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Metals and Mining: Sector Outlook
Indian metals and mining companies are in a sweet spot right now. With increases in
commodity prices across the globe, strong demand and constrained supply in India, they are
set to reap the benefits of increasing earnings. We would increase exposure to companies
that have implemented new projects, lock in resources and will see earnings growth.
Demand growth to remain strong: India’s growth story remains intact, with GDP
forecasts at 8.5% for the next two years, which would support demand for metals for the
next few years. Also, India’s per capita consumption of all the metals is much below
those of developed countries, giving a considerable opportunity to grow.
Supply constrained and tightening further: Setting up new capacities is becoming
increasingly difficult, with projects facing delays due to long approval process and difficulty
in land acquisition. India has become a net importer of steel as well as thermal coal due to
the slow increase in capacity. Lately, another constraint, logistics, has been making it
difficult for companies like Coal India and NMDC to meet their production targets.
Lowest-cost producers: Indian base metal companies are at the low-end of the cost
curve and are highly profitable. They have been able to reap the advantage of being
nearer to market, low labour cost and free allocation of resources by government so far.
Prefer exposure in integrated companies: Getting access to resources is becoming
increasingly difficult with multiple layers of regulatory approvals required from Ministry of
Environment and Forest. We like integrated companies which have been able to make
progress in setting up capacities. Top picks – JSP IN, TATA IN and GNC IN
Sector Top Picks
Top Buy Recommendation/s
Jindal Steel and Power (JSP IN; Outperform; TP Rs962; Potential Upside: 41%)
Re-rating of the steel business as it increases capacity: The company has grown its
capacity three-fold to become one of the largest private sector steel company in India. Its
unique technology makes it lowest cost producer of steel. Also, earnings are likely to start
early as its captive power plants are nearing completion and will gain from selling power in
lucrative merchant market as early as the current quarter. We believe that the market is
undervaluing the steel business at about $3-4bn, and the IPO of its power business should
result in re-rating of the stock.
Growth backed by resources: JSPL's is the largest private sector owner of resources,
which includes 2.5bnt of thermal coal and around 1bnt of iron ore. This improves its
attractiveness as a resource company, since its three-fold increase in steel capacity to
12mtpa and five-fold increase in power capacity to 5GW are backed by resources, locking
low costs and high margins.
Sustained earnings growth: The company is expected to report an increase in
consolidated earnings by 30% in FY11, with steel business profit expected to grow by 74%
in FY11. The steel business should retain its prominence and is expected to contribute
more than 70% to consolidated earnings in the next three years. We expect consolidated
earnings to grow at CAGR of 20%+ in the next three years.
Key Near-Term Catalyst
Earnings growth of 6-7% QoQ as JSP increases its power capacity by 15-20% every
quarter starting from current quarter. Also its metallics capacity goes up by 50% in Jan
Possible IPO of its power business by Jan'11 – We expect the power business to be
valued at $10bn, leaving only $3-4bn for steel assets, valuing it at 4-5x PER.
Approval of its second leg , 1200MW of its 2400MW power plant
Valuation
The stock is currently trading at a PER of 13-14x PER, with an earnings CAGR of 20%+ in
the next three years.
Top Buy Recommendation/s
Tata Steel (TATA IN, Outperform; TP Rs887; Potential Upside: 39%)
Indian operations key driver of earnings: Tata Steel’s Indian steel operations contribute
about 80% of the earnings, which should continue. These operations are largely integrated
for both iron ore and coking coal and are growing capacity by 50% by FY12 to reach 10mt.
As the company grows its integrated capacities, it will grow profitability, as 100% iron ore
integration and about 45% coking coal integration on coking coal will help sustain high
margins.
European operations - sharp rebound to recovery: Tata Steel’s raw material initiatives
of getting (1) Coking coal from Mozambique and (2) Iron ore from Canada will help
increase raw material integration for Corus capacity to 17%, which should help achieve a
sharp recovery in margin.
Strengthening balance sheet: Tata Steel currently has about $10.7bn of net debt on its
balance sheet. However, the company has been able to refinance $4.58bn on debt on
Corus balance sheet and has no major payments scheduled till 2015 and has no EBITDA
linked covenants for 4.5years, giving it flexibility to invest in its capex program In India and
raw material initiatives.
Key Near-Term Catalyst
Continued earnings growth and upgrades by consensus: We believe that consensus
is currently underestimating the profitability of European arm, building in breakeven
numbers for 2H. We believe that more clarity on European arm and continued profitability
at Indian operations will drive earnings upgrades and will result in re rating of the stock.
Valuation
The stock is currently trading at 7.6x FY12 PER, and is one of the cheapest in the region.
Top Buy Recommendation/s
Gujarat NRE Coke (GNC IN, Outperform, TP: Rs103; Potential Upside: 54%)
Australia business – mine development to be a key catalyst for the stock: The
company is on track to expand its mining capacity in its Australian subsidiary to 6.2mtpa
and this development is the key to unlocking value at GNC. Long-wall mining has
commenced in the company's Wongawilli Colliery, which leads to doubling of the
company's production and reduces the cost of production by 30%. Also, it has already
ordered the second wall, which will help achieve its capacity expansion.
India business – coke making business to grow: GNC is also expanding its coke
making capacity in India, from 1.25mtpa to 4mtpa. This will be increased in line with
increasing capacity in the coal mines. .
Coking coal fundamentals remain strong: Spot coking coal prices have already moved
up to US$240/t. Also, disruptions in Queensland due to above-average rainfall will
contribute to the tightness in the coking coal market In the medium term, recovering blast
furnace production rates through the world ex China are likely to keep the market tight
going into 2011, in our view.
Key Near-Term Catalyst
Capacity expansion: Increased profitability from its Australian subsidiary
Valuation
The stock is trading at an attractive valuation of around 4.7x PER in FY12E. We rate it
Outperform with TP of Rs103
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