steel stocks-Melting under pressure

A cap on the selling price, restriction on exports, a weak rupee and higher input prices are adding to the woes of steel companies, which are already troubled on the margin front
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After sugar and cement, steel has caught the eye of the government, and with an aim to cool down the scorching inflation, the government has started intervening to check steel price rise.

While the actions may partly help in curbing inflation, for investors it is not good news and may become a cause of worry if the Indian steel sector follows the path of sugar and cement, which have lost the fancy on the stock exchanges after policy changes.

"These developments will not only severely hurt the profitability of the steel industry, but also discourage investors from making new investments in the sector," says a chief financial officer of an integrated steel company.

The Indian steel sector would have been in relatively better times if the domestic steel prices could have reflected the prevailing international prices, which is only possible in free market economy. Steel prices have risen in the recent past in the international market, but it is not reflected in domestic prices.

The difference of about $100 a tonne in the domestic and international steel prices is attributed to the Indian government's recent cap on steel prices, which restricts the upside for steel players.

Additionally, the imposition of export duty on steel will only discourage exports leading to lower volumes. This cap on finished product prices comes at a time when companies are feeling the pain of unprecedented rise in input costs such as coking coke (up 200 per cent in the last year) and iron ore (up 65 per cent).

Also, the rupee depreciation and the export duty on coking coke imposed by China have only added to the cost of imported raw materials.

The impact of rising input costs is already visible on the margins of some steel companies for the quarter ended March 2008. For instance, JSW Steel has seen its EBITDA margin drop by 575 basis points to 25.9 per cent on year-on-year (YoY) basis.

Others like Monnet Ispat and Mukand, too, are facing the heat. Even integrated players like Sail, which use 100 per cent captive iron ore, are dependent on the coal and imported about two-thirds of its total coal requirements.

Limiting realisations
More recently, the government had persuaded steel companies to roll back steel prices by Rs 4,000 per tonne in flat products and Rs 2,000 per tonne for long products, which the companies agreed to hold for the next three months. But, this is only going to increase their pain.

If steel prices are not allowed to be market driven and the companies continue to bear the burden of the rising raw material prices, then things may get worse in the times to come as analysts predict.

"The margins will be under further pressure as the new contract for coking coke will be at prevailing market rate, which are hovering at about $300 per tonne against about $96-98 per tonne during last year," says steel analyst at Religare Securities.

Besides the cap on steel product prices, the government also imposed 5-15 per cent export duties on various steel products, which is aimed at improving the domestic availability of steel and bring down domestic prices.

Export duty of 15 per cent was imposed on primary or semi finished steel and HR (hot rolled) coils, while a 10 per cent duty has been imposed on rolled products including CR (cold rolled) coils and sheets. The move will adversely affect most of the steel companies, which are exporting in the overseas markets and the companies supplying steel to the subsidiaries in the overseas markets.

"We bought companies overseas to get access to large markets as well as take advantage of India's low cost advantage, and in this hope we are raising capacities of certain steel products in the domestic market. But, the proposed duty on export will adversely affect our company," says the CFO of the integrated steel company.

Indian steel companies such as Tata Steel (acquired Corus, UK) and JSW Steel (bought a US-based steel company) have bought several companies abroad. If the companies feed basic steel to their foreign subsidiaries, it will now become more costly or the option is to dump the production (meant for exports) in the domestic market and at lower prices.

Analysts believe that a part of these export duties are offset by the depreciating rupee, and a lot will depend on whether the value of the rupee is sustained at current levels, considering that its depreciation is a recent phenomenon.

"Higher export duty will discourage companies from exporting and increase the availability of steel in the domestic market, thus controlling domestic prices and hit the margins of domestic players as companies will not enjoy the same pricing as in the export market," says V S R Murthy, group director, Sujana group.

Relaxation in imports?
To set off the impact of rising raw material prices and provide relief to steel producers, the government relaxed import duty on certain inputs such as coking coke from 5 per cent earlier to nil. While it may appear positive, the benefits have been more than offset by some other developments.

