IPO files: Agha Steel’s ‘Midas’ touch

06 Oct, 2020

For the first time in a long time, steel melting furnaces in Pakistan could soon be churning gold. And Agha Steel (PSX: AGHA), despite a rather novice history in premium steel-making, wants to be in the thick of it. With its imminent IPO which will finance its ambitious expansion program in billets and reinforcing bars; that may very well be true.

Steel, like other large-scale manufacturing industries in Pakistan, has had a tough few years; marred by demand snags, and limited investment in domestic capacity. The industry is largely informal and only a handful of players operate in the documented segment with any considerable plant capacity. But formal sector players have operated under-capacity for years (50-70 percent utilization) due to cheaper, ungraded steel coming from shipbreaking sector and small rolling mills found across the country by the dozens.

Then there are imports. The government, to its credit, has attempted to protect local players by slapping a range of tariffs on imports, notably regulatory duties (15 percent on billets; 25 percent on rebars) on top of custom duties, while several steel products, particularly long steel rebars also have anti-dumping duties (24 percent on rebars) in place. Despite these protections, imports are still 45 percent of total while total consumption in the country remains at least 5 times below the global average.

For all its fault, 2020 may prove to be a turning point for steel, on account of a construction amnesty scheme where investment in construction may yield sweet profits for investors. The no-questions-asked policy could potentially harness a huge influx of undocumented cash into the sector which would in turn generate substantial demand for building and construction materials manufacturers. Then there is the Karachi Transformation Plan with the highest chunk of development spending (51 percent) dedicated to construction of roads, rail, and mass transit.

In addition, aside from two mega dams Diamer-Basha and Mohmand, there are at least 10 more dams that are either in their initial stages of development or planned. One important point to mention here is that a typical building construction uses 1 ton of steel against 4-7 tons of cement depending upon the type of development (more cement is used than steel); however, dams have a 1:1 ratio i.e. as much steel is used as cement or even 1:2 where more steel is required. There are also several roads and rail infrastructure projects on top of wind power, coal fired power, gas, railway, and transmission lines projects already planned, many of which are part of CPEC. Let’s also not forget, the 100,000 houses being constructed under Naya Pakistan.

Various estimates based on sensitivity analysis suggest steel demand over the next year could increase between 1.2 million tons (up 39 percent) to 2.5 million tons (up 82 percent) and continue to increase over successive years on average between 10-12 percent. Cumulatively (optimistically), that means steel consumption could be touching 9-10 million tons over the next six years from its current 3-3.5 million tons.

It then makes sense that Agha is going public now. In the first phase that ended in Jun-18, Agha completed a BMR to increase melting capacity from 250,000 tons to 450,000 tons (imported scrap to billet) and rolling capacity to 250,000 tons from 150,000 tons (billet to rebar). The new melting capacity enables the company to make specialized grades of billets which it would sell to the market. In the second phase, the company is going beyond capacity expansion (to 650,000 tons of rebars). It is bringing a new re-rolling mill called Micro Mill Danieli (Mi.Da) supplied by an Italian company.

This will put Agha solidly a head and shoulder ahead of its peers as Mi.Da will make its steel-making machinery tremendously efficient. A process (scrap to billet to rebar) that takes days for any steel manufacturer in Pakistan will be condensed down to merely 2 hours once Mi.Da comes online; like travelling on the Pakistani railway against flying. Since it is a continuous process, the company will attain a higher yield from billet to rebar — 99.2 percent against the country average of 90-92 percent and global average of 96 - 96.5 percent.

As Hussain Agha estimated in an interview with BR Research: “Today, if our sale revenues are about Rs20 billion — and let’s assume the yield benefit is around 5 percent — just by adopting this technology, our bottom-line could grow by Rs1 billion”. Mi.Da also uses less power. As it stands, Agha’s melting capacity is already energy-efficient as the installed Electric-Arc Furnace saves the company 20-25 percent of electricity against an induction furnace. With Mi.Da, this will be further reduced. If a rolling mill consumed 100kwh per ton of capacity, Mi.Da will use only 60— it is 40 percent more efficient.

