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Electrosteel Castings review and analysis by Angel Broking

By Angel Broking

 

Electrosteel Castings (ECL) is a leading player in ductile iron (DI) pipes and is venturing into steel making through its subsidiary Electrosteel Integrated (EIL), which is setting up a 2.2mn tonne steel plant expected to be commissioned by FY2012E. ECL's backward integration initiatives through allocation of coking coal mines are expected to result in expansion of EBITDA Margin by 1,304bp over FY2009-12E. The company is also awaiting final environmental clearance for its iron ore mine, which will further lower costs, but has not been factored in our estimates. Further, listing of EIL in which ECL holds 40% stake could unlock value for ECL. We Initiate Coverage on the stock, with a Buy recommendation and 18-month SOTP Target Price of Rs72, valuing the Core business at 8x FY2012E FDEPS and its investments in the Steel business at 1x Book Value.

Moving towards an Integrated business model: ECL is on track to have in place an integrated business model going ahead through a) Backward integration initiatives led by the allocation of mines, and b) Focus on beefing up its logistic infrastructure to further reduce costs. The company has already started coal production from its coal mines at Parbatpur, Jharkhand. This is likely to result in EBITDA Margin improving by 1,304bp to 28.0% over FY2009-12E, despite the fall in DI realisations. Moreover, grant of iron ore mining lease, with estimated reserves of 91mn tonnes could further improve Margins, which is not factored in our estimates.

Value unlocking through listing of EIL: ECL is setting up a 2.2mn tonne steel plant through EIL, in which it holds 40% stake. The total project cost of Rs7,262cr has been funded through a Debt-Equity ratio of 3:1 and the project has already achieved financial closure. Of the total equity contribution of Rs1,815cr, ECL has made an investment of Rs726cr. ECL plans to list EIL to raise Rs300cr, which is likely to  unlockvalue for ECL.

 

 

 

 

 

 

Investment Arguments

 

Moving towards an Integrated business model

ECL is on track to have in place an integrated business model going ahead through a) Backward integration initiatives led by the allocation of mines, and b) Focus on beefing up its logistic infrastructure to further reduce costs.

The company was granted mining lease for the Parbatpur coking coal mine in Jharkhand in January 2008 for 30 years. The mine is estimated to have reserves of 231.2mn tonnes. Production at the mine has already started and we expect 20% and 25% of the company's total coal requirement in FY2011E and FY2012E respectively, to be met through this captive coal mine. As a result, EBITDA Margins are expected to expand by 1,304bp to 28.0% over FY2009-12E, despite an expected fall in DI pipe realisations on account of the competitors’ capacity coming on-stream.

 

 

 

 

 

On the iron ore side, the company is in the process of acquiring the mining lease for the iron ore mine at Kodolibad, Jharkhand. Currently, the company is awaiting final clearance from the forest and environmental authorities. The cost reduction resulting from the captive iron ore mine would result in significant Margin expansion as iron ore cost would reduce by 40-50%. However, we have not factored the same in our estimates as the final grant of the mining lease is pending.

The company holds 49% stake in North Dhadhu Mining Company for a non-coking coal block at the North Dhadhu coal field in Jharkhand. The thermal coal from the mine will be utilised for its power plants, which would result in further reduction in costs.

Currently, ECL outsources its logistic requirements to a third party. However, the company has started work on building a captive railway siding at Parbatpur and Kodolibad (subject to mining lease being granted) to optimise its logistic costs.

ECL is incurring capex mainly for development of the coal mines and setting up the railway siding, which will be funded through internal accruals. The company plans to incur total capex of Rs1,200cr, out of which Rs250cr has already been spent, while the balance is expected to be incurred by FY2013E.

 

 

 

 

Value unlocking through listing of Electrosteel Integrated

ECL, through its subsidiary EIL, expects to commission its 2.2mn tonne integrated green-field steel plant in Jharkhand by FY2012E. The Rs7,262cr project is being financed through 3:1 Debt/Equity ratio and has already achieved financial closure. ECL holds 40% in the steel project, while Stemcor, ILFS and others hold 20%, 8% and 32%, respectively. Stemcor is the world's largest steel trader with a network of 80 offices across the globe. The strategic alliance with Stemcor will enable EIL to leverage on the former’s well-spread distribution channel.

