Costs dent JSW Steel's earnings prospects

Analysts expect profits to come under pressure this financial year, due to higher iron ore and interest costs. 

The recent Supreme Court ruling, allowing Karnataka-based mining companies to sell 25 million tonnes (mt) of iron ore inventory, has brought some respite to JSW Steel. But analysts believe the company will face margin pressure due to the relatively high cost of iron ore sourced from other states and entities like NMDC. A slowing Indian economy, especially real estate, industrial capex and infrastructure, also means weaker demand and lower pricing power for companies like JSW, which sells most of its produce in local markets. 

JSW’s share price, which touched its 52-week low of Rs 594.65 on August 26, has since risen to the current of Rs 722, in anticipation of a resolution to the mining issue. However, against the backdrop of margin pressure and a subdued outlook, most analysts — 18 out of 24, according to Bloomberg data — are ‘bearish’ to ‘neutral’ and have a ‘sell’ or a ‘hold’ rating on the stock. 
 

MARGIN PRESSURE
Rs  crore	FY11	FY12E
Net sales	23,900	32,209
% chg y-o-y	26.1	34.8
Ebitda	4,663	5,516
% chg y-o-y	14.6	18.3
Ebitda (%)	19.5	17.1
Net profit	1,754	1,884
% chg y-o-y	9.8	7.4
EPS (Rs )	84.6	74.6
P/E (x)	8.5	13.0
E: Estimates     Source: CapitaLine, Bloomberg, analyst reports

SUPPLIES RESTORED, BUT COSTS WILL RISE
JSW Steel, an efficient player in the space, has been ahead of domestic peers in terms of capacity expansions. Its 10-mtpa Vijaynagar plant in Karnataka, which alone accounts for 70 per cent of the company’s installed capacity, had started facing problems after a blanket ban was imposed on mining of iron ore in Bellary district. The plant depended heavily on iron ore supplies from this belt. JSW requires 45,000-50,000 tonnes of high-grade iron ore a day and, if the ore is of low grade, its requirement goes up to 60,000 tonnes a day. After the mining ban in Karnataka, up to 15,000 tonnes was being sourced from NMDC, while JSW was procuring another 20,000 tonnes a day from Chhattisgarh, Jharkhand and Orissa. 

Some respite has now come, with the Supreme Court allowing steel makers based in Karnataka to sell 25 mt iron ore inventories in the state (according to their capacities with pricing based on the quality of ore). Reports indicate that 1.5 mt of iron ore per month (50,000 tonnes a day) will be available for e-auction. This decision brings reason to cheer for JSW, which had been finding it difficult to run at even 80 per cent capacity. Nomura Equity Research’s analyst estimates the court order would enable JSW to meet half its requirement, albeit at a higher cost. Prabhudas Lilladher’s analysts observe that JSW will now be able to operate the plant at 80 per cent utilisation, similar to the guidance given by the management. 
 

COST WOES
Iron ore source	Incre- mental cost	% of procu- rement	Effective increase	Reason
Bailadila	1,500	25	375	Higher Freight cost
NMDC- Bellary	100	25	25	Higher royalty
E-auctions	400	50	200	Auction price
Net increase			600
All figures are in Rs  per tonne                                                 Source - Nomura Estimates

Additionally, analysts at Nirmal Bang Institutional Equities observe that JSW is better placed than peers in Karnataka, as it has 23 mt beneficiation plant, a 14 mt sinter plant and a 9 mt pallet plant, which will also help it utilise low-grade iron ore (14 mt of 25 mt inventories in Karnataka is of low-grade ore). 

On the flip side, the cost of procurement is likely to rise, and will impact the company’s margins. Though procuring low-grade iron ore from e-auctions may, to some extent, control rising procurement costs, procuring iron ore from other sources will be at higher prices. Add to that the transportation cost. Bellary was an ideal source for JSW to procure iron ore at reasonable prices. Earlier, restrictions on iron ore exports from Karnataka had benefitted JSW, as it could procure the ore at lower prices from the spot market. Nomura’s analyst estimates iron ore costs to increase by Rs 500-600 a tonne, which translates into an impact of Rs 1,000 per tonne at the operating profit level. 

OUTLOOK
Apart from rising operating costs, Ravindra Deshpande from Elara Capital points to debt that has risen on JSW’s books after the Ispat acquisition, leading to higher interest costs. The returns from Ispat, however, will still require time to catch up till its complete turnaround happens. Most analysts are, thus, expecting the company’s earnings to fall in the current financial year. 

While the Supreme Court ruling should help JSW tide over the situation on volumes the company’s margins are expected to decline in 2011-12. Analysts say the resumption of iron-ore mining from Bellary or higher steel prices (which look unlikely for now) is key to JSW’s profitability. While some analysts remain optimistic on the mining issue, believing the Bellary mining issue will be resolved quickly, most others remain sceptical.