"Though the import duty has been reduced on coking coal, it is not enough considering that coal prices have gone up substantially. Also, as most of India's requirement of coking coal is met from China, the imposition of 20 per cent export duty on the coking coal by China means, that prices of the coal are higher to that extent. The depreciating rupee will only make imports more costly," says G D Agarwal, director, Adhunik Metaliks.

Besides these factors, the companies are also worried given that freight rates have gone up significantly, which will further increase the cost of imported coking coal. Overall, the impact of these developments will be seen in the margins of companies in the coming quarters.

According to estimates for every tonne of steel manufactured, about one tonne of coking coal is required. Considering that coal prices have gone up by over $200 per tonne, the cost of steel manufactured will go up by about Rs 8,400 per tonne (based on a rupee-dollar rate of Rs 42).

That apart, the price of iron ore, which is the key raw material for making steel, has simultaneously gone up in the domestic as well as international markets. The country is self sufficient as far as iron ore reserves are concerned; India produced about 170 million tonne of iron ore as against the 80-100 million tonne of domestic consumption.

But as domestic iron ore prices reflect the international trend, the domestic steel producers will feel the cost pressure on this count too.

To discourage export of iron ore, the steel industry has asked for ad valorem duty on export of iron ore to the tune of 15-20 per cent. However, this is yet to materialise. Also, there are very few companies having their own iron ore mines, except companies like Tata Steel and Sail and, most of the other mines are controlled by government companies.

Steel companies have requested the government to ask raw material producers such as NMDC, MOIL and Coal India to roll back the increase in raw material prices (for long-term contracts) and provide some relief. If the government approves this, there can be substantial relief on the cost front, which could lead to an upgrade of earnings for steel companies.

Overall, till that time, high iron ore prices will continue to remain a concern for most steel producers (especially non-integrated companies) and hit their margins further.

LOOSING STRENGTH
Rs crore Trailing 12 months ended March 2008 CMP (Rs) M-Cap
Net Sales % ch Net Profit % ch Op. profit % ch OPM% (08) OPM% (07) PE (x)
Bhushan Steel 4203.95 9.54 411.12 31.24 886.05 26.63 21.08 18.23 8.10 784.05 3329.00
Jindal Saw* 6787.76 76.05 412.60 145.80 821.93 89.80 12.11 11.23 3.63 576.00 3002.00
Jindal Stainless 5169.16 5.98 264.25 -25.14 820.16 -2.23 15.87 17.20 8.14 140.94 2742.00
JSW Steel 11420.00 33.50 1728.19 33.76 3611.74 28.40 31.63 32.88 12.30 1077.09 20146.00
Maha Seamless 1498.84 7.29 221.47 -5.29 349.17 -6.25 23.30 26.66 10.56 331.45 2338.00
Monnet Ispat 1161.67 82.14 173.68 28.86 274.58 37.68 23.64 31.27 18.00 550.04 2645.00
Mukand 1926.78 6.42 52.24 -43.99 263.03 -10.46 13.65 16.23 11.80 86.50 632.00
SAIL 40214.16 16.67 7536.78 21.52 12957.85 17.80 32.22 31.91 9.44 172.95 71435.00
Tata Steel* 18937.03 13.47 4585.02 17.51 8437.21 25.67 44.55 40.23 5.62 896.50 65554.00
Usha Martin 1655.90 17.56 144.84 42.73 357.02 24.84 21.56 20.30 13.70 93.40 2400.00
Uttam Galva 3155.84 22.54 123.86 9.55 302.96 11.48 9.60 10.55 3.70 40.00 456.00
Welspun Gujarat 4010.40 49.45 351.40 146.42 671.50 97.15 16.74 12.69 19.66 376.80 6699.00
Standalone financials for the trailing 12 months, *December 2007 ended


Outlook
The domestic steel demand is growing at over 11-12 per cent, whereas the supply is lagging at about five per cent. As major expansion plans are expected to go on-stream from financial year 2009-10, except for the 1.8 million tonne expansion of Tata Steel (expected by June 2008) and 3 million tonne expansion of JSW Steel (expected by September 2008), the supply of steel is expected to remain tight.

Fundamentally, the Indian steel industry holds its grounds in the long-term on the back of huge investments lined up in infrastructure ($500 billion during the Eleventh Five Year Plan). However, in the near-term, risk arises from the policy intervention and the inability of companies to pass on the increase in raw material prices.

