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UBS Investment Research
India Steel Sector
Correction—selective buying opportunity
Key issues such as higher raw material costs, slowing demand priced in
We believe the recent correction (up to 23% in the past three months) in the Indian
steel sector presents selective buying opportunities. In our view, the key reasons
for the recent correction are not structural in nature: 1) rising coking coal prices
(US$300/tonne compared to US$225 for January-March contracts) due to flooding
in Australia, which has impacted 40% of global seaborne trade. However, we
believe prices should adjust in Q2 FY12 as supply is restored after the flooding.
We think this could increase costs US$60/t for the April-June quarter. And 2) weak
domestic macro datapoints: YTD domestic steel consumption growth has slowed to
8.3% (compared to 11.1% YTD to September).
Steel prices likely to rise near term; H111 likely to be strong
We expect steel prices to be strong in H111 driven by restocking, seasonality and
higher input costs But unlike 2008, we think it could be difficult to pass on costs
given lower global utilisation (91% in 2008 compared to the current 75%). We
think the market is already factoring in pressure on margins, as reflected by the
recent sector underperformance and therefore think any increase in steel prices
would be a positive catalyst.
Upgrade JSW to Buy; maintain Buy on Tata; downgrade SAIL to Neutral
We adjust our price targets as we roll forward the target period (normalised
EBITDA FY12-13). We upgrade JSW Steel (JSW) from Neutral to Buy and raise
our price target from Rs1,200 to Rs1,300, factoring in the cash infusion by JFE.
JSW has underperformed the Sensex 23% in the past three months. Tata Steel
(Tata) remains our top pick. We raise our PT from Rs710 to Rs820. We downgrade
SAIL from Buy to Neutral and lower our PT from Rs240 to Rs190 on our lower
earnings forecasts. We value JSW on mid-cycle EV/EBITDA of 6.7x and Tata
Steel India/SAIL at a 10% premium (7.4x). We value Corus at 6xEV/EBITDA.
Recent correction: cost pressures priced in
Indian steel stocks (except Tata Steel) have significantly underperformed the
benchmark Sensex by up to 23% over the past three months. Tata Steel has
outperformed the most among the Indian steel names, while JSW has been the
biggest underperformer among the large cap steel stocks under our coverage.
We believe the recent correction in the Indian steel sector presents selective
buying opportunities. We believe the key reasons for the recent correction are
possible margin compression in the next one or two quarters from:
(1) Higher raw material prices
— Potential coking coal price rise in Q4 FY11: the Queensland floods could
increase the April-June contract prices above US$300/t (compared to
US$225/t in January-March), implying a US$60/t increase in steel cost.
Though the spot coking coal price is cUS$315/t, most Indian companies
have about 1.5 months of inventory. We therefore do not see an impact on
production or costs in Q111. Most Indian companies believe that supplies
should take 30-45 days to resume after the rains end as evacuation and
draining flood water will take time. Companies are optimistic that
supplies should resume by end-February.
— Iron ore prices have been strong: China CFR iron ore prices increased
16% to US$178/t over the last 30 days.
— While all the large steel companies we cover in India are exposed to
coking coal prices (SAIL imports 70%, JSW imports 100%, Tata Steel
India/Europe import 50%/100% of their requirements), JSW has the least
captive iron ore resources (SAIL 100% captive, Tata Steel India/Europe
100%/0% captive, JSW 20% captive). However, though JSW has 20%
captive, it buys 40% of its ore from spot in Karnataka (where prices are
under pressure due to an export ban), and 40% from NMDC, which sells
at a discount to global prices. JSW has underperformed the Sensex 23%
in the past three months. The share price has also corrected on the
company’s acquisition of Ispat. However, we believe the recent
correction is overdone.
(2) Weak macro domestic datapoints: YTD domestic steel consumption growth
has slowed to 8.3% (compared to 11.1% YTD to September). However, we
believe structural growth in India is intact, as our economist Philip Wyatt
expects Indian GDP to grow at 8.5%/9% in FY12/13. We expect Indian
steel demand to growth at 12% in FY12 and FY13.
Steel prices to rise; H111 likely to be strong
We expect steel prices to be strong in H111, driven by restocking, seasonality
and higher input costs. But unlike 2008, we think it may be difficult to pass on
costs given lower global utilisation (91% in 2008 compared to the current 75%).
However, we believe the market is already factoring in pressure on margins, as
reflected by the recent sector underperformance. We therefore think any
increase in steel prices would be a positive catalyst.
