Steel -Stocks have nearly doubled, but improvement not fully priced in; Multiple specific catalysts other than steel cycle :: JPMorgan

Indian steel stocks have nearly doubled from their August lows and investor
interest has picked up. Admittedly from here with Chinese iron ore inventories
increasing, there is a risk of a pull-back in spot prices, which can lead to some
correction in the Indian steel names. However, we would view any correction as a
buying opportunity. In our view, the multi-year headwinds facing the sector have
just started to ease. Operating environment improvement is not fully priced in,
with INR weakness aiding volume growth. The multi-year domestic demand
slowdown is likely to turn in FY15E, aiding local premium increase. We maintain
our view that the Indian steel names are less of a steel price play and more of
specific country/company events. We see upside risks to our and street estimates
for FY15-16E. TATA remains our top pick as Europe improvement continues,
while SAIL has the biggest beta to domestic demand. JSW benefits the most from
INR weakness. Valuations are not expensive and investor positioning is still UW.
Bull/Bear case fair values imply risk reward is still in favor at current prices
 Stocks have nearly doubled, but operating environment improvement has
just started. We highlighted in our ~200 page industry note (India Metals &
Mining: From Cash Guzzlers to Cash Generators: Why the sector is NOT Dead
Money but can give large returns dated 20 Aug, 2013) that stocks were pricing
in the perfect storm and investor positioning was at multi-year lows. From there
a global sector rally (triggered by positive Chinese data points) triggered a sharp
up move in the Indian names, but over the past month, Indian steel names have
broken out and continued to move up. We believe this is justified and near-term
corrections aside, likely to continue over the next 12 months. INR weakness
provides strong volume and ASP support across the sector. Margins across the
three companies are likely to pick up sharply in H2FY14, in our view, and we
see upside risks to our street-high FY15E estimates.
 Domestic demand coming out of multi-year declines; Capex cycle coming to
a close: Steel import substitution and export pick-up has just started and at INR
of 60+ would be likely ongoing. The ~3 year domestic demand weakness has
likely peaked and from here demand, particularly in Longs should improve. The
capex cycle for these companies is broadly coming to a close.
 Less of a steel play and more of country/company play: We maintain our
view, that the Indian steel names are less of a steel price play. SAIL is a Beta on
domestic India economic growth given its domestic exposure, and presence in
Long products. TATA remains our top pick and with Europe improving, we
believe TATA is the name with potentially the largest potential upside over the
next two years on an improving Europe. We expect JSW to benefit from cost
savings and an impressive operating performance.
 Bull vs Bear case highlight risk reward is still in favor of investors at CMP

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Rally has been sharp, but multiple drivers coming together
Admittedly the rally has been sharp with stocks nearly doubling from August 2013
lows vs a 7% gain in the SENSEX for the same period. The two key factors driving
the initial rebound in our view were: 1) positive data points out of China which led to
a global Metals and Mining rally and 2) investor positioning in Indian MM which
was at multi-year lows. The weaker INR also benefitted the sector. Admittedly, given
the very sharp run up, there is a risk of profit booking/correction. Chinese iron ore
port inventories are at 1 year highs, and steel production growth has slowed, which
does increase the risk of a correction in spot iron ore prices, which in turn is
sentiment negative for the Indian steel names.
We remain bullish on the Indian steel names, and see further potential upside on a 12
month basis for the three Indian steel names. Our top OW remains TATA and in our
view continuous improvement in Europe is likely to re rate the stock further. The key
factors underpinning our OW rating on the sector:
 INR depreciation to drive operating earnings upgrades: The sharp INR
weakness has allowed Indian steel companies to focus on the export
markets, and also allowed import substitution. YTDFY14, India's steel trade
is now in balance, given sharp decline in steel imports and a pick up in steel
exports. This trend is likely to continue. While JSW is a direct beneficiary
given its ability to export, even SAIL is a beneficiary, as it reduces domestic
supply and allows price increases to sustain. We see upside risks to our
street-high FY15 EBITDA estimates.
 Domestic demand should come out of its multi-year declines; Local
premiums should increase given tight capacity: Real steel demand has
been broadly flat for over 2 years now, with Long products in particular hurt
by the sharp slowdown in construction. We believe the demand cycle has
likely bottomed and from here over the next 2 years, we see demand
rebounding to 5-8% levels. While headline capacity indicates surplus, we
would highlight a) Some of the Flat product capacity is unlikely to ramp up
given raw material availability issues and b) Limited addition to Long
product capacity. An improvement in domestic demand, should aid local
premiums. Over the last 2 years, weak domestic demand, has taken local
prices to a discount of Rs5000-8000/T vs being at a premium when
domestic demand was strong. We believe the discount vs imported prices
should reduce in FY15-16E as domestic demand picks up.
 Limited scope for domestic iron ore price reduction: In our view, there is
limited scope for any further reduction in local iron ore prices with prices
actually increasing over the last 3 months. Local iron ore prices are already
at a steep discount to imported prices, and production increase would
require incentivizing local miners by allowing exports.
 Global steel prices should remain range bound: Over the last 2 years,
Chinese HRC export prices have been in the range of $510-610/T,
effectively a $100/T range. Iron ore prices have been in the $110-150/T
range in the same time frame. Admittedly from here iron ore supply is
increasing and this should put pressure on global iron ore prices, there is
little scope to see sharp steel export price falls from current levels

 Valuations not expensive vs global peers; Demand inflexion can lead to
sharp earnings jump: One of the arguments against the Indian steel names
is that after the sharp rally, valuations have become expensive. We argue
against it for 3 reasons: a) Compared to global peers, Indian steel names are
not really expensive, (TATA trades at 5.3x FY15E EV/EBITDA vs 5.6x for
Arcelor Mittal); b) Consensus earnings are likely to see upgrades, given
demand and INR boost; c) Indian steel companies are also carrying large
implied Capital Works in Progress on their balance sheet, which as of now
are not being reflected in stock prices, as investors essentially ignore these
investments. This is particularly true for SAIL and TATA.
Bull, Bear and Base case for the Indian steel names
We have received multiple investor queries as to what would be the Bull and Bear
case for the Indian steel names be, the underlying assumptions of the same, the
implied stock prices in the different scenarios, and the upside/downside vs current
stock price. We lay out the same in this report
Key Assumptions for Bull Case
 Domestic demand sees a sharper-than-expected recovery over FY15-16E vs
our current estimates of 6-8%
 Domestic demand recovery leads to an increase in domestic premiums
 Global steel prices remain in the ~$100/T range seen over the last 2 years
 INR does not appreciate below 60
 Europe demand recovery and margins surprise on the upside
Key Assumptions for Bear Case
 Domestic demand continues to remain at current weak levels
 EBITDA/T margins decline with lower volumes and weaker domestic market
As the calculations in the below table show, our PTs would essentially double if
a domestic demand recovery cycle were to start, while the downside is
essentially ~20-30% against current price. In our view risk reward remains every
much in favor for investors.