The turmoil in global financial markets and a slowdown in demand from major consuming economies are weighing heavily on metal stocks
The world's largest consuming economies the US, Europe and Japan are slowing down as are the fastest growing emerging economies China and India.
For China, which accounts for about a third of global commodities consumption, the weakening domestic investment (and slowdown in construction-related activities; some of it related to the Olympics) are affecting demand.
The impact of the approaching slowdown is getting mirrored in the falling commodity prices (energy, metals and agriculture). For instance, the prices of most metals are down by 10-40 per cent in the last six months. And, the inventories are only piling up. Little wonder, producers have started cutting production to curb supplies.
Although some may argue that the recent appreciation in the value of the US dollar (dollar's weakness had reportedly seen increased demand for commodities as a safe haven) is partly responsible for weak commodity prices, the larger issue is that the demand outlook for commodities remains weak. To know more on the prospects of the ferrous and non-ferrous producers, read on.
Ferrous metals - Steel
Globally, the biggest steel consuming markets are China, Europe and the US, which together account for 61 per cent of world consumption. China, which accounts for 33.8 per cent of world steel consumption, is expected to witness a slowdown in demand from 12-13 per cent last year to 7-8 per cent in FY09. The recent numbers are proof of this.
While China's crude steel production during January to August 2008 grew 8.3 per cent year-on-year (y-o-y) to 351 million tonnes, it grew by 1.3 per cent y-o-y to 42.6 million tonnes in August 2008 (it was lower by 5.2 per cent as compared to July 2008), according to International Iron and Steel Institute.
Overall, the growth in global steel consumption is expected to slowdown to 4-4.5 per cent to about 1,256 million tonnes in 2008. While this means lower volume growth for companies, the pricing environment has also turned unfavourable (global prices have fallen by 15-20 per cent in the last one month), all of which could dent margins if raw material prices do not cool off soon.
According to industry estimates, for every tonne of steel manufactured, about one tonne of coking coal is required. For India, a major part (40-50 per cent) is met through imports.
The international coking coal price have moved up by over $200 per tonne (Rs 8,400 per tonne; $=Rs 42) in the last one year to $380 per tone currently. The recent increase in value of the dollar (to Rs 46) has increased the cost by another Rs 1,520 per tonne.
But, the industry is expecting this trend to change. "Considering the expected slowdown in the steel demand and the rising prices of the coking coal, the companies are not buying much of coal in the international markets. After correction in the iron ore and steel prices, we expect that it is time for a correction in coking coal prices, which could be significant," says Manoj Kumar Agarwal, MD, Adhunik Metaliks.
Going forward, some relief for select steel producers could come from the falling iron ore prices. The price of iron ore (1.8 tonne of iron ore is required to manufacture a tonne of steel), which had become a cause of worry for non-integrated steel companies, has recently fallen by about 27 per cent to $145 per tonne in the last three months.
For Sesa Goa, though, it is bad news as it generates about 65 per cent of its revenue from export of iron ore to China alone. Notably, as the company adopted a strategy to sell a higher amount of its production in the spot market, its revenues and the realisations could be lower to the extent of the fall in iron ore prices.
“We expect the international iron ore price to correct by another 20 per cent from current levels and thus have lowered our earning estimates for Sesa Goa's by 5.9 per cent to Rs 32.27 for FY09 and by 42.9 per cent to Rs 20.19 for FY10, as compared to our earlier estimates,” says Preeti Dubey, analyst, BNP Paribas.
The domestic spot prices of iron ore have also come down only by 15 per cent reflecting the international trend. But, this will provide a small relief to domestic steel industry.
That's because, most domestic companies procure their iron ore requirements either from their captive mines or at subsidised rates from NMDC and others (about 30 per cent lower than international prices) on long term contract basis. But, if iron ore prices remain soft, these gains should also reflect in lower contract prices.
For JSW Steel, the gains are bigger as it procures about 50 per cent of its iron ore requirement from the spot market. Also, JSW is expected to complete the 3 million tonne expansion at Vijaynagar by the end of September 2008, taking the plant's capacity to 6.8 million tonne.
Thus, volume growth of about 25-30 per cent over the next two years should partly help offset the pressure on revenues due to the decline in steel prices. Since the company procures 100 per cent of its coking coal requirement from the market, any correction in the coking coal prices should also help.
In light of the uncertainties over input costs such as iron ore and coking coal, analysts prefer integrated companies like SAIL and Tata Steel. For the latter, there are not major concerns regarding its domestic operations (due to captive iron ore and coal mines).
But, even as the company is further investing in new coking coal mines in the Mozambique, there are some concerns on account of its overseas business, which is susceptible to the slowdown in markets like Europe. Analysts though suggest that most of these concerns are factored in and are recommending a 'buy' in light of the historically cheap valuations.
