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Expect demand revival in 4Q

Weakness in current quarter is temporary

 Demand remains tepid in current quarter

* This quarter was impacted by several factors, seasonal and non-seasonal, resulting in lower-than-anticipated demand.

* The correction in international steel prices has been the key reason for poor demand as buyers have deferred purchases.

* Most of the buyers are waiting sideways and ordering only on an absolute requirement basis; no restocking demand is observed.

* Dealers have sufficient inventory and appear to be de-stocking in the event of a price correction.

* There is strong competition from secondary steel players in the Pipes and Tubes segment. They have started rolling narrow sheets from bigger billets and have been supplying sheets to the P&T segment – this is in direct competition with the Hot Rolled Coil market, especially in the Narrow-width segment

* An extended monsoon in the southern region and non-seasonal rains in the northern region have contributed to the market disruption.

* NCR, a major construction market, is facing a ban due to pollution, which has now become an annual feature around this time of the year.

* The resurgence of COVID in the form of the Omicron variant is bringing back memories of the disruption witnessed during the Delta variant.

 Target to turn net debt zero by 1QFY23

* SAIL has not chalked out its growth capex and has maintenance capex for the current year, in our view.

* We believe the growth capex may not start before 2HFY23 as the company plans the entire capex, scopes the land requirement and matches the availability, works out the end product configuration, and finalizes the suppliers.

* By this time, the company will have achieved the net debt nil status, which it had almost a decade ago.

 Next round of growth capex to be modular, with low debt burden

* SAIL is unlikely to embark on a big bang capex – which the company had initiated in FY10, as a result of which it was saddled with debt and had challenges commissioning its plants in various locations.

* The current management has decided to implement a modular strategy, i.e., it plans to adopt the ‘one location at a time’ approach – SAIL will initiate capex at a single location; when this nears completion, it will initiate capex at another location. In this manner, cashflow from the newly commissioned facilities should augment the cashflow needed for the next round of capex.

* Notably, the company has made a big shift in its capex strategy and is unlikely to fall into the debt trap again, which should allay investor concerns regarding its capex plans.

* We believe SAIL may construct a single blast furnace with capacity of 3–4mt at each of its locations, with matching downstream as a part of the next round of growth capex. Although, the new norm for most economical blast furnaces is 5mt. However, these plans are still in the drawing board stage.

3QFY22 to witness trough EBITDA margin

* The management highlighted that coking coal costs would be higher by INR7,000–7,500/t on a QoQ basis

* NSR is also down in the quarter for the reasons discussed above.

* Exports have been lower on a QoQ basis due to EU quotas for the quarter being exhausted on the first day of the quarter.

* With sales volumes down QoQ, fixed cost absorption should also be lower, resulting in reduced overall EBITDA.

* However, the stock has corrected 30% from the peak in anticipation of this reduction and now prices in the steel price correction.

Our view: Stock has bottomed out in the near term

* The management has reiterated its decision to turn net debt zero by 1QFY23.

* The company has already made cumulative provisions of INR20b towards wage revision, and we believe any further provision may not be material. Additionally, the company would benefit from the normal attrition process (retirement). Positions have not been filled completely due to process improvements, automation, and productivity improvements. Furthermore, the replacements are at a significantly lower cost, with higher productivity.

* SAIL has higher exposure to the Construction segment vis-à-vis peers. Hence, any revival in the Construction segment in 4Q should help the company improve its margins on a QoQ basis.

* It also has a lower proportion of exports compared with peers – which are likely to witness a sharper correction in NSR (v/s SAIL) as export opportunities have reduced sharply in 3QFY22.

* While coking coal prices would impact 3QFY22 margins significantly, we believe this is already priced in. The coking coal impact is likely to ebb in 4Q as prices have already softened from the peak, while steel prices are likely to pick up from Jan/Feb.

* We expect commodities to revive in China post the Beijing Olympics as the country eases construction activity and strives to lower carbon emissions – to ensure clear skies during the Winter Olympics.

* We further note that the downturn in Steel and Real Estate, the two most important components in China’s GDP, is unlikely to sustain.

* The stock is trading at 3.4x/4x/2x our FY22E/FY23E EV/EBITDA. It is trading at a P/B of 0.8x on FY22E/FY23E; we do not build in a recessionary scenario and expect demand to revive in 4Q. We maintain a BUY rating, with Target Price of INR142 at 5x FY23E EV/EBITDA. A key risk to our call is the prolonged downturn in China steel prices.

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