Asian Daily
India Steel Sector ----------------------------------------------------------- Maintain UNDERWEIGHT
New report: Just the beginning of the fall
● The remarkable surge in steelmakers’ profitability over the past 7–
8 years has turned, and we believe is likely to continue over the next few years. Both components
of profitability, i.e., mining and
smelting profits are likely to see continued pressure going forward.
● Slowing Chinese demand growth is hurting RM prices, and global oversupply has hurt smelting
profits, offsetting the supply delays in India that have pushed out (but not permanently obviated)
local oversupply. We do not build it in yet, but see similarities between CIS in the 90s and China
today vis-à-vis threat of steel exports.
● Arguments against selling steel equities: (1) Aren’t they cheap? No: on EV/t (Fig 2) the reset
is far from done, and on P/B, the pain may be long-drawn; (2) Are “All these” priced in? No:
Marking to market on ore and coal, fair value is far lower; (3) Won’t seasonality help in Dec/Jan?
No: seasonality not as predictable as it would seem.
● We reduce our assumptions on ore, coal and steel (Fig 1). Our FY13–
15 EPS estimates fall 15–50%. We cut price targets for SAIL (from Rs66 to Rs 50) & Tata (from Rs340
to Rs300), and maintain UNDERPERFORM. We downgrade JSPL from Outperofrm to
NEUTRAL (lower TP from Rs500 to Rx450). Click here for full report.
Valuation Metrics
Company Ticker Rating Price Year P/E (x)
P/B (x)
Local Target T T+1 T+2 T+1
JSW Steel JSTL.BO U 726.5 400.00 03/12 26.9 13.3 0.9
Tata Steel TISC.BO U 407.5 300.00 03/12 9.6 7.7
0.9
SAIL SAIL.BO U 82.7 50.00 03/12 9.6 11.3
0.9
JSPL JNSP.BO O 413.0 450.00 03/12 9.7 10.1
2.1
Note: O = OUTPERFORM, N = NEUTRAL, U = UNDERPERFORM Source: Company data, Credit Suisse estimates
All round pressure on profits
In our framework, we split steelmakers’ EBITDA into smelting and mining EBITDA: i.e., profits made
on the conversion of ore and coal, and those due to access to cheaper iron ore and coking coal than
market prices. Thus, profits are driven both by prices of iron ore and coking coal, as well as the
spread between them and steel prices.
The remarkable surge in mining as well as smelting EBITDA that occurred over the past 7-8 years is
now reversing. Iron ore and coking coal recently broke psychological barriers on the downside; and
while the smelting spread is also now the lowest since 2003, it was higher than current levels only
in one year in the whole of the 1990s.
The reset on Chinese demand growth expectations have hurt RM prices, and continuing capacity growth
is an overhang on already weak smelting margins. CS China economists believe monetary easing
or fiscal stimulus cannot lift the Chinese economy out of the current slump: only structural
reforms can, and that too services led.
Indian smelting margins to fall further
Despite seeing some of the highest steel prices globally due to import duties, smelting margins for
Indian firms have disappointed. Earlier in the year, we flagged the risks of India potentially
turning a net exporter of steel, as steel producers lined up capacity expansion plans. While supply
growth has disappointed due to raw material shortages that led to smaller marginal producers
shutting shop, steel prices have still come down due to global oversupply being worse than
expected. A surge in Japanese and Korean imports, which are not exposed to import duties due to
FTAs, has now brought domestic prices closer to
international benchmarks. With domestic supply still expanding, smelting profits in India are
likely to stay under pressure.
And while we do not yet build it into our numbers, we believe it is important to assess the
potential impact of a pick-up in Chinese exports. We analyse the pick-up in exports from the CIS in
the 90s and the underlying causes. While the Chinese macroeconomic situation is by no means
comparable to that seen during the collapse of the USSR, there are notable similarities when it
comes to the threat of steel exports: (1) the relative scale of exports to global production; (2)
importance of the industry, especially given the Chinese steel industry’s debt ratios, and (3)
potential government support.
Figure 1: Changes in assumptions
US$/t FY13 FY14
FY15
Old New Old New Old New
Iron ore 140 110 145 100 128
100
Coking coal 215 180 210 170 205
170
Steel 663 605 661 567 661
567
Source: Company data, Credit Suisse estimates.
A sharp long-term reset, but near term?
With a cloudy medium-term outlook, the three most frequent arguments against
further downside in steel equities are: (1) aren’t they cheap enough; (2) isn’t all of this
negativity already priced in; and (3) is this the right time? Our answers: No, No and Yes.
(1) With both mining and smelting profitability likely to be under pressure over the medium term,
we believe the EV/t reset is far from done (Fig 2), and while already below 1x P/B, still have
meaningful downside. As the increased costs of expansion (depreciation and interest costs) meet
depleted EBITDA, operating leverage below the line has risen: this has the potential of depleting
book values for the weaker players like SAIL. (2) Marking to market on spot iron ore and coking
coal prices it is quite clear that the implied assumptions are much higher than they should be. (3)
We believe steel prices in India have more to fall. We cut price target prices for SAIL and Tata,
and maintain UNDERPERFORM. We downgrade JSPL to NEUTRAL.
Figure 2: The EV/t reset far from complete
50 0 0
40 0 0
30 0 0
20 0 0
10 0 0
0
Ap r - 93 A pr - 96 A pr - 99 A p r - 0 2 A pr - 05
A pr - 08 A pr - 11
SA I L T a ta S t e e l In d ia ( a d ju s t e d )
Source: Company data, Credit Suisse estimates.
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MARKET WATCH 18th OCT 2012
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