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Earnings disappoint, but costs to peak in 2QFY23

* SAIL’s revenue grew 16% YoY but dipped 22% QoQ to INR240b in 1QFY23, ~8% ahead of our estimate. The beat was largely driven by 9% ASP beat.

* EBITDA contracted 65% YoY and 47% QoQ to INR23b due to consumption of coking coal at peak coal prices. Management highlighted that it had purchased coal at even near-peak rates and the same was consumed in 1QFY23. This together with falling steel prices led to a sharp drop in EBITDA. EBITDA/t at INR7,295 declined 63% YoY and 21% QoQ but was 17% higher than our estimates mainly because of better-than-estimated ASP.

* SAIL invoiced Indian Railways for an additional INR4.89b due to a revision in the contract with them for FY22. Adjusting for the same, EBITDA declined 73% YoY and 62% QoQ to INR18b and was ~9% lower than our estimate of INR20b. We note that this is a recurring phenomenon and not a one-time charge as the adjustment to invoicing happens annually post-negotiations.

* Net profit plunged 89% YoY and 68% QoQ to INR8b, which was largely in line with our estimate of INR7b.

* Coking coal has corrected sharply to ~USD200/t, ahead of our expectations. The La-Nina phenomenon in Australia is over and coking coal supplies within China has improved. Hence, we expect new coal prices to start reflecting in SAIL’s Sep’22 profitability numbers. With steel price at over INR55,000/t and coking coal cost at USD200/t, we believe margins should normalize in 3QFY23 and improve in 4Q. Correction in coking coal price was severe, above our expectation and more than our assumption for FY23E. Consequently, we raise our FY23E/24E EBITDA by 27%/30%, respectively. We also increase our TP to INR96 premised on 5x FY23E EV/EBITDA.

Peak costs behind, profitability to improve in 2HFY23E

* In 1QFY23, RM cost/t was the highest in the last 36 quarters. Similarly, conversion cost (total cost ex-RM cost) was the highest on per tonne basis in the last 36 quarters.

* However, RM cost is likely to reduce from 2QFY23 onwards as coking coal costs correct.

* We believe with the increase in volumes, the fixed cost absorption level will also improve and the profitability should expand in 2HFY23E. In addition, release of cash locked in working capital will ensure debt reduction in the next two quarters and help improve the valuation of the stock

Valuation and view

* Prime coking coal price has corrected to USD204/t from the peak of USD703/t (FoB, Australia). We believe the share of premium coking coal in the coal blend is the highest for SAIL v/s other leading integrated steel manufacturers.

* SAIL was the most adversely impacted when coking coal prices shot up, and the reverse also holds true that SAIL will benefit the most from this contraction in coking coal prices.

* While we remain conservative in our volume estimates, we note that the steel ASP especially in the long products has stabilized now aided by the secondary TMT price that is likely to remain elevated due to high thermal coal costs

* We raise our FY23E/24E EBITDA by 27%/30%, respectively, factoring in the reduction in coking coal costs. We raise our TP to INR96 (v/s INR81) based on 5x FY23 EV/EBITDA. The key risk to our call is the rise in coking coal costs..

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