Indian steel HRC prices have risen only a marginal 3% in the past month
(Rs33,250/t ex works). The China HRC price rose to US$591 (excluding
17% VAT) compared to US$549/t on 1 December. Baosteel raised its
February prices by US$15/t, while SAIL and JSW raised January prices 3%
and 4-5%, respectively.
UBS China steel analyst Hubert Tang expects China to enter a restocking
cycle in mid-February.
— Annual restocking cycle as suggested by the seasonal strong activity
following Chinese New Year over the past several years.
— Hubert believes most traders rely on bank loans to build their inventories
and hence new loans are essential to their restocking. In 2006-10, China
banks loaned 38% of their full-year quota in Q1, well above the other
three quarters. He thinks this important pattern is likely to be repeated in
2011.
— China’s manufacturing and construction activity also tends to be higher in
March than in January and February, as workers return from their
holidays and weather conditions generally improve.
Steel Imports: Imports also have been steadily declining, in April-November
2010 imports grew just 11% YoY to 5.1mt compared to 39% growth in
April-September 2010 (to 4.49mt).
Inventories have steadily declined in the past three months. Inventories in
November 2010 declined to 1.99mt (-13% YoY and -21% from April 2010).
This indicates destocking. Steel prices are still 9% lower (Rs33,250/t) than
the peak in May 2010.
Domestic prices on the rise
HRC prices have increased 3-5% in the past month to cRs33,250/t as imports
declined and prices in the region have firmed up.
Stock preferences
Tata Steel is our most preferred stock in the India steel sector. We maintain
our Buy rating and raise our price target to Rs820 from Rs710. We do not
change our valuation methodology for Tata Steel. We value it on an SOTP
basis, with the Indian business at 7.4x EV/EBITDA, Europe at 6x, and others
at 6.5x on normalized EBITDA (FY12-13E). We estimate the value of its
24% stake in Riversdale could be Rs46/share (at A$16 per share for
Riversdale). We have not factored the potential Riversdale stake sale in to
our valuation.
We upgrade our rating on JSW from Neutral to Buy given the significant
share price underperformance. JSW is trading at attractive valuations of
4.1x/3.0x FY12E/FY13E EV/EBITDA, 10.3x/5.5x FY12E/FY13E PE and
1.2x/1.0x FY12E/FY13E P/BV, compared to the large-cap steel peer
averages of: 1) 5.1x/4.4x FY12E/FY13E EV/EBITDA; 2) 11.3x/7.6x
FY12E/FY13E PE; and 3) 1.6x/1.4x FY12/FY13 P/BV. Though we have
lowered our earnings estimates, we raise our price target as we: 1) roll
forward our earnings to include FY13 EBITDA estimates (we now value it
on normalised EBITDA on FY12-13 estimates), and the full impact of the
increased capacity of 11mt (from 7.8mt) will come in FY13; 2) adjust for
JFE’s cash infusion of Rs54bn, c36m shares/GDRs issued to JFE at
Rs1,500/share. We value its stake in Ispat at book value of the investment
(Rs21.57bn for 41%).
We downgrade our rating on SAIL from Buy to Neutral as we lower our
earnings estimates on our lower earnings assumptions (on lower
volumes/realisations) and higher costs. We lower our price target from
Rs240 to Rs190 based on EV of 7.4x normalised FY12-13E EBITDA. We
earlier valued SAIL on 6.7x EV/EBITDA; we now apply a 10% premium
given the strong raw material cost environment—SAIL has 100% captive
iron ore and buys 30% of its coal from domestic sources. We believe SAIL is
expensive relative to its peers given the large equity dilution in the pipeline,
which will be an overhang on the stock. It is trading at 5.0x/4.0x on
FY12E/FY13E EV/EBIDTA; 12.3x/9.0x FY12E/FY13E PE and 1.7x/1.5x
FY12E/FY13E P/BV
UBS vs consensus
We are lower than consensus on earnings estimates for all three large steel
companies under our coverage. While we think consensus estimates are likely to
come down, we see upside potential in Tata Steel/JSW Steel from current levels
based on our estimates. We believe SAIL is expensive at current levels.
JSW: We think consensus numbers are very bullish for JSW. The company
achieved an EBITDA margin of 16% in Q2 FY11—consensus is estimating a
20% margin for FY11 and a further margin expansion in FY12. However,
though consensus earnings could be revised downwards the stock has already
corrected about 25% from its previous peak and we view the current level as a
good opportunity.
SAIL: We think there are likely to be downward revisions to consensus
estimates for SAIL.
Global steel production
In 2011, we expect global steel production to grow 5% and Chinese steel
production to grow 6%. We expect Chinese domestic demand to increase 7% in
2011, implying that China’s net exports are unlikely to increase (in absolute
number).
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