EIL has already acquired the land for setting up the steel plant and construction work is in progress. The company has entered into a 20-year long-term agreement with ECL-owned mines and plans to set up a 120MW captive power plant to meet 84% of the plant’s power requirement. The total equity requirement of the project is Rs1,815cr, and ECL has already infused its equity obligation of Rs726cr. Out of the balance equity requirement of Rs1,100cr, Rs800cr has been infused by other stake holders and EIL proposes to make an initial public offer (IPO) of the remaining Rs300cr, which is expected to unlock value for ECL.

 

Leading DI player, to benefit from Investment in Water infrastructure

The ECL Group and Jindal Saw are the key players in the domestic DI market. ECL has total capacity of 460,000 tonnes in the DI Segment, while Jindal Saw has a capacity of 300,000 tonnes. Others players like Jai Balaji, with a capacity of 240,000 tonnes and Tata Metaliks with a capacity of 110,000 tonnes in collaboration with Kubota Corporation of Japan are expected to foray into the segment with their plants expected to come on-stream by 2010E.

 

 

 

 

 

 

Increasing investments in Water Infrastructure to boost demand for DI pipes

The demand for DI pipes is directly linked to the investment in water infrastructure as it facilitates water transport. Currently, domestic demand for DI pipes is estimated to be 610ktpa and is expected to grow at 15% per annum. ECL currently enjoys 65% market share in the domestic market. The international market for DI pipes is worth around US $2bn, of which ECL enjoys a market share of about 6%.

 

 

 

 

 

Availability of water in India over the past few decades has been improving. The access to improved water resources is higher in India at about 86% compared to 76% (average) in South Asia and 83% in lower middle income countries.

 

 

 

 

As per the planning commission, in India, 9% of the urban population and ~25% of rural population does not have access to water supply. While access to water resources is high, 76% of the water supply in rural India is still being sourced from tubewells, handpumps, wells and others. In urban India, 31% of the water supply is through sources other than tap. This indicates the strong potential for developing pipeline network for supplying safe drinking water to households.

 

 

 

 

In India, poor sanitation system continues to be a major area to be addressed by the government. Improved sanitation facilities, as a percentage of total population, in India is very low at 33% as compared to 53% (average) in South Asia and 68% in thelower middle income countries.

 

 

 

 

Over the years, the Indian Government has been laying emphasis on setting up adequate water supply facilities and improving sanitation levels in the country. This is reflected in the higher Plan allocation of Rs143,730cr in the Eleventh Plan, up 122% over the previous Plan.

 

 

 

 

By end of the Eleventh Five-Year Plan (2012), the government aims to provide 100% water supply to the entire urban population at an estimated investment of Rs53,666cr. Moreover, with a view to develop water and sanitation facilities in the urban areas, the government has launched two new programmes, viz. Jawaharlal Nehru National Urban Renewal Mission (JNNURM) and Urban Infrastructure Development Scheme for Small and Medium Towns (UIDSSMT).

- JNNURM will cover 63 cities with a population above one million including 35 metros and other State capitals with a total outlay of Rs1,00,000cr where water supply, and sanitation accounts for 40% of the outlay.

- UIDSSMT will cover the remaining 5,098 towns having a population less than one million.

 

 

ECL’s strong relationship with government to hold it in good stead

Lately, the company has been facing stiff competition due to the entry of Jindal Saw and competition is likely to intensify going ahead with the upcoming capacity of Jai Balaji and Tata Metalliks in the same space. However, we believe that the risks of ECL losing market share is minimal, as it has a long-standing relationship with the government agencies. We believe that the strong relationship with the government coupled with the company’s integration initiatives will aid it in maintaining its marketshare.

 

Thrust on Exports

ECL continues to focus on its export strategy through its presence in Europe (France, Spain, UK and Portugal), Algeria in Africa and Asian markets (Singapore, Hong Kong, Mauritius, Sri Lanka, Bangladesh, Qatar and Bahrain). Currently, the company is exploring new markets like USA with the establishment of its American subsidiary. Moreover, with the investment in water infrastructure expected to increase worldwide to US $180bn by 2025E from current levels of around US $70bn as estimated by the World Commission on Water, we believe that ECL is well poised to benefit from its expanding export initiatives.

