Are steel scrips still a steal?

Likely capacity
addition (mt)

Outlay
(Rs crore)

SAIL12

8 (by 2011-12)

25,000 Tata Steel4612,000 Jindal Iron & Steel Co.2.5

7.5 (by 2010-11)

2,000 Jindal Steel & Power0.5

2 (by Sept 2006)

1,400 Ispat1.52840 Essar Steel2.41.2700 Posco & BHP Billiton

-

1039,000 Mitsui

-

512,000 Vedanta Resources

-

512,500 Total22.946.7105,440  Demand growth to persist
Domestic steel firms rode on the back of rising steel prices to record profits, or increase them substantially, after waging a long battle against high interest rates and a dull pricing scenario. Low interest rates coupled with higher prices helped them put up a good show in FY04.  According to analysts, demand growth is likely to sustain in FY05 also, while the outlook on prices continues to remain strong. Strong demand from the housing and infrastructure sectors, with additional growth potential in the auto and consumer durables sectors, is likely to drive demand going forward.  The global demand scenario, too, is looking good. After a sluggish period, global steel demand turned around in 2002 as Chinese offtake went through the roof. The percentage of annual growth of global steel consumption was at 6.60 in 2002; it went up to 7.30 in 2003. The growth rate is pegged at 6.20 per cent for the current year.  However, there are some concerns that demand growth may slow down going forward. With China taking steps to cool down its overheated economy, demand from that country is expected to slow down.  According to an estimate by the International Iron and Steel Institute (IISI), the growth rate is likely to come down to 4.5 per cent in 2005 due to the likely drop in Chinese demand growth.  According to analysts, any shortfall in demand from China may be offset by growth in demand in the US, Europe and Japan as economic recovery gathers steam. But there are other reasons why steel prices may not slip any time soon.  The cost of iron ore, a key input for steel, increased by 75 per cent between June 2003 and July 2004, while that of scrap rose by 91 per cent.  The cost of another major raw material, coke, went up 113 per cent, while freight costs moved up by 50 per cent in the same period. Keeping this in mind, analysts say domestic steel prices will rule firm for the next six months at least. However, this may not translate into bottomline gains for steel firms.  The cycle may be turning
The cyclical nature of the industry is such that any downturn in demand or consumption patterns could see the prices moving southwards.  "Prices are likely to remain firm for the next six months, but they are likely to soften towards the year-end," says an analyst. Iyer disagrees.  "Price variations do happen in a commodity cycle. But I don't seen any fall in prices. The rise of raw material costs should keep prices high. Demand is also expected to be high," he observes.  Recently, leading domestic companies announced price cuts of Rs 500-2,000 a tonne on their main products sold to direct customers.  Besides, the government has decided to cut import duty on non-alloy steel to 5 per cent from 10 per cent to check inflation.  Though analysts say price cuts are likely to dent the toplines of steel companies by 3-8 per cent only, they are of the view that the import duty cut would reduce the scope for steel companies to hike prices, as it would result in a reduction in the landed costs of imports.  The reduction in customs duty also means that domestic firms are exposed to international competition, leading to dumping of steel from foreign companies.  Cash flows are strong
With interest rates bottoming out and steel prices expected to come down, there are worries that the domestic steel sector may be entering a phase similar to the late 1990s and early 2000s when companies were saddled with high costs of debt and falling demand and prices.  With high investments earmarked for the next few years, debt funding has come into the spotlight once again. Though leading steel companies have been able to retire a substantial portion of debt, concerns regarding the strength of their balance-sheets persist.  While high prices allowed steel companies to repay Rs 8,000 crore of high cost debt to financial institutions in 2003-04, they still have debts of Rs 20,000 crore left. While SAIL repaid Rs 4,500 crore, private steel firms like Essar Steel and Jindal Iron & Steel cut their debt burden Rs 1,900 crore and Rs 1,200 crore respectively.  Tata Steel, too, brought down its outstanding debt by Rs 400 crore. These companies have also converted their high-cost loans to low-cost ones, improving their cash flows in the last three years. Improved cash flows are expected to enable steel companies to service their capital investments through internal cash generation.  "Most of the big steel companies have enough money to support their expansion plans. They are well on the way to repaying their debts. Their future cash flows, too, are expected to be good. Thus they can service most of their investment plans from internal cash flows alone, without resorting to too much borrowing," reasons Iyer.  The return on capital employed (RoCE) has shown a marked improvement for most steel companies last fiscal. While RoCE for SAIL has improved to 29.30 per cent in FY04 from 8.8 per cent in FY03, that of Tata Steel has improved to 37.50 per cent from 21.30 per cent in FY03.  Companies like Essar Steel and Ispat Industries have also shown an improvement in this regard. While SAIL pared its debt-equity ratio to 1.86 at the end of FY04 from 6.50 in FY03, Tata Steel's debt-equity ratio is comfortable at less than 1 per cent. Clearly, there is no worry in the short term on this front.  "All these companies have substantial cash flows. So debt-equity ratio is not likely to be affected much," notes an analyst with a foreign investment bank.  While a lower debt-equity ratio enhances a company's credit rating and helps it access low-cost debt, the interest rate outlook is changing at a time when these companies want to borrow more for expansion. Dollops of equity may help them balance the picture.  Valuations of steel majors are going cheap too, especially given the current bullish phase. Analysts are bullish on SAIL and expect it to sustain momentum on the back of continuing growth in demand and firm steel prices. They point out that the scrip is relatively cheap at an estimated P/E ratio of 4x for FY05. Ditto for Tata Steel.  "The company should be able to clock Rs 2,500-2,600 crore in net profit in FY05," says Bhavin Chedda, analyst with domestic securities firm Pioneer Intermediaries. 
 

