Tata Steel, JSPL: Morgan Stanley bullish on steel stocks; do you own any?

Supported by strong domestic demand in China, healthy exports, and rebound in domestic demand, global brokerage Morgan Stanley believes the steel industry's profitability cycle is turning faster

Beaten down metal stocks, such as Tata Steel Hindalco, Vedanta, and JSW Steel, have seen a sharp reversal in their trading pattern and have surged up to 141 per cent between March and August, 2020. Supported by strong domestic demand in China, increase in raw material prices, healthy exports, and rebound in domestic demand, global brokerage Morgan Stanley believes the Indian steel industry's profitability cycle is turning faster with a sharp rebound in 2Q itself. Furthermore, it expects profitability to bottom out in 1Q and improve to previous peak levels of the steel cycle by Q4FY21.

In a report dated August 21, the global brokerage noted that the demand-supply equation is expected to be well balanced though financial year 2021 and it should manifest itself in the form of stable inventory levels despite production normalising faster than demand. "Against this backdrop, we expect recent price hikes to stick through Q2 (helped by exports) and H2 realizations/spreads to be similar to Q2 (helped by pick-up in domestic demand). Over the next 3 quarters, we expect profitability (EBITDA/tonne) to improve back to previous peak levels of the cycle seen in Jun-18 quarter," it said.

Steel companies have taken price hikes of Rs 3,000-3,500/t since the last week of July. Besides, India exported 1 million tonnes of semi-finished steel to China during April and May, while total semi-finished steel exports stood at 1.3 million tonnes. READ MORE

"Based on our checks, we expect domestic demand to be stable in August (vs. July) with some pick up in September. As long as demand stays stable, we believe high visibility on export orders until September provides confidence for the steel producers to keep prices high through 2Q despite weak domestic demand," the report said. 

More steam left?

According to the analysts at the brokerage, steel stocks have scope for for earnings estimate upgrades if demand revival continues. "Concerns around sustainability of price hikes, especially during weak season, and outperformance since the trough in March 2020 are creating skepticism among investors in remaining constructive on these stocks. However, after revising our estimates, we are 6-29 per cent ahead of consensus on F22 EBITDA forecasts... We note that a positive revision cycle by consensus has already started – and it is likely to continue," they noted in their sector report.

That apart, Morgan Stanley believes despite the stocks outperforming since March 2020 lows, they are still underperforming over the full cycle. They observe that most of the stocks (barring JSPL) are still showing large underperformance viz-a-viz the S&P BSE Sensex since October 2018, implying further outperformance. 

"Last, steel stocks are direct proxies for economic and industrial growth recovery in India, as seen in the last several cycles. Historically, steel stocks (weighted average market cap of coverage) have bottomed out ahead of the bottoming of the country's PMI index. Even in the current cycle, stocks bottomed out in March, while PMI bottomed out in April. With continued economic recovery, we see scope for steel stocks to do well along with India's PMI index," it said.

Between December 31, 2019 and March 25, 2020, metal stocks underperformed than benchmark S&P BSE Sensex, ACE Equity data show. Vedanta tumbled the most, down 58 per cent, during the period, followed by Hindalco (down 56 per cent), SAIL and NMDC (down 49 per cent each), Jindal Steel and Power (45 per cent), JSW Steel (44 per cent), and Tata Steel (40 per cent). In comparison, the S&P BSE Sensex was down 31 per cent during this period.

Since then (till August 21) most stocks have made a u-turn with Jindal Steel and Power rallyng 141 per cent, Vendata and Hindalco (up 100 per cent each), SAIL (93 per cent), JSW Steel (87 per cent), Hindustan Zinc (65 per cent), and Tata Steel (50 per cent). In comparison, the S&P BSE Sensex has recovered 35 per cent during the period.

The brokerage expects labor availability to improve after 2Q which, it says, should help in driving demand from the construction sector. A gradual recovery in industry demand, they believe, should help larger players to gain market share in F21, as secondary players are unable to ramp up their production levels. 

Investment ideas

Morgan Stanley maintains an 'overweight' rating on Tata Steel with a target price of Rs 565 (Rs 705 in bull case; Rs 590 in base case; and Rs 350 in bear case). It believes the current slowdown has created a level playing field for Tata Steel on volume growth and has provided more time to pursue its expansion plan. Relative to their coverage, Tata Steel appears best placed with respect to balance sheet position as far as liquidity. "Long-term debt due for repayment over the next 1-2 years is just around 4 per cent of total long-term debt... Valuation has already moved closer to the historical trough on a one-year-forward P/B basis; we see favorable risk-reward given our expectation on improving steel prices," it said.

As regards Jindal Steel and Power, the brokerage believes the company's F2021 FCF should be able to cover not only its interest costs but also part of repayments due in F2021. It is 'overweight' on the stock with a target price of Rs 280 (Rs 405 in bull case; Rs 297 in base case; and Rs 102 in bear case).

The brokerage is 'equalweight' on JSW Steel and sees limited potential upside on the stock. "Given high capex, there will be near-term mismatch in FCF and repayment/interest obligations that will require either refinancing or lowering of capex plans. We believe refinancing would not be a risk in a normal environment. However, in the current uncertain environment, stronger liquidity on the balance sheet would be preferable," it said.

Lastly, Morgan Stanley in 'underweight' on SAIL with target price of Rs 43 (Rs 70 in bull case; Rs 40 in base case; and Rs 25 in bear case).

Company Name	Price on BSE as on March 25	Price on BSE as on Aug 21	% change
Jindal Steel & Power Ltd.	92.4	223.6	141.99
Hindalco Industries Ltd.	94.75	196.2	107.07
Vedanta Ltd.	64.3	130.75	103.34
Steel Authority Of India Ltd.	21.95	42.45	93.39
JSW Steel Ltd.	150.9	281.75	86.71
Hindustan Zinc Ltd.	137.8	227.05	64.77
Tata Steel Ltd.	285.65	428.9	50.15
NMDC Ltd.	66.2	96.1	45.17
S&P Bse Sensex	28535.78	38434.72	34.69
National Aluminium Company Ltd.	28.8	38.15	32.47
Coal India Ltd.	124.5	139.5	12.05

Source: ACE Equity
Note: All prices are is Rs