 

 

 

DI pipes better placed than Cast Iron (CI) pipes

Globally, DI pipes have replaced CI pipes and mild steel pipes primarily due to its inherent quality of providing superior strength, greater resistance power, corrosion resistance and ductility. As the demand for DI pipes has been growing over the years, ECL has been focusing on increasing its production of DI pipes, while the production of CI pipes has been muted. The company's DI pipes production registered a CAGR of 11.6% over FY2006-09, while CI pipes production declined at a CAGR of 10.3% inthe mentioned period.

 

 

 

 

Key Concerns

 

Delay in the development of the mines

Any delay in the development of the Parbatpur coal mines could adversely impact our estimates of lower coal cost. Although we have not accounted for the iron ore mines, any delay in the allotment process will impact the company's vision of becoming an integrated player.

Delay in setting up of the steel plant

ECL has already invested its equity component of Rs726cr and expects the green-field steel plant to get commissioned by FY2012E. It may be noted here that management has no prior experience in steel making. Hence, any delay could impact future plans of the company.

Adverse movement in product prices

Any significant price fluctuation for DI/CI pipes may impact the company's Earnings as well as our estimates.

 

 

Financial Analysis

 

Core business to grow…

We expect Revenue to de-grow by 25.5% in FY2010E to Rs1,451cr on account of lower sales volume of DI pipes due to the blast furnace shutdown in 4QFY2010 and absence of low-Margin trading revenues in FY2010E. However, we expect Revenues to grow by 17.6% and 6.6% in FY2011E and FY2012E respectively, primarily led by volume growth in the DI Segment. The Core business is expected to constitute around 89% of Revenues in FY2012E as compared to 83% in FY2009.

 

 

 

 

EBITDA Margins to improve

With competitors’ DI capacities coming on-stream, we expect an 8.5% and 4.6% fall in DI pipe realisations in FY2011E and FY2012E, respectively. Benchmark coking coal prices have also increased by 55% for FY2011. Nonetheless, we expect ECL’s Margins to improve over FY2009-12E on account of increased usage of coking coal from the captive mine.

 

 

 

 

Net Profit to increase

Net Income is expected to register CAGR of 22.5% over FY2009-12E to Rs 249cr. Consequently, Net Interest Margins are expected to increase to 13.7% in FY2012E from 6.9% in FY2009 on the back of better Operating performance.

 

 

 

 

Return Ratios on uptrend

We expect a significant improvement in the Operational performance of the company primarily led by higher volumes and lower coal cost. As a result, RoCE is expected to increase from 10.3% in FY2009 to 12.7% in FY2012E, while RoE is expected to improve from 10.4% in FY2009 to 13.6% in FY2012E.

 

 

 

 

Liquidity not a concern…

The company recently raised Rs200cr through a QIP issue and plans to use the issue proceeds for acquisition/development of mines. The company also issued 3.4cr warrants at an exercise price of Rs59.6/warrant. We believe that the fund raising through the QIP along with Operating cash flows would provide enough liquidity for the company to fund its Capex plan of Rs1,200cr.

 

…Net Debt-to-Equity in comfortable zone

 

Despite the high Capex plans, we feel that the company’s leverage is manageable. The Net Debt/Equity ratio is expected to fall to 0.5x in FY2012E compared to 0.6x in FY2009 owing to sufficient liquidity.

 

 

 

 

Outlook and Valuation

We like ECL’s inititatives of gradually venturing into steel making through its subsidiary EIL which is setting up a 2.2mn tonne steel plant expected to be commissioned by FY2012E. In addition, the company’s backward integration initiatives through allocation of coking coal mines are expected to result in EBITDA Margin expansion by 1,304bp to 28.0% over FY2009-12E. The company is also awaiting final environmental clearance for its iron ore mine, which will further lower costs, but has not been factored in our estimates. Further, listing of EIL could result in a value unlocking for ECL shareholders. We Initiate Coverage on the stock with a Buy recommendation and 18-month SOTP Target Price of Rs72, valuing the Core business at 8x FY2012E FDEPS and its investments in the Steel business at 1x Book Value.

 

 

 

Valuation including earnings from steel business

We have valued ECL's share in the steel plant at Rs35 after giving a discount of 20%. We have assumed EBITDA/tonne of US $175/tonne, in line with JSW Steel which is also a partly integrated company. While we have valued the Core business at 8x FY2012E FDEPS, the share in Steel business is valued at Rs35 per share. Accordingly, we have arrived at a value of Rs88 per share.

