Little cheer for steel sector as analysts maintain a cautious view

Medium frequency furnaces account for about 9% of low quality steel capacity

The news of a cut in Chinese steel capacities and falling coal prices led to a rally in steel stocks with the likes of JSW Steel, Tata Steel, SAIL and Bhushan Steel gaining 4-11% on the bourses on Wednesday.

The Chinese government has decided to close all medium frequency furnaces which account for about 9% of low quality steel capacity which is a smaller part of total Chinese steel capacity of 1.13 billion tonnes.

Analysts remain cautious on the development as they will be watching if it can lead to reduced output from China. Steel capacities being cut are of low quality and China had cut about 80 million tonne capacity in 2016 as well but this did not lead to any decline in overall production output from China in 2016.

"A cap on exports by China would be a more appropriate move to curtail global oversupply as steel production of the country will then automatically adjust to local (China) demand," said an analyst with Motilal Oswal Securities. Analysts such as Goutam Chakraborty at Emkay Global too echoes a similar view adding that benefits can accrue only if demand supply balance is achieved.

Thus it seems more of euphoria that may have led to a spurt in stock prices. "Stock prices of domestic steel companies are up today on sentiment but at a business level no material change is expected due to China capacity closure," said Abhisar Jain, senior analyst with Centrum Brokerage.

Amongst those analysts who feel that some impact can be seen, however, will be watching for benefits post Chinese New Year when peak production season starts. They say that impact on steel prices and margins may be not too big in the near future.

Another news that can help bring in the benefits is the decline in coal prices. The premium hard coking coal Australian export prices (free on board) East Coast on January 11 came down to $185.20 a tonne from $308.80 a tonne on November 30. If this trend sustains, input costs for steelmakers could fall.

Coal prices had continued to move northwards in the recent past and coking coal costs during December'16 quarter are estimated to have gone up to $200 a tonne from $92 a tonne in September quarter. Though companies have been taking price hikes, average long and flat steel prices should be higher by 5-10% only as price hikes were taken only in the initial part of December quarter, before demonetisation played spoilsport. The producers have taken some price hikes in January.

The good news now is that the impact of demonetisation seems to be reversing. An Elara Capital report suggests that while demand had slumped 14% in November'16 post demonetisation, December steel consumption reflects growth of 17% month-on-month and 5.2% year-on-year growth and If the trend continues it will be positive for all steel players. Also, domestic finished steel production grew by 12% year-on-year to 8.4MT in December with production of most major producers reporting healthy growth. If these trends continue, it can lead to higher volumes.

Meanwhile, for now, most analysts have cautious view. Analysts at Ambit Capital expect Ebitda growth for domestic steel sector in second half FY17 to be lower than first half on rising coal prices and poor pricing power due to worsening demand-supply dynamics. Analysts at Elara too say that although margin pressure is likely to ease in Q4FY17, they do not see an earnings upgrade in ferrous firms.

Meanwhile, for December quarter, Tata Steel India sales volumes are expected to increase 11% y-o-y while European sales may remain flat. The company's Ebitda per tonne at Rs 7,783 is to increase from Rs 7,308 a tonne in a seasonally weak September quarter and Rs 6,375 in December'16 quarter. For European operations, Ebitda is factored in at $35 a tonne by analysts at Ambit compared to $67 a tonne due to decline in spreads.

For SAIL, while sales volumes are expected to increase 24% y-o-y due to capacity ramp-up, analysts at Ambit expect SAIL reporting Ebitda loss of Rs 311 a tonne. The company will feel the biggest pinch of rise in coal prices.

JSW Steel remains the best pick in the space and can see a boost from increased exports. Analysts at Emkay expect the company's operating profits to increase 177% y-o-y though down 16% sequentially due to rising coal costs.