India Steel: Wait and watch - Elara Capital

Pricing uncertain amid rising input costs

Margins to head southwards

News reports suggest that Rio and BHP have agreed with the Japanese steel makers for a 23% increase in the iron ore contract prices for July-September 2010 quarter. Similarly, news flows imply that the coking coal contract prices are expected to be revised 12.5% upwards for the coming quarter. At the same time, steel prices have been under pressure on the back of the demand slowdown in the developed world and also Chinese concerns. Although we believe, the current downfall in the steel pricing would be arrested due to the cost push factor, margins for steel companies are expected to be under pressure going forward.

Chinese prices may revive

The Chinese steel prices have corrected ~10% in the past three months or so. We believe, at the current HR prices, the Chinese steel mills would only be marginally profitable at the EBITDA level once the revised raw material contracts pricing creeps in. These mills will not be earning a positive RoCE even on brownfield capacity additions as reflected in adjacent table. Hence, we expect steel prices to witness a strong cost push from the middle of the next quarter considering the fact that usually steel companies carry a month to month and halves inventory.

Cost push pressures to mount on Indian companies

Although the domestic demand remains intact, global uncertainties continue to plague the scenario. Going ahead we expect the Indian demand to rule firm, yet we see a strong cost push impact on Indian steel producers at large. Thus, though we expect the volume growth to continue for Indian steel players, their margins would be under stress. Tata Steel (Indian operations) will be the most insulated player with its (only) partial dependence on outside sources for coking coal needs as opposed to entire coking coal imports by SAIL, and entire coking coal and majority of iron ore by JSW Steel. But Corus remains exposed to the vagaries of high raw material pricing regime due to its presence in the European region.

Time to enter into Indian steel stocks

Although the margins of Indian companies would be under pressure going ahead, we expect the volume growth to partially offset the same. We believe the uncertainties in the developed world as well as those with Chinese steel markets are likely to act as an overhang on Indian steel companies. We consider investors should wait for a better entry points for steel stocks. We have revised our target price for JSW Steel (EV/EBITDA of 5.5x FY12E) considering the evident margin pressures and its lower level of integrations.

Source : Equity Bulls

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