Electrosteel Castings - Antique

ElectroSteel Castings Limited 1

December 20, 2007

Initiating Coverage

 

ELECTROSTEEL CASTINGS LIMITED Pipes

CMP: Rs 81 Target: Rs 125

BUY

Key Market Data

Electrosteel Castings Limited (ECL)

is a leading manufacturer of Ductile Iron (DI) Pipes & Fittings and Cast Iron (CI) Pipes used for water supply and sewerage systems. ECL also offers turnkey solutions for water transportation and sewerage management. Its manufacturing facilities are located at Khardah and Haldia in West Bengal and Elavur in Tamil Nadu.

Investment Rationale

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Increased Government thrust on creating water infrastructure would boost demand of DI pipes.

 

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Due to their superior quality, Ductile Iron Pipes have gained acceptance over Cast Iron pipes and have a share of over 70% of the world pipe production for water transportation.

 

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In a bid to increase international presence , ECL has increased its thrust on exports and has been able to market its products in various countries through its subsidiaries. Exports grew 34% in FY07 and contributed nearly 40% to the topline.

 

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To improve margins, ECL has embarked upon cost saving measures by increasing the captive power plant capacity and installing a Sinter plant which would aid ECL to reduce raw material cost by using iron ore fines instead of costly iron ore lumps.

 

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ECL has taken the backward integration path to manage raw material costs efficiently. ECL has been allotted coal and iron ore mines, which would be operational in phases during FY09.

 

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ECL has envisaged a huge investment plan to forward integrate itself into steel manufacturing, through an SPV, ElectroSteel Integrated Ltd (EIL) which would

set up a 1.3mtpa steel plant. ECL will hold 40% stake in EIL with an investment of Rs 5 billion.

Ri

 

High volatility in input prices, unfavorable USD/INR movement and slowdown in investments by the Govt in water infrastructure may affect ECL. Valuation

 

At

Rs 81 ECL's projected EPS (FY09) of Rs 5 is discounted 16.3x. We recommend a ' BUY' on ECL with a price target of Rs 125 by Mar 09.

 

Seven-tenths of our body consists of water, but this does not reflect in our attitude to this precious natural resource. Water flows through our lives every day, but as long as our showers run and our toilets flush, we don't ask too many questions. We can no longer take water for granted.

 

Water, an indispensable resource, has an estimated content at about 1.39 billion cubic kilometers on Earth. Almost 97% of this is salt water and just 3% is fresh water, of which two-thirds is in the form of ice. Thus, usable fresh water constitutes only 1% of all of the water on earth.

 

Inelastic in nature with no substitutes, water has today become a vital commodity, characterized by limited supply and unlimited demand. Additionally, it is being used up at an alarming rate – the per capita availability of water in India has currently fallen to 2,000 cubic meters per annum, from 5,000 cubic meters per annum in 1950.

 

According to estimates of the United Nations, around two-thirds of the world's

population will not have enough water by 2025 if the current trends do not change for the better.

 

Moreover, India scores low on the water poverty index, a holistic water management tool developed by Centre of Hydrology and Ecology. All these facts highlight the growing importance of natural resources management across the globe, if growth has to happen through sustainable development.

 

Water has always played a central role in human societies, but in order to sustain that role, it needs to be harnessed and managed to increase its productive impact. Adequate water infrastructure is required to ensure the sustainability of water resources and overcome scarcity problems.

 

Physical infrastructure is also required to provide water-related services, primarily water supply and sanitation, for the population, agriculture and industry, as well as for treatment and disposal of wastewater.

 

Our positive outlook on the water infrastructure industry and on water transportation in particular has led us to look at

ElectroSteel Castings Ltd (ECL), which provides techno- economic solutions for water supply and sewerage systems. It is one of the leading domestic manufacturers of Ductile Iron Spun Pipes, Ductile Iron Fittings and Cast Iron Spun Pipes. Besides, ECL also offers Turnkey Solutions for water transportation and sewerage management which includes manufacturing, supplying, laying, operating and transferring of complete Ductile Iron Pipe projects.

 

Ductile Iron Spun Pipes

 

This segment is the main stay and the core business for ECL contributing more than 60% of total revenues and enjoying leadership in the domestic market. The mechanical properties of ductile iron as compared to gray cast iron include superior tensile strength, yield strength, ductility and impact resistance.

 

As a corrosion protection, cement mortar lining is an added advantage to ductile iron pipes. The lining provides a physical as well as chemical barrier to corrosion of the iron wall. Ductile Iron Pipes are incredibly versatile and can be used for a multitude of applications like transmission of raw, potable and sea water, distribution of potable water and gas, pipelines under major carriage ways and pipelines in hilly terrains.