These developments can adversely affect the prospects of the sector and may have long-term implications, thus increasing risk for investors looking to invest in these companies–the sad state of oil marketing companies sends shivers down the spine.

These developments also remind of past instances pertaining to the sugar and cement sectors, where share prices of many companies are still trading at low levels.

There is a positive side, too. "Whenever the government intervenes in a particular sector, especially the cyclical industries, the attractiveness of the sectors dips, and hence, the market discounts the prices. However, long-term investors can use these uncertain times for picking good companies at lower valuations of about 6-7 times historical earnings," says Raamdeo Agrawal, joint managing director of Motilal Oswal Securities.

While there is risk in investing in these companies, which are surrounded by uncertainty in the sector, investors with a long-term perspective can pick up companies which are highly integrated and have exposure to the overseas market.

"I think short-term investors should keep away from these sectors (where political risk exists), and only long term investors, who can stay invested to take the advantage of change in the policies, should invest," says I V Subramaniam, director and CIO, Quantum Advisory.

In order to minimise the risk while investing in the steel sector, analysts recommend companies that are well integrated and have access to captive resources.

Tata Steel is one such player, which is considered to be less susceptible to the rising raw material prices (due to ITS backward integration) and may take the advantage of the increasing steel prices globally as 75 per cent of its total capacity (including that of Corus) is located outside India.

In the light of these developments, analysts believe that at least the next two quarters will be difficult for most steel companies.

However, things can change dramatically if positive development takes place in the form of government policy (roll-back of export duty or roll-back of input prices by government owned companies), or if raw material prices (globally) stabilise or decline.

Until then, the uncertainty will prevail and investing in steel stocks will mean a high-risk and low-reward proposition.

Outlook
The domestic steel demand is growing at over 11-12 per cent, whereas the supply is lagging at about five per cent. As major expansion plans are expected to go on-stream from financial year 2009-10, except for the 1.8 million tonne expansion of Tata Steel (expected by June 2008) and 3 million tonne expansion of JSW Steel (expected by September 2008), the supply of steel is expected to remain tight.

Fundamentally, the Indian steel industry holds its grounds in the long-term on the back of huge investments lined up in infrastructure ($500 billion during the Eleventh Five Year Plan). However, in the near-term, risk arises from the policy intervention and the inability of companies to pass on the increase in raw material prices.

These developments can adversely affect the prospects of the sector and may have long-term implications, thus increasing risk for investors looking to invest in these companies–the sad state of oil marketing companies sends shivers down the spine.

These developments also remind of past instances pertaining to the sugar and cement sectors, where share prices of many companies are still trading at low levels.

There is a positive side, too. "Whenever the government intervenes in a particular sector, especially the cyclical industries, the attractiveness of the sectors dips, and hence, the market discounts the prices. However, long-term investors can use these uncertain times for picking good companies at lower valuations of about 6-7 times historical earnings," says Raamdeo Agrawal, joint managing director of Motilal Oswal Securities.

While there is risk in investing in these companies, which are surrounded by uncertainty in the sector, investors with a long-term perspective can pick up companies which are highly integrated and have exposure to the overseas market.

"I think short-term investors should keep away from these sectors (where political risk exists), and only long term investors, who can stay invested to take the advantage of change in the policies, should invest," says I V Subramaniam, director and CIO, Quantum Advisory.

In order to minimise the risk while investing in the steel sector, analysts recommend companies that are well integrated and have access to captive resources.

Tata Steel is one such player, which is considered to be less susceptible to the rising raw material prices (due to ITS backward integration) and may take the advantage of the increasing steel prices globally as 75 per cent of its total capacity (including that of Corus) is located outside India.

In the light of these developments, analysts believe that at least the next two quarters will be difficult for most steel companies.

However, things can change dramatically if positive development takes place in the form of government policy (roll-back of export duty or roll-back of input prices by government owned companies), or if raw material prices (globally) stabilise or decline.

Until then, the uncertainty will prevail and investing in steel stocks will mean a high-risk and low-reward proposition.