Steel: How long can it shine?

SECTOR REVIEW

Vibrant domestic demand should help prices to stay high but worries about China becoming a net exporter are dragging down the scrips.

Thanks to varying business strategies, steel stocks have been showing different shades of valuations for the last one year.

In an increasingly competitive industry, the markets over the past year have been favouring players with greater operating efficiencies and captive raw material sources. This has given rise to a situation where investors need to keep a more watchful eye over the expansion activities of the major players.

Currently, India produces about 38 million tonne (MT) of steel annually. The major players in steel production include Steel Authority of India (about 13 MT), Tata Steel (five MT + 1.8 MT of NatSteel and 1.8 MT of Millennium Steel), JSW (4.5 MT), Essar Steel (three MT) and Ispat Industries (2.4 MT).

At present, valuations of steel stocks stretch from a high of 10.24 times earnings for the last 12 months for Jindal Steel & Power to barely above thrice the earnings per share for Essar Steel. 
 

STEEL STATS
(Rs lakhs)	Net profit			Operating Profit
	9 mth Dec 05	9 mth Dec 04	% Change	9 mth Dec 05	9 mth Dec 04	% Change
Tata Steel	272327	256559	6.15	473395	466845	1.40
SAIL	293519	413898	-29.08	569773	702974	-18.95
JSW Steel	44585	46597	-4.32	128430	125749	2.13
Jindal Steel & Power	42228	36900	14.44	77729	63434	22.54
Essar Steel	44789	31737	41.13	110237	99363	10.94

This is in contrast to the situation a year ago when most of the steel companies were valued at a more uniform five to six times their trailing earnings. Tata Steel carries a price of just under nine times its trailing-four-quarter earnings and Sail has a P/E of 9.96x, while fellow-competitor JSW Steel is priced at just under seven times its earnings.

"The difference in valuations comes from the operating efficiencies of players," points out an analyst, "For instance, Tata Steel is able to realise Rs 29,000 per tonne of its production, not all other players can realise that much."

And while it was operating efficiency which held the key over the last one year, it is likely to be capacity expansion, which is going to be the new arbitrator of value in the future. The steel sector in India, with a capacity of about 38 MT, is expected to increase by about 4.5 MT by FY08. Compared to this, Chinese capacity is said to be about 330 MT, while the total global capacity is about 1,000 MT.

The capacity utilisation by Indian steel companies at present is over 90 per cent. Steel production is on an upswing, it posted a growth of 7.1 per cent in April-December 2005 slightly lower than 7.5 per cent recorded in the corresponding previous period. "The domestic demand for steel is expected to grow by 8-10 per cent over the next few years" according to Manish Bhandari, fund manager, ING Vysya Mutual Fund.

Construction sector, consumer durables and white goods, which together constitute about half the demand for steel in the domestic market, have all been showing signs of increasing activities. The auto sector, which constitute 8-9 per cent of the demand, is expected to grow at 14 per cent per annum till FY09.

Indian steel production rose by 18 per cent in 2005-06. As per the National Steel Policy, the steel capacity is targeted at 100 million tonnes per annum in the year 2019-20. Currently, India exports about 15 per cent of its steel production, primarily to the West Asia and South East Asia. 
 

STEEL STATS
Sales (Rs lakhs)	9 mth Dec 05	9 mth Dec 04	% Change
Tata Steel	1101042	1063426	3.54
SAIL	1875090	1977914	-5.20
JSW Steel	459686	380879	20.69
Jindal Steel & Power	187606	178476	5.12
Essar Steel	467500	419305	11.49

"India is considered cost competitive for steel production due to abundant iron ore and coal availability and the resultant captive power facilities," Bhandari points out. To cater to the increased demand, most companies are in expansion mode. Since the export market has potential, steel majors are also eyeing acquisitions abroad.

In the next couple of years, Tata Steel plans to add new capacity and eventually targets to take it 20-25 MT by 2015. Similarly, JSW Steel is also in the process of expanding its capacity to seven MT by March 09. Sail too is "de-bottle-necking" its operations to realise higher output.

Besides, a foreign player like Korean steel major, Posco has planned 12 MT capacity. Mittal Steel has signed a MoU with the Jharkhand Government for setting up a plant with about 12 MT capacity.

While the increasing domestic supply could be a concern, there are other risks too. Global demand-supply dynamics, including the growing production and consumption in China, may keep prices weak or stable. China, a huge consumer and producer, used to import about 30 million tonne of steel, some years ago. Now it imports only 5.8 MT. If it starts exporting steel after the Olympics in the country in 2008, then it could create an over-supply situation.

Rising costs is another cause for worry for steel companies. For instance, if the cost of production of non-integrated producers is $ 380-390 per tonne, they at least need a price of $ 410-420 to survive.

The raw material prices have been exerting some pressure on the margins of steel producers. However, integrated players like Tata Steel and Sail would not be affected so much as they have their own iron ore mines. Jindal Steel & Power and JSW Steel also have some captive raw material resources. But observers feel that companies like Essar may get affected. Increase in coal prices may affect most players except Tata Steel.

Steel prices are expected to remain stable for a while, with no exponential highs and lows. However, closer to the Olympics in China, analysts expect prices to weaken. Steel prices in India have been in the range of $ 460-470 per tonne. Prices in other regions are: CIS countries ($ 425), China ($ 455), US ($ 525) and Europe ($ 385). Over the last five years, the prices have been in the range of $ 150-650 per tonne.

Analysts feel that global consolidation may rein in more stable steel prices but not immediately. Even if the Mittal Steel is succesful in acquiring Arcelor, it may not have a major impact on steel prices for another year or so. "Mittal has to control about 30 per cent of Chinese capacity to really control global prices" says Pritesh Vinay of Edelweiss Securities.

Another area of concern is the differing tariff-regimes. The budget introduced a five per cent duty on steel melting scrap, while it reduced custom duty on ferro alloys from 10 per cent to 7.5 per cent. Duty imposed on scrap is expected to increase sponge iron prices.

Tata Steel would not be impacted whereas Ispat Industries would have negative impact. Since zinc is used as raw material for galvanised steel, the proposed import duty cut will benefit JSW Steel, Tata Steel and Bhushan Steel. The duty on iron ore has been cut to two per cent, which is not likely to have any effect since the domestic prices are linked to the international prices.

"The capacity utilisation of Indian steel industry is good and will prevent steel prices from going down," says Jaspreet Singh Arora of Angel Broking.