What investors are buying today is a lot of future expectations. If any of these expectations do not materialise, investors will be left with a highly leveraged commodity company having poor return ratios and volatile earnings history.
In commodities stocks, one has to be lucky twice in terms of getting in and out at the right price. A stock that caught market's attention is Godawari Power and Ispat, whose shares have made more than four-fold gains in last one year as investors and market pundits labelled it a turnaround story hoping for higher operating profit and deleveraging of balance sheet.
Out of debt trap?
Godawari’s management has extensive experience in steel industry spanning over two decades. Even during the severe commodity downfall in 2008-09, the company made decent profits and cash flows attributed to its strength in core steel business. The company converts iron ore into pellets and other intermediary products used for the captive consumption as well as selling in the spot market. It is one of the low-cost producers as large part of their raw material is sourced locally in Chhattisgarh. In worst steel cycle during 2009 and 2016 its operating margins have dipped to lows of 10%, otherwise it has maintained margins in the region of 15-20%.
What did not work for Godawari over these years was the heavy reliance on debt-funded growth. Its total capital employed jumped by over Rs 1,250 crore from Rs 1,638 crore in FY12 to Rs 2,962 crore in FY15 largely on account of creation of 2.1 million tonne pellet capacity and other capex. On top of that, it allocated cash generated from the core steel business into unrelated activities like solar in 2013.
For instance, solar presently makes less than 8 percent internal rate of return and account for close to Rs 700 crore of capital deployed in the business. Apparently, this came at a time when its core business was lacking backward integration as only 40% its iron ore requirements were met through captive iron ore mines in FY14.
By the end of FY17, the company was sitting on a debt of close to Rs 2,215 crore on an equity of Rs 696 crore and was barely able to meet its interest costs thereby incurring losses. Even for the first half of the current financial year, the company incurred an interest cost of Rs 132 crore on an income before interest and tax of Rs 160 crore.
Counting on better cash flows
Nothing much has changed except upturn in steel cycle and improving pricing environment. Investors are now hoping that some of these past issues will get rectified with the cash flows improving particularly in the light of ready capacities (2.5 million tonne pellet capacity) and increasing supply from its own iron ore mines.
Estimates suggest global shortage of pellets because of shutdown of excess capacity in China. In the domestic market as well the industry is counting on higher demand for pellets with the recovery in demand and revival of stressed steel companies. This is also a reason that pellets realisations which dipped to about Rs 4,360 per tonne in FY17 as against Rs 9,000 per tonne in FY13 are expected to improve in the coming years.
That apart, as against current pellet production of 1.5 million tonne company is expected to move its production to about 2 million with a majority of iron ore being sourced from the captive mines over the next two years. Higher volumes, lower cost and better realisations would mean higher cash flows which can be used to reduce the debt. One other thing that could work in its favour is that the street is counting on a possible divestment of solar business which can cut its debt meaningfully.
What is in the price?Nevertheless, the stock has rallied on hopes and expectations and it is currently trading at 2 times its price to book value and 12 times its enterprise value to annualised operating profits of FY17. What investors are buying today is a lot of future expectations. If any of these expectations do not materialise, investors will be left with a highly leveraged commodity company having poor return ratios and volatile earnings history.