Financials
Company	FY2004			FY2003
(Rs crore)	Sales	Net Profit	RoCE (%)	Sales	Net Profit	RoCE (%)	CMP (Rs)	P/E
SAIL	24877.31	2512.08	29.00	19725.83	-304.31	8.80	43.15	5.29
Tata Steel	11920.96	1746.22	38.00	9793.27	1012.31	21.30	279.50	6.96
Ispat	4114.71	44.32	5.00	3370.62	82.83	2.60	10.39	-
Jindal Iron & Steel	2265.84	242.70	25.00	1612.26	120.98	27.00	275.35	4.52
Jindal Steel & Power	1550.25	305.46	31.00	1101.30	145.08	29.80	603.95	4.94
Essar Steel*	4024.60	59.99	15.00	1764.78	1.51	13.00	28.50	14.45
* FY03 figures are for six months.

 Among other scrips, Jindal Iron & Steel, which carries a P/E ratio of 5x FY05E, is also held in high regard. "Once the effects of the merger with Jindal Vijaynagar Steel play out, Jindal Iron & Steel will be one of the country's most fully integrated steel companies apart from Tata Steel. Valuations are not too high either," notes one analyst.  Though valuations are attractive, there is no guarantee that there will be any jump in stock prices in the near-term.  "On a P/E basis, most steel companies do not look that expensive, but if steel prices fall from their highs, things will be different. I am skeptical about steel stock prices," says an analyst with a domestic securities firm.  "Steel prices have been ruling high for some time now. So most foreign institutional investors (FIIs) and mutual funds are cautious not to be seen buying into the higher end of a commodity cycle," says he. 
 

LONG-TERM POSITIVES

• Domestic demand growth is expected to double within eight years
• Domestic steel firms have turned the corner in terms of financial performance on the back of rising steel prices
• Steel prices are likely to remain high given the rising demand
• Any shortfall in demand from China is likely to be offset by growth in demand in the US, Europe and Japan

SHORT-TERM NEGATIVES

• Chinese demand may fall as the country plans steps to cool down its overheated economy
• Input costs are rising
• The government