Sunday, November 14, 2010

BSE Metal Index Review Q2 Analysis

Adarsh Gopalakrishnan

Indian steel producers such as SAIL, JSW and Tata Steel have posted spectacular returns of 231, 685 and 315 per cent from the lows of early 2009. On an enterprise value-per-tonne basis, they currently trade at a premium of 45-100 per cent to most global peers such as Arcelor Mittal. This reflects the strong prospects and higher profitability of the domestic steel sector, despite uncertainties faced on the competition and policy fronts.

Anticipating the growing demand for steel, leading producers have embarked on expansion projects that are expected to double the domestic steel production over the next five years. SAIL, Tata Steel, JSW, JSP and NMDC are betting on giant leaps in infrastructure spending and steel consumption in the form of housing, automobiles and consumer durables.

The possible rationale for this huge capacity jump are GDP growth projections of 9-10 per cent, thanks to doubling automobile sales, massive power capacity additions, upcoming real-estate projects, and so on. However the big question is: Can the companies put through these ambitious expansion plans while maintaining their much envied levels of integration and the resultant profitability?

Indian steel companies managed to hold on to profitability in the crisis of 2008, despite rising iron ore, coal and raw material prices, owing to their low operational cost and unique raw material set-up. These companies are now scaling up capacity to join global ranks. However the challenge for players such as SAIL and Tata Steel is not just to move up the value chain and scale, but to maintain their current levels of profitability while they are at it.

HOW to STAY RUNNING

India's top three steel producers — SAIL, JSW and Tata Steel — recorded operating margins of 20-45 per cent over the last three years compared to Korean producer Posco ( the most efficient producer globally) with margins of 10-20 per cent.

The higher margins are a result of Tata Steel, SAIL and Jindal Steel and Power holding mining licences for their entire iron ore and part of their coal requirement since the early days of their operations.

The fixed costs of mining are estimated to be Rs 700-2,500 per tonne, compared with the current global market prices of Rs 6,750/tonne of high-grade iron ore and Rs 9,000/tonne of coking coal. This has been an advantage over the last 4-5 years, as it has almost always been cheaper to incur the fixed costs of mining inputs rather than having to purchase them from international markets.

International prices of iron ore and coking coal have gone up six-fold and four-fold respectively over the decade, with increased consolidation among miners and the increasingly import-reliant Chinese steel sector. Large iron-ore reserves, coupled with low operating costs, integrated power generation capability and a tightly-supplied domestic market enabled Indian steel producers to enjoy a premium among global metal stocks.

The superior margins and growing domestic market have also been a major draw for such global players as Arcelor Mittal, Posco and some Japanese players. This has heated up the competition for both iron ore mines and the land around those mines.

HEADED FOR OVER-CAPACITY?

Sustained weakness in the developed markets is forcing several international steel majors to look towards India for expansion. India's low per capita consumption of steel, at 43 kg, makes several observers sit up at the growth possibilities. The last year has been dynamic in terms of intent expressed by some international players.

Arcelor Mittal plans to set-up multiple 3 mtpa plants across India. Japanese players, such Nippon Steel, Sumitomo and Kobe, have announced tie-ups with Tata Steel, JSW, Bhushan Steel and NMDC, respectively, for specialised steel plants and technology transfer. Posco, whose own greenfield plant faces hurdles, is expected to announce a tie-up with SAIL. These foreign moves are in addition to the massive greenfield and brownfield moves by Tata Steel, JSW, SAIL and JSP, which are expected to take their cumulative capacity from the current 31 million tpa to 51 million tpa over the next two years.

Major additions by Tata Steel and JSW are focussing on the flat product segment, with their crude steel capacity additions accompanied by hot and cold mill additions. Players such as Bhushan Steel, that are steel processors, are looking to vertically integrate by moving into steel billet and slab production. SAIL is taking the middle path by trying to boost margins by moving out of the semis category and expanding the value-added and flat product segments.

With this, the total Indian capacity is expected to hit 110-120 million tpa of capacity from the current 66 mtpa over the next five years. The steel industry's move is best summed up using a poker term — it's an ‘all in' bet. For this bet to pay off, the steel sector needs to bet that steel consumption will grow at a CAGR of 14-15 per cent over the next five years. This is almost double the current rate.

It would not only require explosive and sustained performance from cyclical sectors such as the automobile and consumer durables industry and the bubble-prone real estate space but the government would also have to ramp up its direct spending and support for infrastructure.

