Metal Stocks - Best buys !!

The metals sector has been facing a tough time, partly due to the correction in global commodities prices and also because of certain domestic developments like the ongoing CBI probe into the mining industry in Karnataka.

Many frontline metal stocks like JSW Steel, Tata Steel, Sesa Goa, Hindalco and Sterlite, to name just a few, have seen a severe contraction in prices. What has further compounded the problem is the ongoing crisis in the Euro Zone and the fear that China's metal demand may slow.

It is tough to say which metals segment — copper, steel or aluminium — would take a greater hit than the others or whether the producers catering to domestic demand would be spared from demand recession compared to companies like Tata Steel which has a significant presence in European markets.

But for long term investors, it would be tempting to know whether the current meltdown in metal stocks make them hot investments, even in the likelihood of further price correction in these shares. All the five metal stocks mentioned earlier have suffered serious erosion in value and three of them have seen their Price to Earnings (PE) ratio come down to single digits.

The extent of carnage the sector has suffered could be judged by taking a look at today's NSE closing prices compared to their year's high (given in brackets):

Sesa Goa - Rs 204.25 (Rs 383.65); Jindal Steel and Power – Rs 480 ( Rs 755.50); Tata Steel - Rs 420.70 ( Rs 737); Hindalco - Rs 126.10 (Rs 252.85) and Sterlite - Rs 113.35 (Rs 195.95).

But what is intriguing is that while the stocks of metal companies has seen a correction, it is not as if all metal prices have corrected. For instance, the steel prices have not gone down so much compared to the share price of steel stocks. Given the problem in mining in India, it is possible that domestic steel prices may remain firm, benefiting steel producers.

In an interview to Business Line, Mr Bhavesh Chauhan (Senior Research Analyst  — Metals & Mining), Angel Broking, Mumbai, shares his views on the metal sector's performance and what it holds for them in future. Excerpts:           

Metal stocks have taken a hammering. Do you consider them worthy of investment at current prices or is some more pain due?

The last 6-8 months have been bad for metal companies due to escalating debt crisis in Europe and stocks have been battered. As long as the situation in Europe remains grim, metal demand would remain weak and sentiment will keep metal prices lower. Monetary tightening in China has also played its part, although there hasn't been any huge decline in China's appetite for resources so far.

Different metal stocks (Sterlite (copper), Hindalco (aluminium), JSW Steel, Tata Steel and Sesa Goa) have suffered. Do you see any particular company recovering in the short term? Are all metal stocks in the same league?

Metal being a global commodity, all the stocks would be in the same league, although broadly we classify the companies as ferrous and non-ferrous and then we could have the classification in terms of steel makers and miners as well. Again, recovery of any stock would depend on how Europe shapes out. Also, there are concerns on US going into double dip too. So that factor has to be seen closely.

The reasons for the downslide in shares — controversy in the Karnataka mining sector and slowdown in Europe — are different. Do you think it would take some time for these negative factors to disappear?

 For Karnataka mining, it is more of a regional thing and it affects companies operating in Karnataka. I believe the Karnataka issue could be sorted out in 6-9 months. European slowdown is a big concern actually and how long it will take for these factors to disappear is a challenging question.

The economic slowdown has led to demand contraction resulting in fall in metal prices. But any economic recovery would see demand for metals picking up. So, do you feel the fall in prices is temporary or will it continue for a while?

Any recovery in Europe should see base metal prices recovering, although the way the scenario is today, it is difficult to give a time frame. At least in the near-term I do not expect any recovery in base metal prices.

Which are the sectors that would benefit due to metal prices falling — autos, housing, electrical goods, capital goods. Do they have any upside potential because of this?

Companies in capital goods and infrastructure will benefit if prices fall. However, steel prices have not fallen so far. Steel is the commodity which is used mainly as a raw material in machinery and construction. We do not expect any significant fall in steel prices anyway as prices of raw material remain high and are expected to remain firm due to supply concerns.

Though metal prices have fallen, the woes in Europe and US may not lead to pick-up in demand for products. How will Indian companies benefit?

Base metal prices have fallen. So, a little benefit will flow to some companies. However, steel remains the most widely used commodity.

How will the rise in dollar value and fall in rupee value affect the Indian metal cos? Hasn't the fall in rupee value neutralised any benefit of fall in commodity prices?

With the rupee depreciating, it helps companies selling metals as imports become expensive and hence domestic producers can raise prices. As far as importers of commodities are concerned, so far the falling rupee has offset falling commodity prices as you rightly say.

Have the frontline metal stocks become investment worthy after price correction? What are your picks and why?

We do feel that front-line metal stocks are now worth investing as we believe markets are discounting on the near term global macro issues (primarily Euro zone crisis). The current price levels do not discount the expansion plans by companies over the next 2-3 years. We like companies with captive resources and big expansion plans. With captive resources, these companies would generate higher return on capital employed at even current metal prices. Though we like Hindustan Zinc, SAIL, Sterlite amongst others, Tata Steel and Hindalco are our top picks –Tata Steel with a target price Rs 614 and Hindalco with a target price of Rs 196.

