Usha Martin posted its Q2FY23 nos. today and it has been a solid quarter with significant volume growth. Q2 usually is a weaker quarter domestically due to monsoons and internationally this quarter has had multiple issues like significant currency fluctuations/steel price movement and the rest. What is very heartening is how the margins have remained consistently around 15% during the complete steel cycle (despite the possible inventory write offs) thereby showing the business strength due to its ability to pass on RM price movements. There are some interesting observations one can make from how the Usha Martin story has shaped over the years:
a) Not all backward integration makes sense: Usha Martin tried to get into commodity steel manufacturing to support its inhouse consumption. What this did was following:
-
Made the business cyclical and the margins variable with the steel cycle and hence taking away any predictability of margins. Also since backward integration was leveraged a bad steel cycle resulted in huge value destruction.
-
It forced Usha Martin to get into more commodity products like auto wires and the core business of rope making did less and less of value addition and competing with global companies and became more and more of an inhouse consumer of steel.
b) Owner interest vs Earnings Consistency & Predictability: The goal of a business is to maximize net owner earnings during the course of its existence. Consider the case if Usha Martin had continued with its steel business. There is no doubt during the recent steel cycle upswing and even during other time periods backward integration would have saved significant costs assuming financial leverage was managed properly. Over the longer period having steel plant would have increased owner earnings (look at tata steel long products before the acquisition of Neelachal Ispat). The markets on the other hand value consistency & predictability of earnings & ROEs over the ebbs & flows of earnings even though they might in totality be higher/better.
As a transient shareholder playing the growth and valuation game in this case my interests might not really be with the owners of the business looking to maximize the earnings over its existence.
In conclusion do look at companies going for backward integration and see if they are getting into commodities/commoditized products and unless this backward integration helps in increasing margins of the core product question the margin consistency and predictability.