India Steel Sector: The big cycle turn?

We highlight four major changes that have taken place of late: Firstly, the inventory cycle has bottomed out (globally, and not just in China). Given the extent of destocking and current inventory levels, the restock this time could last more than the usual 6-9 months. Any uptick in demand (expected in 2H) would further elongate this. Our analysis of previous rallies for Tata Steel/JSW suggests that they last for 9-12 months and usually end up returning large gains. Secondly, the weakness in dollar has helped stabilise cost curves. Thirdly, China has laid out plans for a higher fiscal deficit to stimulate the economy. On-the-ground checks by our China team indicate that projects indeed are “moving”, with the central government pushing for more project approvals and lower “preparation time”. And lastly, supply discipline in China would be a further positive. We believe that ~100mt of idling capacity looks unlikely to return from “winter maintenance”.

Ebitda recovery vs. high debt

With the imposition of the MIP, the Indian steel market has become a closed box. Domestic prices have surged $50-60/t (now close to the $445/t MIP level). Even though Chinese prices too have rallied (now at $460/t), we think that the Government’s protectionism is here to stay: saving banks from NPAs appears to be the real motive. We expect MIP to be replaced with more tenable barriers like safeguards (across value chain) and anti-dumping duties by Aug-16. The biggest beneficiaries of MIP so far have been the better placed companies (Tata Steel & JSW). For SAIL, the price surge so far hasn’t been sufficient to make it Ebitda positive.

While steel companies remain highly indebted (and expensive on EV-Ebitda), there are a number of positives: (i) all of them are nearing the end of their capex phase (ii) the resulting higher volumes would add to operational leverage and (iii) the expected recovery in Ebitda adds comfort to the interest cover.

Is now the time to enter?

While the market cap for Indian steel stocks is up 23-53% (last 2M), the EV has barely changed (up only 2-12%). The EV for steel stocks can vary wildly: it falls to as low as $400/t during a down-cycle but could trend at $2000/t+ too in euphoric times. Given that the sector is under-owned, the upswing in stock prices could be sharper this time.

We upgrade Tata Steel (TP of R440, 31% upside), JSW Steel (TP of R1,600, 20% upside) and JSPL (TP of R85, 23% upside) to OUTPERFORM (previously Underperform) while retaining our UNDERPERFORM rating on SAIL (TP of R35, 21% downside). We expect only a sub-10% change in EV for stocks rated OUTPERFORM.

We like Tata Steel the most given the upside from the UK drag reduction and lowest bankruptcy risk. JSW Steel too looks well placed to benefit from higher prices (capacity already commissioned, no major drag in overseas operations ). We value Tata Steel at 1.4x P/B (slightly lower than LT avg. of 1.5x) and JSW Steel at 1.6x P/B multiple (at a 10% discount to its post GFC highs). We value JSPL’s steel business at 7x EV/Ebitda and power at $2.8 bn of EV

(R56 bn/GW, DCF-based). Given its poor financials and high likelihood of a sustained book value erosion, we value SAIL at 0.4x P/B (50% discount to five-year average). Major risk to our thesis: a fall in steel prices, if the demand in China disappoints.

Worst clearly behind us 2016 unlikely to be as bad as 2015

Even though global economic growth continues to look weak, chances of a hard landing in China or a US recession appear remote. CS expects no further deterioration in global GDP growth (2016e at 2.4%) and the recent print for global industrial production looks encouraging too. We believe further upside risks to growth could come from (i) global fiscal policy turning more stimulatory in many countries and (ii) political populism (US Presidential elections, political developments in S. Europe, etc.).

Most importantly, the two-year trend of rising USD seems to have stopped, resulting in most of the EM currencies reversing some of their losses. This puts an inherent floor to commodity prices as until now falling currencies of most major commodity producers were pushing down the cost curve, resulting in lower prices. That trend seems to have stopped now.

Inventory cycle (globally, and not just in China) has bottomed out

However, amidst all the supportive macro arguments (global GDP recovery, DXY movement), we believe that it is the restock that has significantly impacted global prices in the last two months. Note that steel (and iron ore) inventory levels were at seven-year lows immediately after the end of the Chinese New Year break (partly due to the liquidation before Dec-end to shore up cash on the books). The restock in Feb was thus severe. However, compared to a year back, inventory levels are still ~20% down indicating that a continued restock could keep Chinese prices supported in the near term.

