JSW Steel plans to expand but risk-reward unfavourable

JSW Steel Ltd’s stand-alone March quarter recurring profit after tax (PAT) at Rs650 crore (up 47% sequentially) stood higher than our estimates of Rs530 crore, driven by higher realizations and non-operating factors. The company also announced that it is close to acquiring a coking coal mine in the US, with a total reserve base of 123 million tonnes (mt), for a consideration of $100 million. JSW Steel expects 1 mt of coking coal in the first year of operation. However, further details on the proposed acquisition are sketchy. JSW Steel will also issue warrants to promoters, which would lead to a 9% dilution, to accelerate expansion beyond 11 million tonnes per annum (mtpa). Expensive valuations, high leverage and signs of weakness in steel prices make risk-reward unfavourable. Stand-alone earnings before interest, tax, depreciation and amortization (Ebitda) at Rs1,330 crore was 5% ahead of our estimates on higher realizations. Reversal of deferred tax liability due to a reduction in the effective tax rate boosted the positive surprise at PAT levels (tax rate for the fourth quarter was at 24%; effective tax rate 30%). Its US subsidiaries reported a positive Ebitda of $2.2 million, the first in the last five quarters. At current prices, conversion of these warrants would lead to an equity infusion of Rs2,140 crore. The management mentioned that these funds will be utilized to accelerate expansion plans at Vijaynagar or in the West Bengal project. We expect the company to announce firm plans for expansion beyond 11 mtpa, providing visibility on volume growth beyond FY12. Scrap prices, a leading indicator of steel prices, have declined sharply by 12.5% in recent weeks. Moreover, export prices of long products from Turkey have also reflected this weakness in the last few weeks. Our interaction with contacts in the industry suggests a weakening in steel prices recently. With raw material contracts for the first quarter of FY11 contracted at much higher prices, a possible decline in steel prices from hereon poses a threat to earnings and, at current valuations, makes risk-reward unfavourable in our view. The company announced an acquisition of a coking coal mine in the US, with a total reserve base of 123 mt, at price of $100 million translating into an enterprise/tonne of more than $1. The company did not give a breakdown of the reserves into proven, probable and inferred. This valuation compares with current valuations of $10-15 per tonne of reserves for Australian coking coal mining companies and $7-10 per tonne for Chinese companies. Currently, production of the mine is estimated at 180,000 tonnes per annum, which it expects to ramp up to 1 mtpa by the commencement of shipments in October. The production cost of the mines is estimated at $85-110 per tonne on a free on board port of export basis.