JP Morgan: Steel price hikes driven by cost push return

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Indian Steel
Steel price hikes driven by cost push return; we prefer 
integrated mills in an increasingly tough domestic 
environment


• In new era of mini cycles, cost push returns - Stay with integrated mills in
India: We are seeing a repeat of last year with cost push (both iron ore and
coking coal are moving up) combined with seasonal pick-up in demand driving
up global steel prices. We would prefer steel mills in India with captive raw
materials (TATA) where the steel price hikes flow through into the bottom line.
Importantly, TATA also has a highly profitable India expansion being
commissioned in Q4CY11E.

• Near-term margin expansion across the board likely optical given lagged
impact: Given that raw material cost increases flow through with a lag in the
P&L (as steel mills carry around 1.5 months of inventory in our view), we
believe margins would likely expand across the board in the March quarter, but
this, in our view, would largely be optical as it would be more of timing
difference for the non integrated steel mills in India (like JSW) with margins
likely correcting in the next 2 quarters (June/Sept). We expect Dec-10 quarter to
be disappointing across the board as the Oct steel price hikes did not sustain.

• An increasingly tough domestic environment given overcapacity, sluggish
demand: We expect Indian flat steel market to become increasingly tough and
competitive given the spate of new capacities being commissioned. Demand has
been lackluster adding to the pressure and increasing inventories in the system.
In this context, we believe integrated mills are better positioned in the market
given cost advantage.

• Cost push could become bigger on weather, capacity re-starts:  A tight
coking coal market could become tighter if the current wet weather in Australia
continues. Potential steel capacity re-starts in China, combined with lower iron
ore exports out of India could result in iron ore prices remaining elevated.

• What is holding back TATA- Fears of large equity dilution in our view:
While TATA has been more resilient (+5% v/s -8% for SAIL and -19% for
JSTL) since November when cost push started, we believe fears of large equity
dilution is the key factor holding back stock performance. TATA has publicly
announced potential fund raising of $1.5bn with potential instruments including
GDR, DVR, and FCCB. FY12E Corus earnings remain an issue given the
European situation. However, we believe Europe's importance is likely to wane
for TATA's earnings given domestic capacity expansions. In our view, TATA
should benefit from any outcome on Riversdale (as long as TATA does not put
in any aggressive counter bid).

• Mining bill is a large unknown factor in our view and estimating the impact
of the same is difficult given the lack of visibility and details on the bill.