Input costs, lower prices cloud majors

Given the higher raw material costs and pressure on operating profit margins, analysts are bearish in the near term.

The share prices of Tata Steel, SAIL and JSW Steel have corrected 20-25 per cent since January, underperforming the Sensex, which fell 17-18 per cent during the same period. The sector is beset with concerns over a possible fall in steel prices and demand ,particularly in a scenario where domestic interest rates are high, economic growth is slowing and industrial and infrastructure capex has fallen.

Additionally, the pressure on margins is going to mount, given that raw material prices remain high. The analysts have already lowered their earnings estimate by five to eight per cent and believe there could be more pressure. “We lower the price objective for Indian steel companies by three to 10 per cent due to moderating fundamentals and near-term margin risks. We expect domestic prices to correct further in the near term due to rising headwinds,” says Bhaskar N Basu, analyst at BofA Merrill Lynch, in his recent note on the steel sector.
 

PROFITABILITY CONCERNS
In Rs crore, Q4FY11	JSW Steel	SAIL	Tata Steel
Sales	7,209	11,945	33,443
% change	32.5	-0.1	22.8
Operating margin	24	23	21
Change in bps	-200	-660	300
Net profit	794	1,507	1,896
% change	29.9	-27.7	-22.1
P/E (x) FY12E	8.1	10.1	9.7
P/E (x) FY13E	6.4	7.7	8.1
Source: Capitaline,Bloomberg, % change is y-o-y

Coking coal prices have gone up by almost $100 per tonne to $330 per tonne. Iron ore prices, currently $190-200 per tonne, have come down marginally but are still significantly higher compared to last year. “Due to higher input costs, we have raised the steel prices by about Rs 600 per tonne in June 2011. But that would not be sufficient to cover up the spike in costs. So, there is definitely a pressure on the margins,” says Seshagiri Rao, joint MD & group CFO of JSW Steel.
 

PRICING GAINS
FY12 EPS impact	% chg*
Tata India	3.0
Tata-Corus	8.0
Tata-Consolidated	12.0
JSW Steel	12.0
SAIL	5.0
JSPL-Consolidated	1.2
JSPL-standalone	3.0
*1 per cent change in realisation Source: BofA Merrill Lynch Global Research estimates

INPUT COST
Companies are already feeling the pressure of higher raw material prices, which could increase in the coming months. The March quarter of 201-11 saw SAIL and JSW Steel report a 660 and 200 basis drop in their operating margins, respectively. “Iron ore prices are firm but there has been a further hike in coking coal prices. This is definitely going to have an impact on the profitability of the steel companies, mainly the non-integrated players. However, the impact will be seen over the next two quarters, as most of these companies are sitting on inventories of about 60 days,” says Jatin Damania, who tracks the metal sector at SBICAP Securities.

MUTED OUTLOOK
Companies such as SAIL are fully integrated in terms of iron ore supply. However, it still imports about 70 per cent of coking coal requirements. In fact the company’s cost per tonne has already gone up by 16.7 per cent to Rs 31,343 per tonne, leading to a 600-basis point decline in operating profit margins during the quarter ended March. A further hike in coking coal prices is the key risk to margins and earnings. Especially, given the fact that the company does not have much room in terms of volumes, which are expected to grow at six to eight per cent over the next two years. This is also a reason that most analysts have an underweight rating on its stock.

Among others, JSW Steel is partially integrated, with 20 per cent captive iron ore and almost all coking coal requirements are sourced from the markets. This is also a reason that the company’s per-tonne cost of raw material has gone up from Rs 19,168 in the fourth quarter of 2009-10 to Rs 24,502 per tonne in the same quarter of 2010-11, a 28 per cent increase as against the 19 per cent jump in realisation. Thus, JSW Steel, too could feel the pinch of higher input prices. However the company could still do better, given the recent rise in steel prices, cost cutting and strong volumes’ growth of about 22 per cent annually over the next two years.

In the case of Tata Steel, its standalone business is fully integrated. However, the problems could crop up from its non-integrated European (Corus) operations, particularly because it accounts for 60 per cent of the revenue. European steel production was down in April, led by concerns over demand. Prices have come down by about 10 per cent since February this year, to $800 per tonne. BofA Merrill Lynch has reduced Tata Steel’s earnings estimates by three per cent and cut the Ebitda (earnings before interest, taxes, depreciation and amortisation) estimates by five per cent for Corus. Its analyst expects Corus margins to be under pressure after the June quarter, due to lower prices and the lagged impact of higher costs.