Merrill Lynch has recommended buy rating on Steel Authority of India raising the price objective from Rs 135 to Rs 182. SAIL trades at P/E of 8.5x FY08E and 7.8x FY09E. This is a discount of 27% to 36% to the Asian average, which includes Posco and Baosteel.
Raising PO to Rs 182; potential upside of 25%
Steel continues to be a good place to be in and we reiterate our Buy on SAIL with a new price target of Rs 182. This is underpinned by DCF. SAIL offers ownership of iron ore, strong volume growth, high free cash flow despite capex and is more than 25% undervalued versus global peers on FY08E and FY09E P/E multiples.
Earnings upgraded by 3% in FY08E and 7% in FY09E
Steel prices have done slightly better than our expectations in the current year and we forecast a 4% rise next year in benchmark steel prices versus flat earlier. As a result we now expect EPS to grow 21% in FY08 to Rs 17 and another 9% in FY09 to Rs 18.6.
Quality business with large volume growth & mix gains
We forecast SAIL's steel volumes to increase from 12 million tons in FY07 to 22 million tons in FY13, implying CAGR of 11%. This is based entirely on brownfield and modernization capex and is fully backed by in-house availability of iron ore. In addition, we look for product mix improvement – we forecast share of low-margin semi-finished to decline from 18% in FY07 to 7% in FY13.
Valuation discount unjustified in a booming iron ore market
SAIL trades at P/E of 8.5x FY08E and 7.8x FY09E. This is a 27-36% discount to regional peers and, in our opinion, unjustified. We expect the stock to get re-rated as investor focus increases towards India's resource-rich companies which offer healthy free cash flows and attractive volume growth potential.
Key investment arguments
Steel prices – higher for longer
Our Asia head of metals and mining, Alex Latzer, recently increased his steel price forecasts for the China region. In 2008, he expects flat steel prices to rise 4% and longs to rise 5% versus 2% and 0%. The anticipated price increase is led by continuing robust demand and supply under control in China. While China exports are unlikely to decline sharply, these have not led to increased supply in India. In addition, strong domestic demand in CIS has also meant that there have not been any supply fears for Indian steel companies. Lastly, within India, we estimate deficit is likely to rise as consumption is growing at 7-10% and supply growth has lagged. Overall, we believe the steel pricing environment in India remains strong. We forecast average realizations for SAIL to increase 6% in FY08 and 2% in FY09.
Attractive volume growth potential
SAIL is India's largest steel company, with current sales volume of 12 million tons. We forecast this to almost double to 22 million tons in FY13. This implies CAGR of 11% over the period FY07-13E. This volume has very high probability of being delivered, in our view, because it is coming through brownfield and modernization capex. Volume growth beyond FY13 also looks impressive with plans for 60 million tons by FY2021. However, this is not built into our long term forecasts and DCF valuation.
Ownership of iron ore
SAIL's volume growth plans are fully backed by in-house availability of iron ore. We expect iron ore prices to rise 5-6% CAGR over the next two years. This would help underpin higher steel prices or put pressure on margins of steel companies that are not fully integrated. In either of the two cases, SAIL will likely stand out with better profitability.
Product mix improvements
SAIL's large modernization capex should lead to lower production costs and improvement in product mix. We believe these will be likely gradual and backended, but powerful nonetheless. We expect share of low-margin semi-finished steel to fall from 18% in FY07 to 7% by FY13.
Valuation discount unjustified
SAIL trades at P/E of 8.5x FY08E and 7.8x FY09E. This is a discount of 27% to 36% to the Asian average, which includes Posco and Baosteel. We believe this discount is unjustified given SAIL's ownership of raw materials and large volume growth plans. Our PO of Rs 182 is based on DCF valuation. At Rs 182, SAIL would trade at P/E of 10.6x FY08E and 9.7x FY09E. This would still imply a 9% discount to Asian peers for FY09E.
Raising PO to Rs 182; potential upside of 25%
Steel continues to be a good place to be in and we reiterate our Buy on SAIL with a new price target of Rs 182. This is underpinned by DCF. SAIL offers ownership of iron ore, strong volume growth, high free cash flow despite capex and is more than 25% undervalued versus global peers on FY08E and FY09E P/E multiples.
Earnings upgraded by 3% in FY08E and 7% in FY09E
Steel prices have done slightly better than our expectations in the current year and we forecast a 4% rise next year in benchmark steel prices versus flat earlier. As a result we now expect EPS to grow 21% in FY08 to Rs 17 and another 9% in FY09 to Rs 18.6.
Quality business with large volume growth & mix gains
We forecast SAIL's steel volumes to increase from 12 million tons in FY07 to 22 million tons in FY13, implying CAGR of 11%. This is based entirely on brownfield and modernization capex and is fully backed by in-house availability of iron ore. In addition, we look for product mix improvement – we forecast share of low-margin semi-finished to decline from 18% in FY07 to 7% in FY13.
Valuation discount unjustified in a booming iron ore market
SAIL trades at P/E of 8.5x FY08E and 7.8x FY09E. This is a 27-36% discount to regional peers and, in our opinion, unjustified. We expect the stock to get re-rated as investor focus increases towards India's resource-rich companies which offer healthy free cash flows and attractive volume growth potential.
Key investment arguments
Steel prices – higher for longer
Our Asia head of metals and mining, Alex Latzer, recently increased his steel price forecasts for the China region. In 2008, he expects flat steel prices to rise 4% and longs to rise 5% versus 2% and 0%. The anticipated price increase is led by continuing robust demand and supply under control in China. While China exports are unlikely to decline sharply, these have not led to increased supply in India. In addition, strong domestic demand in CIS has also meant that there have not been any supply fears for Indian steel companies. Lastly, within India, we estimate deficit is likely to rise as consumption is growing at 7-10% and supply growth has lagged. Overall, we believe the steel pricing environment in India remains strong. We forecast average realizations for SAIL to increase 6% in FY08 and 2% in FY09.
Attractive volume growth potential
SAIL is India's largest steel company, with current sales volume of 12 million tons. We forecast this to almost double to 22 million tons in FY13. This implies CAGR of 11% over the period FY07-13E. This volume has very high probability of being delivered, in our view, because it is coming through brownfield and modernization capex. Volume growth beyond FY13 also looks impressive with plans for 60 million tons by FY2021. However, this is not built into our long term forecasts and DCF valuation.
Ownership of iron ore
SAIL's volume growth plans are fully backed by in-house availability of iron ore. We expect iron ore prices to rise 5-6% CAGR over the next two years. This would help underpin higher steel prices or put pressure on margins of steel companies that are not fully integrated. In either of the two cases, SAIL will likely stand out with better profitability.
Product mix improvements
SAIL's large modernization capex should lead to lower production costs and improvement in product mix. We believe these will be likely gradual and backended, but powerful nonetheless. We expect share of low-margin semi-finished steel to fall from 18% in FY07 to 7% by FY13.
Valuation discount unjustified
SAIL trades at P/E of 8.5x FY08E and 7.8x FY09E. This is a discount of 27% to 36% to the Asian average, which includes Posco and Baosteel. We believe this discount is unjustified given SAIL's ownership of raw materials and large volume growth plans. Our PO of Rs 182 is based on DCF valuation. At Rs 182, SAIL would trade at P/E of 10.6x FY08E and 9.7x FY09E. This would still imply a 9% discount to Asian peers for FY09E.
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