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India: Steel
Equity Research
Rising costs to trigger further price hikes; Buy Tata Steel, JSW Steel
Higher cash costs to push up steel prices; 15% increase in 4QFY11E
Following the floods in Australia, spot coking coal prices have been rising
sharply - subsequently, Goldman Sachs & Partners commodities team
have revised up their coking coal forecasts by 15%/21% for FY12E/FY13E,
with 1QFY12 forecast at $280/ton. In our view, expectations for higher
1QFY12 cash costs will provide an additional impetus for a sharp rise in
steel prices in 4QFY11 – note that steel prices in India have already risen
by 8-10% (or $63) since Dec, and we expect a further 5%-7% increase in
prices in 1Q. Strong demand momentum in 4Q coupled with rising regional
prices (up 14% ytd) presents a solid platform for domestic steelmakers to
hike prices in the near to medium term. We now expect the domestic HRC
price to rise by 5% yoy in FY12E (vs. 2% growth previously).
Strong operating margins for 4QFY11/1QFY12
Against the backdrop of rising steel prices and higher offtake, we believe
that 4QFY11/1QFY12 should be relatively strong quarters for Indian
steel makers. With higher raw material costs to start flowing in only from
1QFY12, we expect the Indian steelmakers to witness strong operating
margins for at least the next two quarters. Based on our calculations, the
increase in domestic prices since Dec (+$63) is more than what is
needed to completely pass on the higher cash costs from rising
coking coal prices (assuming $280/ton for 1QFY12).
Indian steel makers adequately covered for coking coal
Based on channel checks, Indian steel makers under coverage have
comfortable levels of coking coal inventory that can last for the next 2
months. Moreover, steelmakers are in talks with the suppliers in North
America, to plan for any further delays in supply. In our view, while
disruption in coking coal supply is not a source of concern for Indian steel
mills in the near term, we believe that any further increases in contract
prices (current estimate of $280/ton for 1QFY12) remain a source of risk.
Best Buy ideas: Tata Steel (CL), JSW Steel on valuations
We reiterate CL Buy on Tata Steel with a new 12m TP of Rs761, implying 22%
upside. We reiterate Buy on JSW Steel with a new 12m TP of Rs1286. We
maintain Neutral on SAIL with a new 12m TP of Rs181 (TPs based on FY12E
P/B). We revise down FY11E-13E EPS ests by 1%-17% to incorporate new
commodity, currency assumptions. We revise down 12-mo TPs by 0.5%-9%
Rising costs to trigger further prices hikes, valuations attractive
Following the floods in Australia, spot coking coal prices have been rising sharply, with channel
checks indicating that replacement tonnage in Australia is being sold at as high as $350/ton.
Subsequently, the commodities team at Goldman Sachs & Partners has revised its coking coal
forecasts upwards by 15%/21% for FY12E/FY13E, with 1QFY12 forecast at $280/ton.
In our view, expectations for higher 1QFY12 cash costs will provide an additional
impetus for a sharp rise in steel prices in 4QFY11 – note that steel prices in India have
already risen by 8-10% (or $63) in the last 5 weeks, and we expect further price hikes in 1Q. In
our view, increased steel offtake in 4QFY11 coupled with rising regional prices (our Asian steel
analyst expects an 11% increase in East Asia HRC for CY11) presents a solid platform for
domestic steelmakers to hike prices in the near to medium term. We now expect average
domestic HRC price to rise by 14%/5% yoy in FY11E/FY12E (vs. 12%/2% previously).
In our view, given the strong demand momentum, tight market balance and robust regional
pricing, Indian steelmakers will be able to pass through almost the entire additional cost from
higher raw material prices for the next couple of quarters and report stable to higher EBITDA
per ton spread. Steel prices tend to rise in expectation of higher cash costs, as such,
margins expand before higher costs start flowing in. With higher raw material costs to
start flowing in only from 1QFY12, we believe that 4QFY11/1QFY12 should be relatively
strong quarters for Indian steel makers. Moreover, Indian steelmakers continue to be in an
advantageous position, in our view, given access to low-cost iron ore and high leverage to
rising prices.
Our positive stance on domestic prices hinges primarily on two factors:
Rising regional steel prices: East Asian HRC prices have risen by $90 or 15% since
December, more than what is needed to completely pass on the higher cash costs from rising
coking coal prices. Our Asia steel analyst has highlighted in the report Déjà vu: Steel cash costs
heading back towards 2008 highs…, dated Jan 19, 2011, that regional prices are on an upward
trajectory - the reasons being attributed to the sharp rise are : (1) seasonal restocking, (2) after a
lack of buying in 4Q2010 that has run down inventories quite a bit, (3) coupled with some panic
buying, looking at rising costs, and (4) emerging arbitrage opportunities, as US steel prices
have risen to US$880/t (a 22% premium to Asian prices). Traders believe that these price hikes
will continue as there is a general acceptance that Asian prices will rise, given the rise in cash
costs following the floods in Australia.
Domestic steel prices have historically tracked regional prices (+90% correlation) and
have been traded at a premium most of CY10, given strong demand, constrained supply
response and lower imports. Currently (post the price hikes), domestic steel prices are at a
marginal premium to landed cost, implying that further increase in regional prices and rupee
depreciation will trigger a sharper rise in domestic prices.
