More gains in store for metal stocks

While the news flow is positive, a picky approach would yield better results, say analysts, who prefer Tata Steel, Sesa Sterlite & Nalco

After the broader indices scaled three-year highs, it was the turn of the underperformers. Last week, metal stocks were the biggest gainers, with the BSE Metal Index rising 3.4 per cent, led by Tata Steel, Sesa Sterlite, Hindustan Zinc and Hindalco. Positive news flow in the recent past has turned the Street positive on metal companies. Earlier, the postponing of quantitative easing tapering by the US Federal Reserve to early 2014 had improved sentiments as the delay meant liquidity infusion by the US central bank would continue, thereby supporting growth. The latest news comes from China, which posted better-than-expected GDP growth of 7.8 per cent for the September quarter. This is good news, given China is a large consumer of metals. However, analysts say there are more gains ahead, but investors should be selective while considering metal companies, as they see hurdles for some.

Within the metal space, the biggest gainer is Tata Steel, up 70 per cent from its lows of Rs 195 in August to Rs 338 (up 10 per cent in one week). However, analysts say the gains are more to do with stability in the European business and lower valuations. Despite the run-up, Tata Steel is trading 0.8 times its book value and six times its enterprise value to operating profits, based on FY15 estimates. The domestic steel sector though may face growth challenge as demand from construction, automobile and consumer goods could take some time to recover. In a recent note, the World Steel Association lowered India's steel demand growth estimates to 3.4 per cent in 2013 against the earlier estimates of 5.9 per cent. Analysts believe there could be pressure on the margins as a result of higher input cost and increase in freight rates. However, since Tata Steel’s domestic operations are among the low-cost steel producers globally (and fully integrated), it would stand out among Indian peers. And, with expanded capacities, it could capture market share.

In this context, Tata Steel remains the top pick of most analysts. "Tata Steel remains our preferred play in the steel space as JSW Steel continues to grapple with ore procurement issues while SAIL is struggling with its inherent structural weaknesses of high costs and inefficiency," said Ashutosh Somani, who tracks the sector at JM Financial in a note. In the case of JSW Steel, analysts have highlighted issues of lower earnings visibility because of the merger of the erstwhile Ispat (now JSW Ispat). Due to the merger, broking house IIFL expects JSW’s earnings before interest, taxes, depreciation and amortisation (Ebitda) a tonne to drop from Rs 7,110 in FY13 to Rs 5,998 in FY14. Both high cost operations of JSW Ispat and higher interest cost are expected to weigh on the earnings.

"We believe non-ferrous companies are structurally better placed than steel companies in terms of demand and pricing scenario in India," said Motilal Oswal Securities in a recent note. However, in the non-ferrous space, too, analysts are selective. Sesa Sterlite is preferred, as analysts expect it to benefit on an improvement in price, demand and attractive stock valuations. Recent news about working permit for its iron ore mines in Karnataka, the likelihood of Sesa purchasing remaining government stake in Hindustan Zinc and expected higher dividend from Cairn India are seen in positive light.

Positively, except aluminium, which was down marginally, recently, the London Metal Exchange price of copper and zinc has seen risen two-three per cent compared to the average price in the September quarter. If the trend continues, non-ferrous companies should earn better realisations. However, players like Hindalco may remain under pressure. "We remain negative on aluminium plays such as Hindalco, which may be further affected by the new warehouse norms," said Ashutosh Somani of JM Financial.

At the current aluminium prices, experts believe almost half the world aluminium producers are making losses. Prices are subdued due to lower consumption. During January-August, production had exceeded consumption by 1.1 million tonnes (mt) versus 0.5 mt a year ago. Though Hindalco is among the low-cost aluminium producers globally, there are some near-term concerns, say analysts.

"We have a sell rating on Hindalco owing to uncertainty on the commissioning of the captive coal blocks and muted aluminium price or premium outlook. At the current price, it factors in a high Ebitda of $720 a tonne from the enhanced domestic aluminium capacity of 1.3 mt compared to $500 a tonne in FY13 from existing domestic capacity," said Parita Ashar, who tracks the sector at Ambit Capital.

Instead, analysts prefer Nalco, competitive in terms of its cost of production and has large exposure to high-margin alumina business. They say it is sitting on huge cash, almost Rs 19 a share or 55 per cent of the  share price of Rs 35.