Steel sector - Favorable tailwinds, but upside priced in - Elara Capital

Steel sector

Favorable tailwinds, but upside priced in

Indian steel stocks exploit global scenario, run up sharply

Indian steel majors have reacted positively to happenings in the steel sector so far by rallying 15%-40% in the last one month. The stock performance was largely due to the positive sentiment of margin expansion on the back of pricing improvements and a reduction in raw material costs. Going ahead, we believe margins for steel players will continue to be better off than previous quarters, considering the events in China and the overall domestic pricing regime.

Chinese actions favorable to Indian players

Recent developments in the Chinese steel industry, though not so favorable for that country, have been a positive for the Indian steel industry. Steel production in China has been subdued since the second quarter of this calendar year due to the demand slowdown in the country. Besides, the higher cost of electricity and forced shutdowns of mills in some regions, citing pollution concerns, have hampered the steel production growth in that country. The same has also resulted in lower exports from China. Given the lower threat of Chinese exports, Indian steel makers decided to go for price hikes recently. This coupled with cooling key raw material prices would ensure better margins for Indian steel players. JSW will be the largest beneficiary as levels of integration remain low hence savings on cost front will be the highest.

Margins to remain advantageous on lower input prices

Given the price hikes and lower iron ore and coking coal contract prices for Oct–Dec 2010 quarter, we expect margins for steel majors to improve. We also expect raw material prices to remain under pressure going ahead as Chinese imports of these raw materials are not expected to rise significantly for a while. However, any drastic improvement in the Chinese production might affect the entire steel equations in India.

Ratings revised: Reduce for Tata & JSW, Sell for SAIL

We have rolled over our valuation multiple from FY11E to FY12E. The global peers are trading in the range of 5.0x EV/EBITDA and the Chinese peers are trading close to 5.75x EV/EBITDA. We have used a premium for Indian steel companies considering the inherent volume growth and cost advantage compared to global peers. We have valued SAIL and Tata Steel at 6.0x FY12E EV/EBITDA, and used 6.5x FY12E EV/EBITDA for JSW Steel. We have used a premium multiple for JSW Steel considering the largest volume growth benefits despite lower levels of integration as compared to other majors. We have also changed our target price of JSW Steel to INR1,340, Tata Steel for INR 654 and INR190 for SAIL. We recommend Reduce for Tata Steel and JSW Steel considering the sharp run up in these stocks and continue to maintain Sell for Steel Authority of India.

Source : Equity Bulls

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