Analysts predict further weakness for top three steel stocks

Consequent to slowing demand, lower steel prices and premium valuations, the stocks of Tata Steel, SAIL and JSW Steel are expected to remain under pressure

Stocks of major steel companies like SAIL, Tata Steel and JSW Steel are down four to seven per cent in the last one week, even after considering Tuesday's minor rebound. Analysts have downgraded some of the steel counters as they believe there could be more downside to the earnings due to lower demand and price outlook. “Metal stocks have been battered over the past six months on account of escalating euro zone debt crisis, subdued domestic demand, decreasing prices, rising input costs, CAG (Comptroller and Auditor General of India) report on coal and delays in obtaining procedural clearances for mines,” says Bhavesh Chauhan who tracks the sector at Angel Broking.

As concerns persist and valuations, too, provide some room there could be further downside for the stocks. “Indian steel stocks are still commanding premium valuations, though globally steel stocks have been de-rated. According to our scenario analysis, the probability of positive returns (over 12 months) is two out of nine in Tata Steel, one out of three in SAIL and one out of nine in JSW Steel Ltd,” says Sanjay Jain of Motilal Oswal Securities in his recent report on the sector.

Key concerns
Due to the global economic slowdown, demand for steel in key markets, including Europe, the US and China, is down. In fact, the situation in the Chinese markets, which is the largest consumer of the metal, is considered to be worse than the 2008-09 crisis as the economy has slowed down significantly. According to the latest available data, world steel production growth has come down to just one-two per cent in recent months and the capacity utilisation is at around 79 per cent, which is very low from the historical perspective.

GROWTH CONCERNS
In Rs  crore	Tata Steel	SAIL	JSW Steel
Sales	132,106	46,532	36,019
% change y-o-y	-0.6	0.3	4.8
Ebitda	15,016	7,437	6,541
% change y-o-y	20.9	22.0	7.2
Ebitda (%)	11.4	16.0	18.2
Net profit	4,222	3,747	1,132
% change y-o-y	-19.1	0.8	-23.7
EPS (Rs )	41.8	9.1	50.7
PE (x)	8.7	8.5	13.3
All figures are FY13 consolidated estimates Source:          Bloomberg, Analyst reports

The domestic steel demand, which was growing by about 10-12 per cent annually a year back, grew just 4.7 per cent in July 2012. The rating agency, Fitch, in its outlook for steel producers said it expected steel demand growth to be in the region of six to seven per cent for the remaining months of the year 2012. Companies have already cut production in recent months. With outlook for steel demand remaining subdued in the near term, both in the domestic and international markets, it has also resulted in pressure on prices, which is expected to remain. In Europe, steel prices have already corrected from about $550 per tonne in May 2012 to currently around $490. Similarly, Chinese steel prices are down to about $560 a tonne from about $680 in April and May. India, too, followed suit, as steel prices have corrected by about 10-12 per cent since May 2012. “Major decline witnessed in steel prices in June and July will impact earnings in Q2FY13 with a lag effect. Operating costs are rising across the sector,” says an analyst with Motilal Oswal Securities in its Q1FY13 review note.

The top three
Thankfully, due to less production, especially in China, which accounts for 60 per cent of raw material demand, the prices of international coking coal and iron ore have corrected. This should help on the margin front, albeit marginally given the rupee’s depreciation. However, fixed (interest costs) will remain firm, which in a scenario of muted top line growth would lead to pressure on the bottom line.

Meanwhile, analysts also expect the gains from decline in input costs to be negligible for non-integrated players like JSW Steel. Nevertheless, the odds are still not favourable for the company. This is not just due to weak sector dynamics, but analysts have downgraded the stock also due to the merger of JSW Ispat with JSW Steel. CLSA has a sell rating on the stock. Its analyst said in a recent note, “Our analysis shows that the merger of JSW Ispat into JSW Steel is EPS dilutive to the extent of 6-16 per cent over FY13-14 and value dilutive to the extent of Rs 63 per share. JSW’s total acquisition cost for Ispat now stands at Rs 3,700 crore, which translates to 16 times FY14 EV/Ebitda – extremely expensive for such a high cost asset.”

On the other hand, decline in raw material prices is not good news for Tata Steel’s domestic business given its integrated operations. Lower steel prices and demand will also hurt Tata Steel’s global operations. “Although we have negative view on the entire sector, most vulnerable in this space would be Tata Steel given its exposure in the European markets,” says Giriraj Daga, who tracks the sector at Nirmal Bang Equities. Tata Steel’s European operations account for over 65 per cent of volumes and have seen a slowdown. Analysts have recently cut their estimates for the company as they believe that due to lower prices the realisation will dip while volumes will be hit due to slowdown in demand, which would negate gains from lower input costs.

SAIL, which is largely in the Indian market, would have been a better choice. But it is also feeling the pressure due to slowing domestic demand and lower steel prices. For instance, in the first quarter, SAIL produced three million tonnes (mt) of steel and sold only 2.5 mt.

Besides sectorial issues, analysts are also concerned about delay in ongoing capital expenditure of Rs 72,100 crore, where SAIL has spent about Rs 40,000 crore. This, along with higher interest cost, is impacting its return ratios (500 basis points estimated decline in return on equity from FY11 to just nil per cent in FY13) and earnings outlook.