Equity Analysis /
Pakistan

Pakistan Steel: Q4 FY 19 preview – Rising finance cost to drag on profits

    Ahmed Raza
    Ahmed Raza

    Investment Analyst

    Intermarket Securities
    16 August 2019

    Steel sector profits will likely continue their downward trajectory during Q4 FY 19. In addition to subdued demand and PKR depreciation, large increase in interest rates will elevate finance costs for all the companies.

    Budgetary measures brought more pain for the long steel players which will no longer pay a concessionary sales tax rate. More immediate-term concern is the reduction in tax credit on new investment for FY 19 (reduced from 10% to 5% of investment amount). This might lead to reversal of tax credits availed in 9M FY 19 in the Q4 result.

    Despite long steel players trading at significant discount to book values (64% for ASTL and 38% for MUGHAL on latest accounts), the above mentioned concerns may continue to weigh on stock prices. We prefer ISL (Jun’20 TP: PKR50/sh), as there are opportunities for import substitution in the interim. Although its competitor, Aisha Steel (ASL) has ended ISL’s monopoly in galvanized products with its new capacity, price increases by both players alleviates concerns of price war. 

    Finance cost to hit hard along with PKR depreciation

    We expect another quarter of sequential profit decline among IMS Steel universe in Q4 results. While muted demand and PKR depreciation have been the biggest factors in weak profits, interest expense is expected to escalate quickly due to elevated borrowing and higher interest rates (DR up 200bps to 12.75% during Q4). Amreli Steels (ASTL) is expected to post its second consecutive quarterly loss (LPS: PKR0.66) as pricing power remains weak in rebar segment. The expected sequential decrease in losses during Q4 is mainly due to the absence of consultancy charges (PKR150mn in Q2/Q3 each). Presence of Mughal Steel (MUGHAL) in girder segment should continue to benefit it in terms of gross profits but higher finance cost is expected to drag NPAT by 38% yoy (Q4 EPS: PKR0.85). We forecast a DPS of PKR1.50 along with Q4 result for MUGHAL (vs PKR2.2 in FY18). ISL is expected to post a sharper yoy drop in Q4 NPAT (EPS: PKR1.04, down 60%yoy) due to lower margins/finance cost. ISL will declare a final dividend of PKR1.0/sh, in our view, taking full year DPS to PKR2.5.

    More negatives for long steel in FY 20 budget 

    FY 20 budget brought sales tax structure of long steel at par with other sectors. Earlier, they were paying sales tax on units of electricity consumed but now their products are charged 17% federal excise duty (FED). This measure alone resulted in price increase of around PKR5,000/ton from Jul’19. Rebar prices are up by 20% qoq in Q4 FY 19 to around PKR118,000/ton to accommodate the impact of PKR depreciation and higher energy prices. Additionally, tax credit on new investments has been reduced to 5%/0% for FY 19/FY 20 (it was 10% previously), which may result in tax credit reversals during Q4 result. We have not incorporated any reversals as unrealized credits may be used to offset them. Higher energy prices will also affect long steel players more, in our view.

    Flat steel players in better position

    Amid the concersn above, we are cautious on long steel dynamics until demand improves, which requires the return of the government’s focus on infrastructure growth and softer macroeconomic backdrop. ASTL and MUGHAL are trading at P/B of 0.38x and 0.64x (book value as per latest accounts) but we think periodic increases in electricity tariff will keep pushing up raw material costs. This is challenging, given a weaker pricing consensus compared to flat steel. Flat steel sector has a duopoly structure, where despite the recent entry of Aisha Steel (ASL) in galvanized products (previously dominated by ISL), chances of a price war are low. Additionally, around 40% of flat steel is still imported, presenting opportunities for import substitution in the interim. ISL is our preferred pick among the covered steel players with Jun’20 TP of PKR50/sh. 

    Risks: i) PKR depreciation, ii) expansion by competitors, and iii) increase in electricity/gas tariff.