Steel Sector - Iron Ore Prices Tumble, Expansion In Margins Likely - Nirmal Bang

Global iron ore prices have plunged 28% over the past six months, hitting a five-year low in the current week. Although we do not have global steel/iron ore data for August 2014, it is apparent that oversupply is primarily behind the steep fall in iron ore prices. Global steel output rose 3.8% in May-July 2014, while China's steel production increased 5.5% in the same period. China's iron ore imports grew 14.9% over the past three months i.e. May-July 2014. We believe the recent fall in global iron ore prices will render Chinese supplies uncompetitive, thereby leading to some improvement in iron ore prices. However, as observed over the past six months, the drop in steel prices has been lower than the decline in raw material prices, resulting in a higher spread for steel manufacturers. The steel profitability index for European companies (operating via BoF route) improved from €20/tn in 3QFY14 to €48/tn in 4QFY14 and to €79/tn in 1QFY15. In 2QFY15 so far, the spread stands at €81/tn, implying expansion in margins for steel producers. In domestic market, the steel demand scenario is improving led by positive sentiment in respect of the investment cycle, revival of stalled projects and renewed focus on manufacturing. Rising spread for steel manufacturers coupled with domestic steel prices moving to import-parity level (led by improvement in the demand scenario) augurs well for local steel players. We have a positive view on the steel sector and, therefore, retained our Buy rating on all ferrous stocks, barring Steel Authority of India (SAIL) on which we have Accumulate rating.

News flow on domestic iron ore: NMDC has rolled forward its August 2014 iron ore prices for September 2014, despite a steep fall in international prices, driven by supply constraints. As regards iron ore supply constraints, the media reported that Jharkhand government has also closed down iron ore mines which are running beyond their first lease (on the lines of Odisha government). Tata Steel meets ~30% of its iron ore requirement from Jharkhand, while SAIL meets ~75% of its requirement from the state. However, as seen in the past, we expect these matters to get resolved in a few weeks and supply to resume. Jharkhand government can also pass 'express orders' on the lines of Odisha government. Hence, we have not revised our estimates currently, but we will keep a close watch. We also like to highlight that a slight delay in restarting closed mines can impact our FY15 earnings estimates. However, as our target prices are based on FY16 earnings estimates, we don't foresee any change in ratings.

Domestic players poised for better times: In view of strong demand growth likely in the steel sector on the back of revival in investment, we expect steel prices to again move towards import-parity level. Considering the slow growth in the past two years, we believe there is a sizeable pent-up demand in the system, which will aid average steel consumption growth to sustain above 8% in the coming two-three years. Although we acknowledge the fact that there will be an initial oversupply period in the flat steel segment because of capacity addition by SAIL, Tata Steel and JSW Steel, it will be absorbed by demand growth and capacity fine-tuning. We also like to point out that capacity addition has slowed down in the past two-three years, which along with a high gestation period will result in demandsupply equilibrium in three-four years.

Source : Equity Bulls

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