17-01-2017

India Steel: Disrupted recovery calls for caution

steel

Sector profitability will be hit in Q3 and Q4 due to higher raw material costs, which we believe is not incorporated by the market. Sector profitability will be hit in Q3 and Q4 due to higher raw material costs, which we believe is not incorporated by the market.

India steel has held firm in absolute terms in the last quarter, albeit generally underperforming global peers. With reduced imports and improving pricing, the lows of January 2016 feel a long time ago. But the demand picture is subdued (as it was even before demonetisation) and outpaced by growth in supply. Sector profitability will be hit in Q3 and Q4 due to higher raw material costs, which we believe is not incorporated by the market. Deleveraging has not yet started for any of the main players. And stocks are still pricing in a step-up in mid-term profitability, in our view. Amidst this unfavourable risk/reward skew we maintain a Sell rating on JSW Steel and Neutral on Tata Steel and JSPL.

Sentiment the key risk to our cautious view

We do not think higher raw material costs in Q3 results will be a surprise for the market per se, but consensus expectations have not moved since the spike in coal and iron ore prices in Q4 2016 so we see downgrades (we cut our FY17e Ebitda estimates by c.10- 15%). We accept the market can (sometimes) look through a couple of soft quarters. But demand has been patchy for a while and our strategy team sees pressure on growth and earnings until H2FY18. Perhaps the key risks to our cautious view are: (i) positive sentiment arising from Union Budget, but in our 2017 India outlook note our strategy team argues expectations for this are already high; (ii) wider commodity market factors such as sentiment following the US election or capacity cuts in the Chinese market.

Demonetisation should not be ignored

Our thesis for the metals and mining sector remains that demonetisation is a ‘low risk’ , but not a ‘no risk’ event. While it is primarily B2B in India, large steel players operate retail networks and the industry overall is exposed to end markets like property and construction. Companies themselves have certainly acknowledged some negative impact, but it is not possible to reliably quantify it at this stage.

Valuation

We still prefer Tata Steel (Neutral, PT R440) as news of European restructuring remains a potentially positive catalyst. We are cautious on JSW Steel (Sell, PT R145) given greatest earnings risk and a stretched valuation. JSPL (Neutral, PT R80) remains too tough to call until there is more visibility on deleveraging.

Is India an oversupplied steel market?

There are some short-term pressures if demand does not strengthen in 2017/2018 amidst growing domestic supply. We retain our longer-term confidence based on discipline in the larger players, debt constraints to expansion in smaller players, as well as the long-term India infrastructure growth story.

Do we still worry about leverage in 2016/17?

Balance sheets are looking better, but still a drag on sentiment/valuation for the sector. With capex programmes completing, we are convinced debt peaks and free cash flow improves from FY17/FY18. We believe debt will remain a bigger issue for the long-tail of non-covered companies.

Disrupted recovery

Unclear trends in demand: We have been concerned about demand for some time given the deceleration observed since the middle of 2016. Market data quality makes short-term assessment hard: our rolling 3m indicator is impacted by an anomalous September reading (+14% y/y) and recent trends have been volatile (October weaker; November better). Demonetisation adds to this uncertainty. Companies reported Q2 before demonetisation announcement and statements since have been vague. So our core thesis of a patchy economic recovery, with some short-term downside risk from demonetisation remains intact.

Production growth and inventories: Steel production in India has remained strong as new capacity comes on stream and idled capacity returns. Inventory data is imperfect, but directionally we are sure that it has risen. Recent JPC December flash figures indicated that in the 9m to December finished steel production in India was up 10.5% vs consumption up 3.3%.

Pricing trends: After muted pricing trends through much of the middle part of 2017, things seem to have improved from November. Retail market data suggests firmer pricing although comments from the companies remain more cautious.

Source: The Financial Express

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