 

Ductile Iron Fittings

 

ECL manufactures Ductile Iron Push-on Joint Socket Fittings which conform to Product Standards: BS-EN-545: 1995 / ISO-2531:1998 / IS-9523: 2000. It also manufacturers D.I. Fittings which are suitable for both Mechanical Joint and Push on Joint conforming to BSEN: 545/1995 and IS:9523/2000. This segment contributes around 3% to the total revenues.

 

The fittings are made at its plant in Khardah (West Bengal), with the most modern casting technique known as Vacuum Lost Foam Process. These Fittings are preferred because of the various advantageous features like easier

handling, superior strength, easier jointing, impact resistance and longer life.

 

Cast Iron Spun Pipes

 

ECL used to be one the leading players in the Cast Iron Pipes segment. However, in line with the demand shift from Cast Iron Pipes to Ductile Iron Pipes due to its superiority, ECL has continued with its focus on DI Pipes. However, to meet the demand in lower sizes in CI pipes and to retain customer relations, the company produces CI pipes at its Elavur Works in Tamil Nadu. ECL may eventually phase out the CI pipes division and focus solely on their core business of DI pipes.

 

Turnkey Projects

 

Under this segment ECL is engaged in activities of Engineering, Procurement & Construction Contracts for

Integrated Water Supply Schemes and Municipal Pipeline Contracts.

 

These contracts, apart from comprising of other civil engineering and electro-mechanical-instrumentation works, also involve substantial quantities of DI pipes and fittings. Scope of work in some contracts include the total Engineering and Operation & Maintenance works too, thereby providing substantial leverage for future similar business. This segment makes up around 10% of the total revenues.

 

The Infrastructure Division is presently involved in Municipal Contracts going on in Rajasthan, Jammu & Kashmir, Delhi, MP, Gujarat, Kerala and Karnataka.

 

INVESTMENT RATIONALE

 

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Government thrust on creating water management infrastructure

India is endowed with a rich and vast diversity of natural resources, water being one of them. Its development and management plays a vital role in the growth of the economy as a whole. Integrated water management is vital for poverty reduction and sustained economic development.

 

As a growing economy the demand for water is increasing everyday and unless there is proper infrastructure in place to conserve and reuse this scarce resource, the demand would far outstrip the supply which would lead to a crisis situation.

 

Understanding the severity of the situation and adverse consequences

of the same, Government of India has taken up the task to push reforms in the water infrastructure space and give adequate budgetary support for the same. The situation is similar to the power sector scenario, where India is targeting to replicate what it has achieved over the last 5 decades – in the next 5-10 years.

 

Aiding the process, international development finance institutions such as World Bank and the Asian Development Bank are extending monetary support. The Accelerated Rural Water Supply Programme (ARWSP) and the Pradhan Mantri Gramodaya Yojana- Rural Drinking Water (PMGYRDW) are aimed at increasing the supply of safe drinking water.

 

All these initiatives on part of the Government have generated a strong demand for DI pipes that are increasingly being used for water transportation.

 

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Ductile Iron pipes gaining acceptance over Cast Iron pipes

From the time Ductile Iron has been discovered it has been the preferred metal used in the manufacture of pipes, gaining acceptance over Cast Iron pipes. Improved properties like increased strength and resistance are recognized to be of particular benefit in the centrifugal pipe industry and as such most of the pipe production is now in Ductile Iron, hence, DI pipes have nearly 70% share of the world's pipe production for water transportation.

 

Domestic demand for DI pipes is buoyant, backed by Government plans laid out and massive replacement demand, cropping up from the need to replace old infrastructure laid down decades ago.

 

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Increased international presence - Thrust on exports

 

There is a huge export market for ECL's core products, Ductile Iron pipes & fittings and accordingly it has positioned itself as an international player.

 

Due to the superior quality, Ductile Iron Pipes are replacing Cast Iron pipes globally; capitalizing on the same, ECL has been able to market its products

in many countries across Asia, Middle East, Europe and Africa. Subsidiary companies Chesterfield Ductile Group Ltd (UK), Singardo International Pte Ltd (S.E Asia), Electrosteel Europe SA (Europe) and Electrosteel Algeria SPA (Algeria) and the newly set up branch in Abu Dhabi have given an impetus to the company's initiative in the challenging overseas markets.

 

Exports contribute nearly 35-40% of the total revenues of ECL and have grown by 34% in FY07 as compared to FY06.

