Key takeaway: Recent domestic steel demand data appears positive, but weak global steel fundamentals, falling global prices and imports will continue to weigh on domestic steel prices, in our view. More protectionist policies are possible, which may offer some relief, but we have doubts around the effectiveness of these measures. Balance Sheet stress could intensify. We stay selective: prefer JSW in the current environment; SAIL remains our least preferred steel stock.
Global steel fundamentals remain challenging: Steel prices are down 7-18% across regions since end September. With Chinese apparent steel demand continuing to contract (-4% y-o-y Oct) and global steel utilisation falling to 68.3% in Oct (69.3% Sept), signs of inflection remain elusive. Iron ore prices have also dipped 21% since September. This lowers cost support further. While downside to steel prices may be limited, steel prices could stay at low levels given the oversupplied steel and iron ore market.
Domestic steel demand data in October encouraging: Domestic apparent steel demand grew 5.5%/6.6% y-o-y in Sept/Oct (YTD 4.5%) as per initial JPC data. This compares to a muted 1.4%y-o-y demand growth in September quarter. Monthly data is often volatile due to data bunching, restatement and inventory data issues, but positive steel demand data seems to corroborate other positive macro data recently. However, imports continue to gain share of domestic demand. Producer inventories have increased further in October.
Steel pricing pressure will persist: Domestic steel prices remain under pressure, as domestic prices are largely driven by import parity and a sharp fall in Chinese steel prices has negated the 20% safeguard duty imposed on HRC (hot-rolled coils) in September. Price hikes announced post safeguard duty have been rolled back. Prices of downstream products are largely unaffected by the duty. Domestic HRC prices are down 3.5%, and long product prices are down 14% since September. We see scope for more correction in December as domestic HRC prices are still at a 4-5% premium to import parity.
Steel mills are seeking greater protection: Imports grew 27% m-o-m (month-on-month) in October, though this mainly pertains to bookings made before the safeguard duty was imposed. A clearer picture will emerge in the coming months. We understand HRC import bookings have moderated, but import orders of downstream products have increased after the safeguard duty was imposed. Steel producers are now seeking a higher safeguard duty, and safeguard duty in other product categories. Producers are also asking the government to set a floor price on steel imports. We think further protectionist measures are possible, but government will also weigh the impact on end-use sectors, especially given its ‘Make in India’ thrust. There was strong opposition from steel consuming industries (autos, re rollers, industry bodies) at the recently held public hearing with regard to safeguard duty on HRC. We are also sceptical of the effectiveness of potential floor prices on imports as (i) implementation would be difficult given large variants of steel grades/products and (ii) exporters would find ways to circumvent floor price restrictions.
Stress testing FY17 Ebitda and balance sheet: We believe balance sheet pressure could mount if prices do not recover materially. If prices sustain near spot (Rs 27,500/t) vs. our est. of Rs 30,500/ton in FY17, FY17 Ebitda at our covered steel names would be lower by over 22% vs. our base case. Net gearing would rise to 0.8-2.5x and net debt/Ebitda would stay over 6.5x across our covered steel names. At SAIL, Ebitda would be inadequate to pay interest costs. We do not foresee major interest payment issues at Tata or JSW Steel but net gearing would exceed 2.5x (2.2x FY16) in FY17 at Tata. Covenant risks appear low and repayments are back-ended at Tata, but operating cash flows may be inadequate to meet capex and debt servicing requirements at Tata and JSW, if steel prices sustain near spot.