We expect domestic steel prices to rise further near term as imports fade post March due to minimum import price (MIP). Recent extension of safeguard duty increases headroom for price hikes, but domestic steel fundamentals may not support steep price hikes near term, in our view. While MIP-based price hikes could support stock prices near term, upside appears capped post recent rally. Maintain Hold on JSW and Tata; Underperform on SAIL.
Safeguard duty extension a surprise
DG Safeguards extended the existing provisional safeguard duty (SGD) on HRC (hot rolled coil) till March 2018, last week. Safeguard duty will stay at 20% till September 2016 and will be reduced in phases till March 2018. The extension is somewhat surprising as government had imposed MIP recently to curb imports. Cumulative protection on HRC is now over 55%. MIP based import parity incl. SGD is R36,860 tonne, near peak domestic steel prices post GFC (global financial crisis). A possible reason for the dual protection may be that government views MIP as a temporary measure and intends to protect the sector through more sustainable WTO compliant measures like SGD/anti dumping duty after MIP expires in August.
More headroom for price hikes
Extension of the SGD may not impact domestic steel prices near term as imports should fall sharply post March due to MIP, in any case. Domestic steel prices would be driven by domestic demand supply in absence of imports. But, SGD extension increases headroom available to steel mills to hike domestic steel prices. HRC ex mill prices are R28,000/ton (+10-13% post MIP) vs. MIP based import parity of R36,860/t (R30,860/t ex SGD). Mills have headroom to raise prices by 31% before HRC imports become competitive, assuming MIP and no leakages.
Can domestic steel prices rise to MIP based import parity near term?
Unlikely. We expect prices (+10-14% post MIP) to rise further near term as imports taper off. But, domestic demand supply fundamentals are not strong enough (demand growth 4.7% in Feb, new capacities) to support large price hikes going forward, in our view. JSW’s suspended capacities have restarted and its new 3.7mt expansion has been commissioned in March. Our domestic HRC price forecasts are R29,770/t in FY17 and R30,254/t in FY18.
End user’s protest against
Reports indicate exporters association Federation of Indian Export Organizations (FIEO) has lodged its protest against MIP. The steel wire manufacturers body has moved Delhi High Court against MIP. We are yet to see any major noise/protests from exporting countries (like Korea, Japan) so far, but possibility of protests from these countries cannot be ruled out.
Chinese steel prices rally continues, but may be peaking.
Besides restocking, and hopes of capacity cuts, talks of mandatory output cuts in Tangshan (~10% of Chinese output), in order to curb pollution during upcoming International Horticultural Exposition (IHE) (April-Oct) has also contributed to the recent sharp price rally as (i) mills are boosting output (supports higher iron ore prices) and (ii) buyers are stocking ahead of expected cuts. However, we believe Chinese steel prices are nearing a peak as (i) spreads at Chinese mills have normalised; (ii) iron ore prices should correct as seasonal supply constraints reverse; and (iii) IHE led impact should fade. Also, any output cuts in steel would also hit iron ore demand and prices. This should drag steel prices lower, even if the spreads sustain.
Sector valuation no longer cheap; upside capped
Our FY17 estimates factor improvement in margins vs. Q3 levels due to MIP. We forecast FY17e EBITDA/ton of (i) R6,772/t (Q 3R3,443/t) at JSW; (ii) R9,172/t (Q3 R6,083/t) at Tata and (iii) R2,437/t (Q3 R4,764/t) at SAIL. Yet on these estimates, steel stocks under our coverage are trading at 7.4x (JSW), 8.7x (Tata) and 11.6x (SAIL) FY17e Ebitda, no longer cheap considering (i) FY17e do not reflect trough earnings and (ii) there are doubts around the sustainability of MIP.