 

 

 

 

 

 

 

 

Business Overview

Incorporated on November 26, 1955, ECL formerly known as Dalmia Iron and Steel was promoted by Orissa Cement, Dalmia Cement and the Kejriwal family. Subsequently, over the years, ECL diversified into the production of DI pipes and increased capacity in both the segments through acquisitions and/or setting up green-field units. The company also undertakes turnkey contracts, viz. execution of DI pipe related engineering, procurement and construction (EPC) projects. The company sells DI pipes and DI fittings in both the domestic and international markets through its subsidiaries mainly in South-East Asia, the Middle East, Europe, Africa, and USA. The CI pipes are only sold in the domestic market.

 

 

 

 

Business Operations

ECL's manufacturing facilities are located at Khardah, West Bengal (for DI pipes and fittings), Elavur, Tamil Nadu (for CI pipes) and Haldia (for intermediate products). The company's operations also include facilities to manufacture pig iron, low ash metallurgical coke (LAMC), sponge iron and power. ECL has five subsidiaries, two associates companies and a joint venture to develop non-coking coal mines in Jharkhand.

 

 

 

 

DI Pipes and Fittings

ECL has an installed capacity of 2,80,000 tonnes for DI pipes, which are used in water infrastructure and sewerage industries. The company manufactures DI pipes in the range of 80mm to 1,100 mm in diameter and 6 metres in length. ECL also has an installed capacity of 5,000 tonnes for DI Fittings that are used along-with the DI spun pipes, to extend the length of pipes, joining across distances and providing bends for complete pipe-laying solutions.

 

Cast Iron (CI) Pipes

ECL's total installed capacity of CI pipes is 90,000 tonnes. The company manufactures CI pipes with diameters ranging from 80-1100mm with a corresponding length ranging from 4-5.5meters.

Coke Plants

Currently, the company has four coke oven batteries plants, having an aggregate capacity of 2,95,000 tonnes at Haldia, West Bengal. Due to the unavailability of coking coal with low ash content, the company meets its additional requirement through imports from Australia. The company has already received the mining lease for coking coal mine at Parbatpur in Jharkhand having estimated reserves of 231.2mn tonnes and expects 25% of its coal requirement to be met through captive mines in FY2012E.

Iron Ore and Sinter plant

Currently, the company sources its iron ore requirement from Orissa. ECL has been allotted the iron ore mine in Kodolibad, Jharkhand and is awaiting final Forest and Environmental clearances. The company has also installed a sinter plant having a capacity of 3,60,000 tonnes at Khardah, which facilitates usage of low-cost fines.

Pig Iron plant

The company's pig iron has capacity of 250,000 tonnes, which is used to manufacture DI and CI pipes. The company however, sources pig iron from a third party for its CI facility at Khardah due to the relatively high logistic cost.

 

Sponge Iron Plant

In order to reduce its dependence on scrap imports, the company has set up a sponge iron plant at Haldia with total capacity of 60,000 tonnes.

Power

- Haldia facility: The company has a 12MW power plant. While the captive power requirement is only 2MW, the balance power produced is sold to the West Bengal State Electricity Board.
- Khardah unit: The unit’s power requirement of 23MW is mainly supplied by CESC. The company has 3.75MW Steam turbine generator (STG) and three 1.1MW diesel generators.
- Elavur facility: The unit’s total power requirement of 1MW is supplied by the Tamil Nadu Electricity Board. The company also has two 0.79MW diesel generators and one 0.5MW diesel generator as a standby arrangement in case of any shortfall.  The unit’s total power requirement of 1MW is supplied by the Tamil Nadu Electricity Board. The company also has two 0.79MW diesel generators and one 0.5MW diesel generator as a standby arrangement in case of any shortfall.

 

 

Appendix

Grant of Mining lease

Mineral resources of country are regulated both by the Central and State governments. The Mineral Concession Rules, 1960, regulates the grant of mineral concessions. There are three types of Mineral concessions, viz. Reconnaissance Permit (RP), Prospecting License (PL) and Mining Lease (ML).

 

 

 

Before start of any mining activity, two important clearances are required, viz. Forest and Environmental clearance. The Central Government grants forest and environmental clearance based on the recommendation of the State Government. Total number of agencies involved are around 10 where the inter-dependency between the different agencies delays the process. The total time taken is usually 7-8 years for a Mining Lease to be granted.