October 5, 2020 (MLN): Agha Steels is the talk of the town these days – at least in the vicinity of Chundrigar Road. The company wants to go public in style, in what could be the biggest initial public offering of the sector, raising between Rs. 3.6 billion and Rs. 5.04 billion with 120 million shares on offer, which make up 20.85% of the total post-IPO paid-up capital.
The company’s prospectus is the kind of report card all of our parents wish to see. Its gross margins exceed 20% in projections and historic values (except for 19% in FY19), beating the industry average of 10-12% by a distance. The performance in terms of net profits was no less impressive, with CAGR at 33% and margins hovering over 10%.
They attribute this extraordinary performance to a number of reasons. First, unlike its peers who use induction furnace, Agha has the electric arc furnace which helps save costs, with respect to electricity and cheaper raw materials (scrap). Then its tilt towards institutional clients, instead of retail, also boosts margins.
However, beyond a first glance at the investment teaser, there are a number of question marks which should be explored in further detail. While Agha Steels boasts about the superiority of its technology and how that brings efficiency into its systems, we don’t know exactly how much that really translates into saved costs. Estimates suggest the electric arc furnace cuts electricity bills to the tune of Rs. 2,250 – 3,000 a tonne. AKD Research quotes another Rs. 10,000 – 12,000 reduction through use of low-grade scrap.
But again, there is more to it than meets the eye. Other than the utility and raw material bills, electric arc furnaces require electrodes and oxygen, which obviously come at a price. An official at Naveena Steels said at the time of conducting feasibility study for their own plant, the total project cost of electric arc exceeded that of induction by 3%, so the company went for the latter. Similarly, AKD projects an additional bill of Rs. 1,500 – 2,000 a tonne for electrodes, which comes on top of the cost of holding long inventory cycles. This technology also produces better quality output, again at a premium ranging between Rs. 3,000 to Rs. 5,000 a Tonne, which the market is generally reluctant to pay, sources said.
This takes us to Agha Steel’s number of days in inventory, which stood at 310 days in FY20, higher than that of Amreli at 92 and 66 for Mughal in 2019. Its receivables turnover stood at 104.39 days in FY20, as compared to corresponding values of 42, 40.61 and 24 for Amreli, Mughal and Ittefaq, respectively (in FY20 since their full-year reports aren’t out yet).
It should be noted that the only reason ASIL’s FY19 values weren’t used is because it reasons that below average ratios were because of factory closure for five months on account of BMRE. However, even after moving one year up or down, the company still comes out as a laggard compared to major peers.
The investment banker leading this IPO attributes the consistently higher receivables of ASIL to its institutional clientele, which requires more favourable terms but then makes up by ensuring relatively higher margin in terms of price.
ASIL also posts more than healthy projections for the years to come, expecting to reap benefits from the technologically sophisticated Mi.Da Rolling Mill. But in the backdrop of overall sectoral performance and outlook in the recent past and future, some doubts remain. For context, the steel sector’s profitability plunged 67% in 2019, according to a report by Foundation Securities. In fact, only Mughal among the major players posted a net profit, while all others incurred losses.
Few factors can help explain why Mughal defied the industry trend: first, it had a wider product line that included girders, unlike other players and then relatively higher construction activity in the north (where the company has a stronghold) as evidenced by local cement despatches helped it maintain a healthy bottom line. On the other hand, the same can’t be said about ASIL so it remains uncertain as to how it came on top despite lackluster fundamentals of the broader sector.
Admittedly, the plunge in the sector’s profitability was largely on account of a broader expansion drive. But even keeping aside that, the outlook for steel is not overly optimistic. For starters, due to the shaky fiscal situation, the Public Sector Development Programme budget is still lower than its FY17 levels, adversely impacting the demand.
“There is a lot of hype created these days around construction activity. However, in FY21 we expect the demand to remain flat to a growth of 5%. Things may start improving in FY22, but it all depends on GDP growth, PSDP allocation, rupee dollar parity, cost of electricity and the ability to pass through the costs,” said Fazal Ahmed, COO and CFO of Amreli Steels.
Another possible cause of concern could be the company’s relatively high leverage, which is currently 2.2:1 compared to the industry average of 1.4:1. The debt-to-equity ratio also stood at 0.69. Of course, that’s something the IPO proceeds will change significantly as the latter is projected to come down to 0.49 in FY21 – a drop of 20 percentage points in just one year.
Finally, ASIL was operating at 62% capacity utilization for rebars and 41% for billets as of FY20, which makes the new Mi.Da plant redundant for a few years ahead. Despite attractive headline numbers, a deeper look into the company’s numbers raises some doubts. We tried to reach out to the management multiple times with a set of questions and an interview, but they couldn’t take the time out because of the IPO.
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