 

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Cost saving measures – Bid to improve margins

 

As ECL is moving ahead with its growth plans, the company is also keenly looking at initiatives which would help them save costs and maintain margins going forward. The company already has an integrated manufacturing process as it manufacturers Pig Iron, Met Coke and Sponge Iron in house

for captive consumption, which helps ECL to control volatility in raw material prices.

 

In FY07 the company successfully implemented

Stamp Charging System at its Coke Oven plant which would help ECL produce quality Metallurgical Coke at a lower cost.

 

Rising prices of raw materials like Iron Ore, which is a major input in the manufacturing process has prompted ECL to install a Sinter Plant at its

plant at Khardah Works. The sinter plant which would be operational by Q4-FY08, will allow the use of iron ore fines instead of the costly iron ore lumps which would save Rs 600-700/tonne, thereby reducing raw material costs and helping ECL attain better operating margins.

 

Power is also one of the crucial cost components in the manufacturing process. ECL has a 3.75 MW power plant at Khardah Works; the company has commissioned a 12 MW power plant at Haldia in the mid - FY07.

 

This initiative has led to significant cost savings for ECL as it reduces the company's dependence on high cost power from other sources. Power at the Haldia plant is generated using waste Gas of Coke Oven Plant and Sponge Iron Plant. Out of the 12 MW, ECL sells 8-9 MW to the SEB grid and the rest is used for captive purposes. Haldia based power plant has been developed as a Clean Development Mechanism (CDM) Project, hence, carbon dioxide emissions would be reduced.

 

This makes the project qualify for carbon credits; ECL is expected to receive Rs 26.3 million from sale of carbon credits in FY08.

 

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Backward Integration – To offset rise in raw material prices

 

Effective and efficient management of raw material is the key to building a sustainable business model. Understanding the importance of the same and in the current scenario of rising raw material prices, ECL has acquired Coal mines and Iron Ore mines, the major components in the manufacturing process.

 

The company has received allocation of Parbatpur Coal Block in Jharia Coal Field which has reserves of 135 mn tonnes. The coal mine would be operational by mid - FY08 and would require a capex of Rs 3,350 million. After the mine is operational, ECL would have savings to the tune of Rs 500/tonne. Royalty of Rs 25/tonne is payable to the Government. ECL has also been allotted an Iron Ore mine in Kodolibad in Jharkand which has reserves of 100 mn tonnes.

 

The iron ore mine would be operational by the end of FY08 and would require a capex of Rs 1,350 million. Savings due to this development is expected to be Rs 700/tonne. If the iron ore production is more than what is required for captive use, the remaining would be sold in the market, we have not taken the upside from the same into our projections.

 

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Aggressive investment plans –Forward Integration through a SPV

ECL has chalked out huge investment plans through a de-risked model by creating an SPV namely Electrosteel Integrated Ltd (EIL) to catapult itself into the big league. ECL, a Rs 11 billion entity, is expected to grow manifold and become a large player over the next few years.

 

The plans include building a 1.3mtpa integrated steel pant in Jharkand and a 1200 MW coal fired thermal power plant, a total expansion plan of Rs 99 billion. The proposed steel plant which is expected to be commissioned in FY11 would entail an investment of Rs 50 billion.

 

The debt equity ratio for EIL is expected to be 3:1, ECL is expected to hold 40% stake in EIL by investing Rs 5 billion, out of which Rs 3 billion has

already been invested. The rest of the equity for the project would be funded by private equity and strategic investments.

 

An additional capacity of 200,000 tonnes of DI pipes is also expected to put up

in EIL going forward. The coal fired thermal power  plant is still on the drawing board. The company has acquired Thermal Coal blocks in North Dhadu which have certified coal reserves of 224 million tones. The estimated development cost of the mines is Rs 6 billion.

 

The projects under EIL are expected to be value accretive for ECL. Going forward, as the events unfold, we would value EIL accordingly.

 

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Investment in Lanco Industries

 

ECL holds 49% stake in Lanco Industries Ltd which is also a manufacturer of DI pipes, Pig Iron and Cement Slag. Lanco Industries has fully integrated operations which aids them in controlling costs.

 

The company has a capacity to produce 120,000 tonnes of DI pipes, 150,000 tonnes of Pig Iron and 90,000 tonnes of slag cement. It also has a Coke Oven Plant along with a 12 MW waste heat recovery based captive power plant. Going ahead, if ECL does increase its stake, Lanco Industries Ltd would become a subsidiary of ECL which could lead to significant synergetic benefits.

 

VALUATION

 

At the current stock price of

Rs 81, ECL's projected EPS (FY09) of Rs 5 is discounted 16.3x. We recommend a 'BUY' on ECL with a price target of Rs 125 by Mar 09.