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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Sail - Avoid for 2011

Company: SAIL

Broking House: Angel Rating: Accumulate

Price Target: `182

SAIL reported a second quarter net profit of `1,107 crore — below forecasts. A negative surprise during the quarter was the fall in the realization per tonne of steel, Angel says. SAIL’s management has indicated that the fall was a one time item — because of liquidation of some defective inventory. Compared to the last year, operating margins were lower as raw material costs have increased substantially.

At its current price, SAIL’s stock is trading at 8.6 times the estimated FY11 earnings. Going ahead, Angel Broking sees the firm benefitting from strong domestic demand. Based on these factors, it has kept an ‘accumulate’ rating on the stock, but has cut the price target from the earlier level of `198

Our Recommendation :

Avoid this stock for this year 2011. With the FPO the floating stock increasing there are more investors likely to book profits at every rise ! Utilize steep corrections to buy the share for long term and build a portfolio with a view to hold the stock for 3-5 years horizon for a decent profit.

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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 Sector - Q1 will be tardy

Commodity pack as a whole has seen tremendous volatility in past few months, and steel stands no exception. European economic crisis, Euro-Dollar fluctuations, huge inventory pile ups in the domestic arena have all added to the misery. Looking at this, the Indian steel manufacturers and around the world resorted to price cuts in June 2010. Prices dropped 5% m-o-m to Rs 32,700/tonne during second week of June.

On the other hand, raw material prices have been adding to the woes of steel manufacturers. Where coking coal saw average spot prices at $220/tonne in Q1FY11, the contract prices at $200/tonne during the first quarter were already 55 percent higher as compared to $129 per tonne in the previous corresponding period. These are likely to see further upside during the second quarter. In the beginning of the first quarter of the current financial year, analysts expected $60-70/mt rise in prices of steel given the rise in coking coal prices. However, the glut due to inventory pile up forced steel manufacturers to opt for price cuts.

Iron ore also stood no exception. The contract prices at $110-120/tonne during first quarter of the current fiscal had seen rise of 80 percent as compared to $61/tonne during FY10. Australian iron ore miners such as BHP Billiton and Rio Tinto have already indicated that contract prices may rise from around $120 a tonne in the April - June 2010 quarter to around $158 a metric ton in Q2FY11.

Despite a steep rise in raw material prices, spot prices for steel at $685/tonne on 30 June, 2010 have been marginally 3 percent higher than $665 on 31 March, 2010; although these were 41.8% higher y-o-y thanks to rock bottom prices of steel a year ago.

For the near-term there are little hopes for early recovery in prices with robust production in China and subdued demand in Europe squeezing the margins for steel manufacturers. This will be reflected in the first quarter results for Indian manufacturers, feel analysts.

SAIL will be hit the hardest on the revenues as well as margins front. With around 1.35 million tonnes (MT) sales volumes in April-May 2010, selling 2.7 MT in Q1FY11 looks difficult. Analysts at Motilal oswal have cut volume estimates to around 2.4 MT for the April-June 2010 quarter, with realizations at Rs 3610 per tonne, down one percent y-o-y. While coke prices were higher, the iron ore supplier - NMDC – has increased contract prices of iron-ore to Rs 270 per tonne during the recently concluded quarter (6-15% higher on various grades).The net sales are pegged at Rs 8664.2 crore, down 5.3% with EBIDTA margins losing 401 bps. Hence, PAT is expected to clock in at Rs 944.4 crore, 29.4% lower than a year ago.

JSW Steel, on the other hand, is expected to be best performer in the first quarter among the lot. Sales volumes are pegged at 1.45 MT up 9.8% y-o-y. Realizations are likely to be at Rs 3510.8 per tonne due to good sales volumes in April-May 2010 before June price cuts. Net sales at Rs 5077.6 crore will thus grow 29.6 % y-o-y with operating margins improving 304 bps to 22.5 and adjusted PAT at Rs 480.6 crore, growing robust 396% on a y-o-y basis, analysts say.

Tata Steels’ sales at 9,12,000 tonnes in Apr-May 2010 were flat, and after price cuts in June, analysts expect the company to report sales volumes at 1.42 MT. With net sales pegged at Rs 5985.3 crore in Q1FY11, realizations are expected to improve by 6.9 percent to Rs 3925.3/tonne. Tata Steel had old inventories and contracts, and hence, iron ore and coal price increases will not affect first quarter's results. However, in the second quarter it should feel the heat in line with other manufacturers. EBIDTA margins in first quarter are likely to gain 610 bps. Their European subsidiary, Corus, is seeing an improvement in realizations, which are pegged at $ 160/ tone and will add to EBIDTA growth sequentially. The consolidated sales for Tata steel are estimated as Rs 29,089.1 crore, growing 24.8 percent y-o-y. Profits are estimated at Rs 2952.9 crore, as against last years’ losses.

