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Through cycle RoEs to stay strong; Initiate with a BUY

We initiate coverage on Shyam Metalics and Energy Ltd (SMEL) with a BUY rating and a target price of Rs400/share based on 1.17x FY24E P/B (which more than adequately discounts for forecasted 18%+ throughcycle RoE). SMEL is a sponge based long product producer (with coal linkages from MCL/CCL, unintegrated in iron ore which the company procures from Odisha) with sponge iron capacity of ~2.11mtpa as on March 10, 2022. It has pellet capacity of 2.4mtpa, with downstream billet and TMT/structural capacity of 892kte and ~820kte, respectively. Key drivers for SMEL are i) mini mill configuration allows for close cost monitoring, ii) capex optimization as some of the expensive EPC contracts can be avoided, iii) conservative capital structure holds the company in good stead through cycles and iv) tightly controlled cost structure and low capex intensity allow for increased return ratios through cycle. High RM costs is a key interim risk to margins.

Significant improvement in operating performance buoyed by sector strength. Given the portfolio of pellets/DRI/billets/TMT+ structurals, SMEL has witnessed a significant improvement in operating profitability over FY21. The significant sectoral tailwinds (in a highly cyclical sector) have also ensured very low leverage and healthy capitalisation metrics – net debt to EBITDA has declined from 1.9x in FY20 to 0.4x in FY21; net debt has declined from Rs12.9bn in FY20 to Rs5.2bn in FY21 and is net cash (~Rs7.6bn) at H1FY22 end.

Significant expansion planned. The company intends to expand capacity across two out of its three plants (at Sambalpur – Odisha and Jamuria, West Bengal). The capacity of pellets has been increased to 3.6mnte from 2.4mnte while the DRI/Pig iron capacities will increase from 2.11mnte as on March 10, 2022 to 3.498mtpa. In subsequent phases, the company also wants to implement blast furnace of 0.6mnte and a Ductile Iron plant of 0.2mnte. SMEL has been expanding capacity in its Sambalpur and Jamuria units; in maintaining low capital intensity and a conservative capital structure. FY18-FY21 cumulative capex incurred by SMEL is Rs18.3bn.

Low capex intensity allows for significantly higher RoE/RoCE through cycle, conservative capital structure allows for significantly improved risk reward. SMEL has been able to maintain a conservative capital structure with FY14-20 average net debt to EBITDA of 2.3x; this includes two meaningful downturn years of FY16 and FY20. Even in the depth of FY16 downcycle, net debt to EBITDA didn’t cross 5x. Also, SMEL is undergoing an expansion of 2.5mtpa steel capacity at a capex of Rs40bn – a significantly low capex metric of US$215/te. This allows us to be a bit more constructive on the through cycle return profile and consequently, through cycle P/BV that one can ascribe to SMEL.

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