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Metals
Action
We expect steel prices to remain strong, driven primarily by high raw material
prices. Therefore, we continue to prefer integrated steelmakers. TATA Steel and
SAIL are our preferred picks in the sector. TATA Steel is our top pick on account of:
1) 2.9mn tonne expansion to drive earnings growth in FY13F, 2) sustainability of
Corus’ turnaround and 3) raw material projects to start production in 12 months.
Catalysts
We believe strong steel prices coupled with news on capacity additions will be
potential key catalysts for the stocks.
Anchor themes
We are Bullish on steel and prefer Indian steel companies over non-ferrous due
primarily to: 1) high volatility in non-ferrous metal prices, 2) India as a net importer
of steel and exporter of aluminium and zinc — two major non-ferrous commodities
that India produces and 3) attractive valuations for steel companies.
Raw material integration the key
Despite improving demand 2010 was a challenging year
The global steel scenario has improved greatly in 2010 with demand at 2008
levels and global utilisation rising above 80%, according to World Steel Dynamics.
However, margins of steelmakers globally have remained under pressure as: 1)
demand is still in recovery mode — although utilisation in 2010 YTD has
improved from 2009 levels, it was not enough to return pricing power to
steelmakers; 2) raw material prices continued to head higher — iron ore and
coking coal prices have increased nearly 100% and 50%, respectively, in 2010
YTD; 3) iron ore prices are volatile — with raw material contracts signed on a
quarterly basis (from annually previously), spot market volatility is reflected in
contracts as well. Globally, the steel industry has yet to adjust to this as sales
contracts, which are largely on a yearly and half yearly basis, are taking time to
shift to shorter term. Although steelmakers have shown remarkable production
constraint, they have not been able to gain pricing power to pass the raw material
hike fully. This has strained margins for non-integrated steelmakers.
Strong demand and high raw material prices to support prices
We expect global steel capacity utilisation to reach 85-90% in 2011F. With limited
capacity additions in the developed world, we estimate that 5-6% demand growth
will help to improve capacity utilisation to more than 85%. At the same time, we
expect raw material prices to remain high — 4Q FY11 contracts signed at 8% q-q
higher rates for coking coal reaffirm our view. With raw material prices remaining
high, we expect the marginal cost of production to remain at US$550-600/t;
hence, we expect steel prices to remain strong in 2011F. However, we continue
to prefer integrated steel makers.
Indian steel players have natural advantages
Indian steelmakers have a natural advantage on: 1) captive iron ore – iron ore
costs for TATA Steel and SAIL are US$15-20/t compared with US$140-150/t for
non integrated players, according to company data. It gives them an advantage of
US$200/t and 2) availability of low-cost skilled labour in India. Hence, Indian
steelmakers are among the lowest cost producers globally. Indian steel makers
like SAIL are also looking to modernise operations and plan to improve efficiency.
Domestic demand strong — India remains net importer
India remains a net importer of steel owing to strong domestic demand outpacing
supply. We expect Indian steel demand to post a CAGR of 10% over the next 3-4
years (there can be upside risks if execution picks up), but capacity additions have not
caught up — most additions are brownfield expansions; greenfield plans remain
caught in the web of land acquisition and environmental issues. Therefore, we expect
net imports to go up in the next one to two years to 8-10mn tonnes. Indian steelmakers
will continue to operate at rated capacity, in our view.
We prefer TATA Steel and SAIL
TATA Steel is our top pick and SAIL is our next preferred pick. Both have captive iron
ore and fit our preference for integrated steelmakers. We prefer TATA Steel because:
1) of its 2.9mn tonne expansion likely by Dec 2011; 2) sustainability of Corus
operations and 3) we believe leverage concerns should ease with improved cashflows.
Non-ferrous commodities – high price volatility; detached from
fundamentals
Non-ferrous commodities have shown high volatility in prices, due to: 1) movements in
US dollars and 2) high liquidity in the system, which has led them to behave like
financial instruments rather than commodities. We believe high LME prices have led to
excess production and inventories remain high for both aluminium and zinc. At the
same time, with energy costs remaining high, production costs have also risen.
We have a BUY rating on Sterlite Industries purely on valuations. However as
explained above, we continue to prefer ferrous companies.
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