than-expected completion of the projects. We expect current round of expansion/modernisation to be completed by FY15-end. If projects are completed before our expectation,there might be an expansion in multiples for the stock.

Standard Chartered