Investors may be looking for potential re-entry points to the sector post the 24-41% correction YTD (year-to-date), but we believe it is still too early. We expect more share price downside with (i) lead indicators still falling; (ii) domestic supply running ahead of muted demand and more supply increase on the cards; (iii) margin squeeze ahead on higher coking-coal cost from the Sept quarter onwards. We cut our FY12-13e EPS (earnings per share) by 5-10% and POs (price objectives) by 4-18%. We remain cautious on all our steel names.
The stock-price performance of Indian steel companies has been correlated with economic lead indicators?India PMI (purchasing managers’ index) and OECD composite lead indicator India (CLI). PMI indicators have declined across most regions (China marginally up). India PMI fell to 52.59 in August (July 53.6). OECD CLI (India) reading was lower in July and the 6M (month) change was negative. With both indicators trending lower, we expect valuation multiples and stock price to come under pressure near term.
Domestic steel demand grew 0.3% YTD FY12 Aug. lagging supply (up 10% YTD) as end-user demand remains weak. We expect demand growth to slow to 7% in FY12 (10.3% in FY11). Supply is set to rise further as 12 mt of new capacity is likely to be added (9.5mt in flats, 29% of demand) over 12-15 months. We expect India to become a net exporter in FY13, which could result in (i) domestic prices shifting to discount to import parity; and (ii) lower utilisations, both not fully discounted.
Supply (up 10%YTD) has outpaced demand YTD and is set to rise further as 12 mt of new capacity is likely to be added over the next 12-15 months, though few firms have pushed back timelines by 3-4months. Flats? capacity addition is likely to be substantial at 29% of flats demand. We expect India to become a net exporter in FY13 which could result in (i) domestic prices shifting to a discount to import parity (vs. in-line or premium over the past few years); or (ii) lower utilisations, both not priced in, in our view. We note that Indian prices were at a discount to import parity before FY08 when India was a net exporter.
Domestic HRC (hot rolled coil) has been range-bound at about R34,000-34,500/t over the past few months, slightly below import parity. We expect some seasonal up-tick in demand post the monsoons, especially in long products. Recent INR (rupee) weakness lifts import parity prices and offers support, but demand is sluggish. Steel mills have partly rolled back 2-3% price hike announced early September. Also, regional prices may ease towards year-end.
We expect the lagged impact of higher coking coal prices and the inability to pass on higher costs due to weak demand to squeeze margins in the next few quarters. Dec Q (quarter) coking coal settlement at $285/t (-$15/t QoQ) may offer some relief, but a high steel output run-rate and uncertain weather patterns could keep coking-coal costs high. Steel stocks generally underperform when steel margins fall.
Steel prices are unlikely to hit FY09 lows as iron ore prices should be supported at higher levels. De-stocking is unlikely to exacerbate apparent demand swings, but domestic real demand is weaker. Balance sheets of Indian steel firms (Tata, JSW) have improved but returns are lower. SAIL appears worse positioned in FY12 on a structurally higher fixed-cost base, lower returns and net debt.
Indian steel stocks trade at about 1x P/B (price-to book), above FY09 lows. A stress test suggests further 28-34% downside potential. In SAIL, we see muted volumes, margin concerns and further cost increase due to wage hikes in FY13. In Tata, we expect margin squeeze at TSE and lower margins in India. In JSW, we believe the market is missing out the cost impact of the mining ban. JSPL appears better placed among steel stocks, but weak power fundamentals and expansion delays are an overhang.
?BofA ML