This case study will be divided into three Parts:
1)Part 1 – 2010
2) Part 2 – 2011-2013
3) Part 3 – 2014
For the purpose of this part, Let’s assume today is 5th August,2010.
Screening: While glancing at steel price chart, you think of searching about indian steel companies since 2008 fall and the name of Bhushan Steel pops out.
Steel as a whole is very old commodity industry. With Tata Steel being the leader in India (Private Player). Steel is made from iron ore.
Bhushan steel is a large integrated steel company – Those steel industry players which produce everything from iron ore to scrap. Initially the company had complete cold rolling mill with downstream flat products. Recently, the company has made an integrated steel plant in Orissa. The company mainly sells to all the automobile manufacturers.
Lets look at the income statement to see how it looks?
The income statement of the company looks like a typical commodity manufacturer, with major cost involvement in Raw Materials while the other rest all as less. Clearly, the gross margins over time have been fluctuating. While as the scale of operations have increased from 2002 to 2010 the benefit of economies of scale seems to be accruing. Let’s confirm the same from balance sheet and the unit economics of the firm.
The Balance Sheet confirms the commoditised nature of the firm with major proportion of fixed assets in the balance sheet. Now if we look deeply at the first glance it seems clear that the size of the balance sheet has grown over time.
Capex: The company is doing huge amounts of capex from 2005-2010. This capex seems to be particularly financed from debt as can be looked at the financing structure. The steel price chart given above (section screening) also confirms the same. This behaviour is typical of commodity companies which do huge amounts of capex in an up cycle, while try to sustain in a down cycle. Let’s further confirm this from the production numbers.
Production numbers further confirm the cyclical behaviour of the firm.
In fact, the company took advantage of operating leverage from 2002-2008, currently due to capex and under-utilised capacity the Fixed cost is high.
Generally, In a commodity industry, the cheapest cost player with a strong balance sheet is the survivor or the winner. Let’s see in further sections whether Bhushan Steel satisfy these parameters.
If looked from a stage of growth of the industry perspective steel is a mature industry in India. While there are multiple players, true competitors in terms of scale, geography and products are tough to define for the Bhushan Steel. However, Tata steel being the oldest, largest and cheapest cost player, could be compared for numbers (Industry leader).
In terms of scale the sales of tata steel is around 100,000 crore while Bhushan steel is a smaller player (5000 crore).
If we focus on the Raw Material Cost per ton, which is the main component in a steel mill, clearly Tata steel seems to be the cheapest cost player. Even the company seems to have advantage in terms of more operating leverage (Fixed cost per ton). Their comparison is not exact, as Tata steel has large integrated steel plants with captive coking coal capacities, while Bhushan has to import the same.
In terms of financial leverage, the balance sheet of Bhushan Steel seems to be weak in comparison to Tata Steel. As of now, There seems to be no huge competitive advantage of Bhushan Steel.
This is in no mean to undermine the hardwork put in by the promoters on the ground. It is just a basic part of the process.
While there are no signs of any kind of active fraud, however, there are seem to be some lapses. An accident occured in the firm in 2004, where ammunition from metal scrap exploded resulting in the death of workers. Similar incident occurred in 2001. The repeated nature results in questioning the safety practices adopted by the company.
As of now, there is no evidence or signs of a large scale fraud.
The steel industry is import dependent, it grows mainly in line with the GDP of the country over the very long run. The growth prospects of the industry are decent though not that great if we compare to other industries. The growth is mainly determined by the factors of demand and supply.
In case of Bhushan Steel, the company is taking over huge capacity expansion projects since 2005, Mainly building a large Integrated steel plant/complex in Orissa to be completed in 2012.
Though industry is not in a tailwind, hence the growth prospects for Bhushan seem to be decent.
From the point of view of employees safety, the quality of the management teams seems questionable. As already mentioned above, There have been two regular accidents in the steel mill in 2001 and 2004.This may be worrisome for future.
The management’s capital allocation skills seems to be an area of concern. The company has acquired coking coal mines in Australia instead of paying down the heavy debt. The model of the company seems to be to grow or improve returns with Leverage ratios as high as 4 times. This trend is particularly visible from 2002 when there was a management split.
In steel industry, unless the product is different/unique this is a deadly combination. The integrated steel plant being made is mainly funded through lot of leverage. It will be interesting to see how does the company cope up with the situation particularly now when the steel industry is going through a downturn.
Valuation tells more about the valuer. It can be done using different methods. It depends more on the time horizon of the one buying.
While using price to book method Bhushan seems to be valued more considering the new project being installed.
If we use replacement cost method Mr. Market seems to be assuming around 6% growth for the next 10 years (more or less the expected GDP growth). If compared to 10 year bond yield which is trading at around 7.7% – This is more or less equal to expected GDP growth.
Our Opinion: Excel is a beautiful software for writing fiction. We have almost no confidence in the valuation estimates of Bhushan Steel Limited due to almost no certainty in terms of competitive advantage or cash flows. However, there seems to be very small option value if Bhushan’s Orissa project is successful and the company pays offs its debt. Right now it is very tough to know. You may have a different viewpoint and we would love to know why it is so?
The balance sheet of the company makes it more fragile due to the large amount of leverage. Significant recession or a longer duration one in the steel industry may take the company for a toss.
At the current price, Bhushan Steel seems fairly valued. We agree with the market. However, we will not allocate any portion of the portfolio to the same. Mainly due to the high leverage of the company at this point of time. The same may change with time. You may have a different viewpoint and we would love to know why?
Key Variables to Track:
A) Marginal ROCE
B) Marginal GFA per ton
C) Sales price and cost price per ton
D) Marginal ROE
The purpose of these case studies is to practice such cases and help all of us develop patterns to take similar decisions in future and avoid mistakes of both omission/comission. Its like practice before the main match. We may have made some mistakes, please happily point to us. You may not agree with us. However, we would love to know why you think so or what you may have done differently? So that we may all learn together.
Before Going further it would be better if you Analyse the case or do the valuation or allocation according to your own Method. That way it may help you to do better with the case further and sharpen your mind for future.
Pick Parts of the case study and use it as it may be helpful to you.
May we all learn and progress together.
We will cover the next phase, from 2011-2013 in part 2. (Please click on 2 on the bottom of the page)