We like Tata Steel for its buoyant business outlook, driven by higher sales volume on completion of its 2.9 mt brown field expansion in Jamshedpur. The company's raw material projects are expected to be commissioned by 4Q FY2012 with lower off take initially; the full benefit is expected to accrue in FY2013E. Additionally, restructuring initiatives at Tata Steel Europe are likely to benefit the company going forward. We believe Hindalco is well placed to benefit from its aluminium expansion plans (capacity increasing by nearly two-three folds in the next two-four years). Most of its new capacities will be backed by captive mines leading to robust margins. Further, we expect steady EBITDA of $1 billion annually from Novelis.   

Steel prices have not fallen much but steel stocks have suffered. Because of the mining issue, steel prices may remain firm. Does that make steel stocks attractive for investment?

Steel prices have not fallen because prices of iron ore and coking coal across the globe are still firm. The mining problem is only India-specific and does not have any impact on the steel prices, which are globally determined. We believe steel stocks are attractive given that their margins have shrunk drastically over the last 9 months or so. We like steel stocks as coking coal prices are expected to fall, interest rates in India should fall sooner than later, capex cycle should pick up in the next six months. The stock prices have discounted all the negatives, leaving some of the stocks highly undervalued. 

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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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Steel Industry - Buy Tata Steel & Jindal Steel Power

With input prices on the rise, non-integrated steel producers may find it difficult to sustain margins if steel prices do not rise in proportion

To produce a tonne of steel it requires about 1.6 tonne of iron ore and about 0.7 tonne of coking coal. And, these raw materials put together account for almost 70-75 per cent of the total cost to produce a tonne of steel. This is also precisely a reason that whenever there is an increase in the raw material cost, steel companies have little option but to increase steel prices so that they can make reasonable profits. In the current scenario, when steel prices are trading at relatively lower levels and there is less appetite for any price rise among the customers, Indian non-integrated steel companies might see an impact on their profitability given the recent increase in raw material prices.

Input prices on the rise…
In January 2010, NMDC had raised its domestic iron ore prices by about 15 per cent. Very recently, NMDC intimated to the industry that it has further increased iron ore prices by about 30-50 per cent on a provisional basis effective April 1. NMDC’s iron ore fines that recently sold at about $43 per tonne in the domestic market are now expected to cost over $70 per tonne. While NMDC’s provides iron ore at lower prices to domestic companies (as compared to its prices for global customers), prices are revised according to the trend in international prices. The rationale behind this seems to be the higher international iron ore prices. The Australian long-term contract prices are now being negotiated at about $110-120 per tonne, which is almost a 100 per cent jump from $60 per tonne a few months back. The Chinese spot iron ore prices have also moved up from $90 per tonne in October 2009 to currently about $152 per tonne.

The situation is equally grim in the case of coking coal prices, which have seen a steady rise for last six months. Coking coal benchmark price for the quarter April 2010 to June 2010 has been set at $200, which is significantly higher compared to last year’s benchmark price of $128 per tonne. Analysts believe that the coking coal prices could further rise and cross the $200 a tonne in 2010-11.

…and its impact
The rise in coal and iron ore prices would mean that the cost of production for the every tonne of steel will go up by almost $120-130 or by Rs 5,400-5,800 per tonne. No wonder that domestic flat steel prices have been moving up; they are up by 18 per cent in last three months and currently hover around Rs 37,810 per tonne.

More importantly, analysts believe as the raw material prices have increased and are expected to increase further, the recent increase in steel prices still does not offset the impact of higher input costs. For instance, Indian steel producers have increased steel prices by Rs 2,500-3,000 per tonne whereas the cost escalation has been in the range of Rs 5,400-5,800 per tonne. This is also a reason that analysts believe that the companies might further increase prices, in a manner that steel demand is not disturbed.

Demand-supply situation
Given the current market scenario, companies have so far been able to pass on a part of the input cost increases to the consumers on the back of the reviving global economic growth. According to the data provided by the World Steel Organisation, India’s steel production was up by 20 per cent in February 2009 followed by 25 per cent growth recorded by China. Even the world steel production was up by 27 per cent in February as a result of recovery in the steel demand.

The demand for steel is expected to continue to be good considering the industrial revival and higher spending on the infrastructure and construction activity in the country.

This in turn should give steel producers some pricing power.

Outlook
Steel producing companies that do not have captive sources of raw material supply can now feel some relief given that higher steel prices will allow them to pass on the increase in raw material prices. However, the major benefit of this will accrue to companies which are fully integrated.

For instance, SAIL has the advantage of 100 per cent captive iron ore, while it procures 30 per cent of its coal requirements from the domestic market and 70 per cent from imports. On the other hand, JSW Steel depends on imported coal for its entire requirement and only 20 per cent of iron ore is from captive sources. This is also a reason that SAIL and JSW Steel earned EBIDTA per tonne of about Rs 8,000-9,000 per tonne as compared to over Rs 13,700 per tonne earned by the Tata Steel, which is a fully integrated player (excluding its global operations).

In the present scenario, analysts thus are expecting companies like Tata Steel and Jindal Steel & Power to be in better position given their access to captive raw material supplies. Any further increase in the steel prices (as expected by analysts) will mean higher gains for these integrated players.

Source BS

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