Metals & Mining — Steel Sector Under The New Regime
Material costs are usually the single largest cost item for a steel producer. Given that raw material price acts as a swing factor in steel companies’ gross and operating margins and given the volatility of input prices in the recent quarters, we highlight the impact of high input prices on the steel industry’s margins. We find that over the last 4-5 quarters, the steel industry’s margins have been compressed significantly. Pricing power is likely to remain with the miners for a couple of years until excess capacity in the steel sector dries up and fresh mining capacity is added.
Operating margins in the steel sector have dropped: Analysis of the differential between steel prices and key raw material prices (which is the biggest cost for a steel producer and usually a swing factor for margin trends) shows that gross and operating margins in the steel sector have dropped since 2008 . Further, markets have taken cognizance of the greater volatility in input prices –stock prices in the sector seem to reflect the spread between steel and input prices rather than the absolute level of steel prices
The change catalyst has been demand rather than the cartel among suppliers: The fragmented nature of the global steel industry and the dominance of a few companies/countries in the global iron ore market are factors that have been prevalent for a long time. In our view, the emergence of China as a major steel producer and importer of iron ore, and the resulting robust demand growth (China’s import of iron ore increased by about 30% p.a. in the 2003-2005 period and has continued to be at more than 15% even in subsequent years), have been the main reason for the substantial iron ore price increase since 2004.
The current level of margins could prevail for a couple of years: Pricing power is likely to remain with the miners for a couple of years until excess capacity in the steel sector dries up and fresh mining capacity is added. Until that time, the current (lower) levels of operating margins are likely to continue, as with the quarterly contract system, miners will be in a position to pull away the benefit of any steel price increase. For the January-March 2011 quarter, we expect iron ore contract prices to settle about 8% higher sequentially while coking coal contract prices should be ~7% higher (in the range of US$220-US$225/t). We expect the steel companies to largely pass on the input price hike to consumers. But a significant expansion in margins, led by any large steel price increase seems unlikely.
How are the Indian companies placed? To understand the risk of higher-than-expected input costs, we look at the level of integration with respect to the key inputs of iron ore and coking coal, as well as the companies’ cost structure. Among the three Indian large-cap steel companies, SAIL is most integrated as far as iron ore is concerned (followed by Tata Steel), and only Tata Steel has protection (although still a relatively low level) with respect to coking coal price increases. JSW Steel’s profitability is most at risk due to higher-than expected RM price increases. Our recommendation on stocks in the sector ( BUY on Tata Steel and JSW Steel and HOLD on SAIL ) relies on: (i) the level of raw material integration; (ii) demand pattern in key markets; and (iii) expected capacity growth.