Domestic demand gains momentum: After a brief spell of soft demand during Oct-Nov,
caused by weak offtake from infrastructure / construction sectors due to an extended rainfall
season, demand has picked up again from December onwards.
While real demand from end consuming segments like automobiles and infrastructure /
construction is regaining traction, buyers are back in the fray anticipating strong growth in
4QFY11, which is seasonally the strongest period for steel consumption. Steel inventories
across the system have been run down and restocking demand has driven higher offtake from
steel mills which have started reporting lower inventories at the end of Dec (compared to Sep
end). Note that ytd steel consumption growth is 8.8% vs. our FY11E forecast of 12%.
Historically, steel stocks tend to trade in line with steel prices, hence, a robust steel price
environment in the near to medium term is positive for steelmakers’ price performance.
We incorporate new commodity price assumptions (steel and coking coal) and forex
assumptions - subsequently, we revise down our EPS estimates by 1%-17% for the Indian
steel coverage. We also revise down FY11E-FY13E EPS for Sesa Goa by 2%-11%, as higher
iron ore prices are not enough to offset lower volumes (on account of continued curbs on
exports from Karnataka and lost volumes from Orissa).
We reiterate our Buy (Conviction List) on Tata Steel (TISC.BO) with a revised 12-m
P/B-based TP of Rs761 (from Rs764). In our view, the current price does not reflect Tata
Steel’s strong growth trajectory (46% FY10-FY13E EBITDA CAGR) and improving return
profile. On earnings-based multiples, the stock is trading at 4.4X FY12E EV/EBITDA, at 29%
discount to the mid-cycle of 6.2X and 23% discount to peers. At 1.6X FY12E P/B, the stock is
trading at 8% premium to the sector average despite sector-leading FY12E ROE of 25%
(sector ROE: 18%). For Tata Steel, we revise down FY11E-FY13E EPS estimates by 5%-15%
to account for recent fundraising and revised forex assumptions.
We reiterate Buy on JSW Steel (JSTL.BO) with a 12-m P/B based TP of Rs1286 (from
Rs1343). The stock is trading at a discount to mid-cycle valuations and peers on both
earnings- and book-based multiples. Moreover, JSW is in the best position to capitalize on
a recovery in steel pricing, given its sector-leading FY12E volume growth and leverage to
steel prices – we expect 1QFY11 to be strong for steel pricing, led by robust seasonal
demand, and cost push. JSW’s growth trajectory (25% 3-year EBITDA CAGR) remains intact,
led by strong volume growth, low conversion costs, and improving upstream integration.
For JSW Steel, we revise down FY11E-FY13E EPS estimates by 1%-9% to account for
revised commodity assumptions and lower volumes.
We maintain Neutral on SAIL (SAIL.BO). We revise down FY11E-FY13E EPS by 11%-17%
to account for revised commodity assumptions and lower volumes and consequently lower
our 12-month P/B-based target price to Rs181 (from Rs199).
Queensland floods: Indian steel makers comfortable on coking coal
supply; pricing remains a risk
Based on our channel checks, Indian steel makers have comfortable levels of coking coal
inventory that can last for the next 2 months. Moreover, all three steelmakers are in talks
with suppliers in North America, to plan for any further delays in supply.
In our view, while disruption in coking coal supply is not a source of concern for Indian
steelmakers, we believe that any further increases in contract pricing (current estimate of
$280/ton for 1QFY12) remain a big source of risk.
Queensland floods - assessing the impact on coal supply for Indian steel companies
Tata Steel
• Tata Steel is carrying enough inventory of coal (for both India and European businesses) to
last for Jan-March quarter.
• For India business - 50% of coal supplies are met from captive mines in India, the balance 50%
is imported from Australia. Of the imported portion, a large amount of semi-soft coal comes
from New South Wales (no force majeure declared) and a smaller portion of HCC from
Queensland. Even if NSW supplies get impacted due to infrastructure issues, they can ramp up
domestic output (although at a cost of lower yield).
• European business sources coking coal from North America and Australia. The company is
carrying comfortable levels of inventory (including material already in transit) to last for JanMarch quarter.
JSW Steel
• JSW Steel imports 100% of its coking coal requirement for blast furnaces from Australia. (For
Corex furnaces – they use thermal/semi soft coal from South Africa).
• Of the Australian supplies – one of the suppliers has not been impacted by the flooding. The
other big supplier has declared force majeure.
• Company has enough stocks to last for about 2 months – hence we see no impact to
production schedule for Jan-March quarter.
• Have booked a few shipments from US in last week of Dec, and continue to be in negotiations
with a few other North American suppliers as contingency plans.
• Their own captive mines in the US likely to commence output this year.
SAIL
• SAIL sources 30% of coal domestically (largely from Coal India) and imports 70%.
• Sources coking coal from Australia, New Zealand and the USA. All 3 suppliers from Australia
have declared force majeure.
• Currently SAIL has enough coking coal inventory (including material in transit) to last for about
45 days. We do not foresee any disruption to production schedule for Jan-March quarter.
• In touch with a few suppliers in the USA as a part of contingency planning.
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