The road ahead for the steel manufacturers seems bumpy, with realizations and margins feeling heat of price cuts in June and raw material costs rising further. The uptick in raw material prices will at some point force steel players to go for price hikes, and analysts expect that raw material prices will start adjusting too. The recovery will come in second half of financial year. Till then, the outlook for this sector remains bleak.

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SAIL - Buy

Investors can consider buying the Steel Authority of India (SAIL) stock (Rs 82), given its low valuation. The stock trades at a price-to-earnings multiple of 4.5 times the trailing 12 month earnings. Though the jury is still out on whether the recovery in steel demand seen so far in 2009 is sustainable, SAIL remains one of the better-placed companies in the steel sector to weather the challenging times. A sharp drop in contract prices for coking coal and iron ore, expected to be negotiated for the coming year, suggests scope for margin expansion, even if steel prices continue to soften.

Low dependence on international orders, a focus on orders from government agencies which may benefit from higher public spending and low leverage and strong cash flows, make the company a preferred exposure in the steel sector. Investors in the stock, however, should be prepared for high volatility, as the stock’s performance may continue to carry strong linkages to global commodity price trends.

Domestic focus helps

The prospect of slowing and even recessionary trends in much of the developed world has weakened the demand for steel from user industries such as forgings, castings, automotive and construction. Both the US and Europe have seen a decline in construction and industrial activity in the last two quarters of 2008. Falling demand prompted production and price cuts by the global steel majors, with players such as Corus, Tokyo Steel and many others cutting back output by up to 30 per cent in October-November ’08.

In India, however, demand has held up better than in the other regions, with the industry’s production still up by about a per cent in the April-December 2008 period. Higher infrastructure spending by the government as a part of its two stimulus packages and a pick up in construction activities following low interest rates could help stimulate growth.

CMIE expects domestic steel production to grow by 1.5 per cent in 2008-09 and achieve a growth of 6.5 per cent in 2009-10. Responding to softening demand, steel prices have been under pressure since last year; hot-rolled coil prices fell 20 per cent from a high of Rs 48,500 per tonne in June 2008 to Rs 39,200 in December 2008.

SAIL’s sales fell in the quarter ended December 31, 2008, given a 11 per cent cut in HRC prices in November. While the effect of price cuts may continue to show up on revenues, a revival in steel volumes (up 9 per cent y-o-y in February ’09), driven by automobile and construction demand, offers some hope. On the cost front, iron ore contracts for the coming year are expected to see a price correction of 30 per cent-plus and coking coal prices are also expected to be 40 per cent lower for the year. Lower input costs would bring substantial margin relief for SAIL, given its high reliance on imported coking coal.

In the December quarter of 2008, SAIL’s profits took a hard blow (down 56 per cent) following a substantial increase in raw material costs as international coking coal prices shot up from $98 per tonne in 2007 to $300 per tonne in 2008.

Resilient to current slowdown

SAIL also looks better placed than its peers to tackle an uncertain global demand environment. SAIL derives just 3 per cent of its revenues from overseas, even as peers such as Tata Steel and JSW Steel have a much larger global exposure.

Within the domestic market too, 40 per cent of the orders are from the government agencies. With the stimulus packages promising higher infrastructure spending by the government, the company may sustain healthy order inflows in the coming quarters.

A diversified customer base is also an advantage, with the company serving a wide range of industries from construction, engineering, power, railway, to automotive and defence. The company has also been realigning its product mix, with value-added products now accounting for 40 per cent of production.

Even as other steel companies are shelving their capex plans, SAIL appears well-placed to bankroll its own expansion. The company had Rs 13,760 crore in cash balances by end-FY08, following strong operating cash flows of over Rs 8,300 crore during the year.

The company’s debt-to-equity ratio of 0.18:1 (in FY08) is low, allowing room to increase borrowings for the planned capex. SAIL has outlined a capex of Rs 53,000 crore for expanding its capacity from 14 million tonnes to 26 million tonnes by 2010-11. Of this, the company has already spent Rs 3,230 crore and has placed orders for equipment worth Rs 36,000 crore. As there are certain equipment sourcing-related delays, the projected additions to capacity may be delayed.

Given its relatively strong balance-sheet, we expect SAIL to reap benefits from recent interest rate cuts, though it may still contract higher borrowings for capex.

Investment Strategy Now :

Our View :

The prices have run up in the last week too fast and with this speed it can touch Rs.125.  One should not invest at this high price but should start buying around 80 levels for a decent gain over a 6 months period.