A liberal compounded growth rate of just under 11 per cent per annum indicates that domestic steel consumption in 2014 will reach 100 million tonnes, resulting in an overhang of 10-20 million tonnes. Imports remain a source of supply too, with exports being outpaced over the last four years. Global competition in the export space comes from countries such as China, Russia, Kazakhstan and Japan. Despite talk of ‘consolidation' in the near term, reports indicate that regional Chinese steel players continue to replace small mills with larger more efficient capacity. Similar additions are underway in Russia, where companies pursue a strong export-led expansion under operating conditions that are rather similar to India in terms of raw material integration. Japan is another steel-surplus economy.

Growing Indian steel exports are a certain possibility, considering our low-cost production know-how but it is likely to remain a challenging and capacity-heavy battleground.

The key counter to capacity additions powering ahead, are delays in the implementation of several greenfield plants which account for at least 30-35 million tonnes of capacity. First is the slowdown in the steel realisations, leading to nervous steel producers deferring investment plans. Reports point to the strong possibility that steel prices are likely to remain under pressure over the near term as the industry adapts to a ‘new normal' of lower consumption in mature markets and China tightens its domestic industry to achieve economies of scale and meet power conservation targets.

Closer home, the new Mining Bill is reported to contain a clause which entails a 20 per cent payment to the local population for the consumption of local raw materials. This move will impact domestic integrated producers and narrow their margin advantage. The last, and possibly the biggest, hurdle is the one of securing mines and land for setting up steel plants, for which clearances appear challenging in light the Environment Ministry's recent firmness in dealing with such issues.

Perceived domestic risks of non-conducive mining and environment policies and archaic land acquisition laws may inadvertently turn out to be the prudent bartender refusing to serve steel producers on a capacity addition binge. However, the latter's actions indicate a certain air of inevitability and expectation that government spending and policy will come good for the capacity they are adding over the next decade.

Position in the cycle

Firm steel prices will ultimately decide whether domestic players expand or hold back. The start of 2010 saw domestic steel players effect regular hikes in response to buoyant demand and rising input costs.

After bumps in the form of the crises in Dubai and Greece and a cooling China, prices have recovered from the July-lows. This was due to surging German exports, Chinese restocking and raw material price hikes. The second quarter of the current fiscal saw both domestic flat and long steel prices rule 8-10 per cent higher, at Rs 35,000 and Rs 28,000 per tonne respectively, than during the same quarter in the previous fiscal. The ‘new normal' in steel could see the shuttering of several less efficient plants in the developed markets as an adjustment to depressed sales as a result lower levels of consumption.

Though steel has historically witnessed a 3-4 year cycle of improving realisations the cycle may turn more volatile with the advent of quarterly price contracts for inputs, the unpredictable influence of the Chinese steel industry and growth uncertainties in developed markets. Prices are likely to moderate and may move south over the next six months.

The fittest ones

In the listed primary steel producer space, SAIL seems the most attractively placed, thanks to high cash, low debt and significant levels of integration and land available for expansion.

All this has led Posco and Arcelor Mittal to try and woo SAIL into JVs for steel production.

Also on the cards is SAIL's foray into specialised steel production with BHEL.

Not far behind are operationally-tight JSW, whose expensive American buy of Jindal SAW's slab and pipe facility operates at low utilisation levels, in addition to costing the company valuable debt that could have come in handy for its domestic foray. Despite early signs of stabilising European operations, Tata Steel must be kicking itself for buying Corus at the peak.

But the company runs a tight ship, coupling operational excellence with mine integration and producing industry-topping margins which, if replicated at the Orissa plant, could result in a more balanced Tata Steel.

The secondary segment features some promising, albeit stiffly- priced, candidates whose operational track record and margins stand to gain with scale and new forays.

Some of these are: Bhushan Steel, which produces cold rolled steel for automobiles and consumer durables.

A foray into steel-making, acquisition of an Australian coking coal miner and tie-up with Sumitomo leave this fully priced company well-spaced to grow margins and volumes.

Usha Martin, which produces steel wires and rods for the infrastructure space also boasts of enviable margins and returns, with scope for better capacity utilisation boosting earnings.

In the steel and power combo space are Jindal Steel and Power and Monnet Ispat, which have ambitious plans to expand in both segments and boast of industry-topping margins in the sponge iron space, that offers good insulation against raw material volatility.

Both the companies are ideal candidates to accumulate on dips.

Source BL



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