For the industry, the other threat emerges from the narrowing gap between prices of domestic steel and landed cost of imported steel, which is now just 2-3 per cent higher as against 17-20 per cent earlier. Thus, any further significant correction in international prices may increase the worries for Indian companies.
The industry players though remain confident. “Even if the international steel prices fall further, they will be accompanied by the fall in the input costs, thus margins will still be protected,” believes Seshagiri Rao, Director Finance, JSW Steel.
Some analysts also argue that domestic demand is likely to grow at about 10 per cent, whereas the supply is lagging at about 5-6 per cent, which will ensure volume growth for the industry.
“About 80 per cent of the new capacities announced recently have been delayed from 2010 to 2013-14. So, the domestic supply is still tight,” says Manoj Kumar Agarwal.
Overall, even assuming that companies manage to maintain margins, lower prices would still mean lower revenues and profits in absolute terms, which can get offset only by a perk up in volumes (relative to the decline in prices).
Non-ferrous metals
Prices of aluminium, copper, lead, zinc and nickel have also fallen by about 15-40 per cent in the last six months, and for reasons well known.
Since the demand for these metals are more related to industrial and household expenditure, these commodities will be hit due to the slowdown in global economic growth, industrial activity and slump in the housing sector. The early signs of a slowdown are already visible. Over the last three months, inventory levels at LME are up; aluminium is up by 11 per cent, copper by 68 per cent and zinc by 10 per cent.
Aluminium
Aluminum is the most widely used non-ferrous metal and finds applications in transport, packaging, building material and electrical industries. The LME aluminium prices are down by 20 per cent in last six months, to an extent driven by higher inventories, which are up 30 per cent to multi-year high of 1.34 million tonnes.
According to the CRU estimates, over the first five months ending May 2008, global aluminium demand growth has come down to 5 per cent as against the 10 per cent in 2007. This is largely because Chinese demand growth fell to sub-trend levels of 12 per cent, compared with 38 per cent for 2007. While for the rest of the world the growth at 2 per cent is not impressive either.
Analysts have forecasted an aluminium surplus of 539 million tonnes in 2008, mainly on account of supply growth of 9.2 per cent and demand growth of 8.6 per cent. But, as prices have already taken a hit, analysts say that there is less room for prices to correct further, as companies are already feeling the pinch of rising input cost such as coal (30-40 per cent of total cost) and alumina (a key input; another 40 per cent of costs).
Copper
Copper prices at LME are also down by 22 per cent since July 2008 as inventories are up by 65 per cent. Positively, while global demand for copper could be higher by just 3-4 per cent (due to slowdown in US, Europe and China), supply growth is pegged at 2.5-2.7 per cent in 2008. The situation though may worsen in 2009 as supply growth is pegged at over 6 per cent.
For Nalco, which manufactures alumina and aluminium, profitability and revenues could come under pressure due to falling alumina and aluminium prices.
Alumina prices, which are down 40 per cent to $370 (compared to April 2006), are expected to fall further on account of surplus production. Besides, the company may have to buy more coal from the export markets, where prices are higher. Thus, analysts have downgraded their earnings estimate by about 8-9 per cent in FY09 (EPS Rs 28) and 25 per cent in FY10 (EPS Rs 31).
For Hindalco, which generates about 37 per cent of its sales and 83 per cent of EBIT (earnings before interest and tax; EBIT margins of 33.9 per cent) from the aluminium business, the situation is equally worrying.
During FY08, the aluminium business reported 3 per cent decline in revenue and 17 per cent fall in EBIT, due to an 11 per cent fall in the realisations.
But despite this, the company's topline grew by 5 per cent as its copper business (63 per cent of the sales; EBIT margins of 4.2 per cent) grew by 10 per cent.
Overall, the concerns still remain on account of coal prices (about 25 per cent is outsourced), lower realisations, demand slowdown, proposed dilution due to the Rs 5,000 crore rights issue and likely deterioration in the performance of its US-based subsidiary, Novelis Inc (due to US slowdown). Analysts, thus, recommend investors ‘avoid’ Nalco and Hindalco.
Post restructuring, Sterlite Industries will have a presence in copper and zinc businesses (through Hindustan Zinc), while its aluminium and the energy business will be transferred to Vedanta Aluminium. The zinc prices have corrected by about 10 per cent since July 2008.
Also, there is a marginal build up in inventories at the LME. Since Sterlite has an exposure to these businesses, it will also feel the impact of a fall in commodity prices and concerns over slower demand growth. However, as it is undergoing restructuring, there could be some value unlocking, which could provide some cushion in a weak business environment.
Overall, the macro environment for the metals sector remains weak in the near to medium term. Unless the situation improves aided by demand growth, lower input costs and reduction in inventory levels, which is at least six to nine months away, metal stocks are unlikely to see an upside any time soon.