And China is not alone! US too has seen inventory levels fall: in tonnage terms, the flat rolled market is at the lowest levels since Dec-13. Inventory levels are down across products and our US team believes that end-market demand is set to accelerate as buyers restock. US domestic HR prices have already crossed $500/st level (highest since Mar-15).

Thus, it is not surprising that prices of both raw materials as well as finished steel have surged this year. Such sharp episodes of price hikes are rare: the last one was seen in 2010-11 in the recovery post GFC.

Normally, we would expect such restock-driven rallies to last 6-9 months; however, given that inventory levels are still far lower than a year ago, any uptick in growth (global and more specifically in China) would only further elongate this cycle.

Demand is the key, supply cuts to be an added boost

The problem with the steel sector is well-known—China accounts for 51% of global steel capacity (nine times more than the next country, Japan). A contraction in Chinese demand (in sub-zero territory since mid-2014) leads to a surge in exports to RoW deflating global prices, given the quantum (almost 12-15% of ex-China production).

Any improvement in global steel outlook therefore hinges on a revival in Chinese demand and/or supply-side reforms. Serendipitously enough, news flow since the start of 2016 has been positive on both counts.

China growth stabilising on the back of abundant liquidity support

At the National People’s Congress held last month, the Chinese Government also laid down its plans for a more proactive fiscal policy, expanding its fiscal deficit to 3.0% of GDP. Compared to 2015, it is targeting a higher growth in both social financing as well as fixed asset investment (growth in infra investment is at a 16-year low).

China’s Q1FY16 real GDP growth at 6.7% y-o-y further supports the argument that China is stabilising (and one should not expect any further deterioration). The rise in commercial activities has been largely driven by liquidity and inventory restock. There has been an across-the-board improvement in lending activities from medium/long term retail loans (property related) to corporate loans and bonds.

In her on-the-ground channel checks, our China materials analyst Trina Chen noted that her industry contacts (steel producers, local construction companies, banks and local governments) were seeing infrastructure projects “moving”, with the central government pushing for more project approvals and lower “preparation time”. Banks’ credit allocation too has improved.

However, we are not very enthused by the recent run in property prices as these have been mostly in the Tier-1 cities (like Shanghai and Shenzhen) whereas unsold inventories are mostly in Tier-2/3 cities. Thus, even though the next round of demand recovery (driven by subways/ water pipelines) is expected to be more cement-intensive than steel-intensive, we expect an improvement in steel demand outlook nevertheless.

Based on this assessment, we now expect a smaller contraction in Chinese steel demand in 2016 at -2.4% vs. -6% previously, and expect growth in 2017. This would also imply that, at ~100mt, Chinese net exports to the rest of the world have probably peaked out. This bodes well for prices as well as volume growth for RoW players.

That brings us to the question of demand scenario in other parts of the world. Demand in 2015 was dismal in many key geographies. The dangerously negative apparent demand figures (specifically for Brazil, Russia, USA) indicate widespread destocking as real demand is unlikely to fall that sharply for such big economies.

However, 2016 is expected to be better, either in terms of higher growth or lower contraction in demand, in line with the reasons we enumerated earlier (supportive monetary/fiscal policy, political populism, receding likelihood of a recession in the US). We explore India’s demand growth in greater detail in the next section.

100-150mt capacity closure targeted for the next 3-5 years

Supply-side reforms were accorded priority in the Chinese State Council conference earlier this year with broad plans being chalked to stamp out excess capacity across sectors (steel, cement, coal, aluminium). The Government has set a five-year closure target of 100-150mt in the steel sector which our Chinese team feels looks achievable in three years. If that transpires, utilisation levels could improve going forward.

However, closures are always tricky, given latent capacity tends to bounce back as soon as prices start to recover and layoffs cause social unrest (economic/political ramifications). In that context, Government’s efforts to stop funding lines, videotape dismantling, seal properties and shut water/electricity supply could effectively tackle latent capacity.

So far, we have seen encouraging signs with very little capacity suspended for winter shutdown returning to operations and that is showing up in the profitability of the functional furnaces. The only risk here is that if a part of the widespread improvement in lending activities is also directed at steel mills, we could see supply returning again.

Managing layoffs though is easier said than done. Re-skilling middle-aged factory workers so that they can be absorbed elsewhere is a challenge. For SoE-run steel plants, absorption of workforce in other SoEs could create overstaffing issues. Given these complexities, a (temporary) revival cannot be based on supply side reforms alone, and we would need a recovery in demand too.