Nearly 45 percent of the proceeds (debt + equity) are going toward capex including Mi.Da plant and an air separation unit. Against competitors, Agha can safely compete on technology as none of the small to big players in Pakistan have an electric arc furnace for melting or a specialized rolling mill that cuts down all the noise; saves on wastage, on time, and on energy. All these translate to superior margins that Agha can already boost.

The company’s six-year revenue CAGR is comparable to peers but it certainly wins on costs. Cost of sales CAGR for the past three years has seen negative growth against increasing costs for both Amreli and Mughal. Agha’s cost per ton sold (estimated for rebars) is also significantly lower than its well-established peers.

As for profitability, in just the past year, Agha’s net profits grew 61 percent against Mughal’s 57 percent decline in earnings and Amreli clocking over a billion-rupee loss. This was a period of low demand but also very low international scrap prices, which Agha seems to have spun to the best of its advantage. The company seems to have completely ploughed back profits so far.

Against these encouraging metrics also stand some challenges. Agha has maintained a negative cash flow over the past three years due to higher financial cost payments and inventory charges, with a highly leveraged balance sheet. Its debt to equity of over 2 times is higher than peers but understandable given the expansion. The higher leverage position necessitated the IPO at this point and post-IPO— given its success — debt to equity may come down. For now, given the company’s interest coverage ratio, it is making satisfactory income to honor its interest payments, though it has fallen over the past three years.

The finer print of the financial statements exposes more vulnerabilities. The company has a very slow inventory turnover than industry average — this is costly evidenced by its negative cash flow situation. Inventory days stand at 236 - 310 for Agha against Mughal’s 65 -100 days and Amreli’s comparable 59 -109 days. The sales structure here matters. While Agha boasts about its high institutional sales — 75 percent against 25 percent direct sales to retail (and undoubtedly saves on distribution costs, retailer margin, discount margin etc.), it is also incurring the danger of inventories lying around for 300 days, locking in liquidity and increasing financing requirement for working capital. In recent years, this has translated into higher fixed interest payment charges.

This could potentially become Agha’s Achilles heel once 200,000 tons of new capacity comes calling. Agha may want to continue maintaining a dominant share of sales in mega projects but it must get its feet wet in the retail market to ensure its capacity is effectively utilized and avoid inventory buildup – capturing a competitive price in the market. Agha’s revenue per ton sold (calculated for rebars) is lower than peers, a telling sign of the skewed sales mix which the management considers a win; but could very well be a double-edged sword. And while one cannot deny Agha has contributed historically to large government and private sector projects and will be able to sustain this position, project-based sales are a volume based business and perhaps the advantage over retail is cost-savings and scale, rather than price retention.

Another challenge that rears its head is scrap. Market insights suggest the company is using low-quality scrap which brings down the quality of its final product and this may affect its sales. However, that can be easily rectified — if in fact true (the company’s low wastage ratio indicates otherwise). The actual challenge is lack of long-term contracts on scrap supplies. Since scrap takes up about 60 - 65 percent of the total manufacturing cost — and given how low scrap prices are trailing globally — Agha should consider long-term contracts fetching better prices, and perhaps quality, ahead of time. Since its sales are mostly project/volume-based, it can ostensibly establish these long-term contracts against peers that are selling and depending on market forces and may not have the same choice.

Amid challenges, there is no denying Agha is an outperformer in several categories. It is operating an efficient plant, soon to channel the highest capacity among peers. It is well-positioned among high-margin institutional sales and is now also selling billets, having secured a contract of Rs10 billion every year with Horizon Steel just last week. Given market eagerness and its standing against peers, Agha could become a star performer on the PSX, if the investors do not attach too large a discount to inventory carrying costs.

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