Steel stocks and the China angle: Here's what investors should take note of

Metal stocks have been among the top performers on Dalal Street on the back of improvement in demand due to shift of business from China to India. On a calendar year basis, the Nifty Metal index has garnered year to date (YTD) returns of 63%. Simultaneously, JSW Steel, Tata Steel, Vedanta, NALCO and SAIL have rallied up to 85% on a YTD basis.

The rally in stock price is also backed by a rise in ferrous prices which has now halted. According to Edelweiss Securities, metal stocks are likely to see a period of consolidation. “At the core of the riveting ferrous saga is China, with its policies lately targeting carbon emissions and production cuts alongside a swift action on clamping down ‘unreasonable’ and ‘speculative’ prices. Meanwhile, crude steel production in China actually continues to rise, whereas domestic steel prices have come off 20% in just a fortnight,” said Edelweiss in a report titled Chinese checkers.

Sizing up China’s HRC price fall

The brokerage firm analysed four scenarios based on historical steel prices, margins and iron ore dips in order to size up the domestic hot-rolled coil price level that Chinese authorities might consider reasonable. The four scenarios are Slip, Slide, Tumble and Crash.

Slip: In this scenario, the Chinese authorities would consider the average profit of the past ten years as reasonable and, hence, would consider the corresponding price level as stable.

Slide: Under this scenario, the prices dip would be arrested only once the industry breaks even at EBITDA (earnings before interest tax depreciation & amortisation), i.e. profit falls to zero. It is not very uncommon for Chinese steel players to operate at a loss. In the history of the past 10 years one–fifth of the time, the Chinese steel industry has operated at an EBITDA loss. If this scenario comes into play global iron ore price to come under further pressure – dropping almost 35% as marginal players reduce production in China.

Tumble: For this scenario, Edelweiss assumes a similar EBITDA level loss as the maximum level over the past ten years, i.e. at Chinese Yuan 519/tonne. In this scenario, production drop further resulting in iron ore prices dropping to $100/tonne.

Crash: In this unlikely scenario maximum EBITDA level loss coupled with iron ore price dropping 60% from current levels to $80/tonne by Q4FY22.

Stock views

As a whole, the macro risks to steel prices will be driven by a sharply lower Chinese credit impulse; rising inflation concerns globally; and buyers’ reluctance due to falling domestic prices in China. Given this Edelweiss is only bullish on Tata Steel among the metal space.

Tata Steel | Rating: Buy | Price target: Rs 1,300 | Upside: 17%

Tata Steel is expected to report record FY22 with domestic operations (standalone) to clock EBITDA (earnings before interest tax depreciation & amortization)/tonne at Rs 29,000/tonne the highest ever. In the case of Tata Steel Europe, current record prices progressively get reflected in contracts resulting in elevated profitability for FY22. The debt reduction of 27% in FY21 would help the company negotiate the cyclical downturn in a better manner than in the past.

JSW Steel | Rating: Reduce | Price target: Rs 635 | Upside: -10%

The global steel industry is becoming bleaker with price dips in China likely to be mirrored in the rest of the world. In JSW Steel’s case, we see a record high level of spreads in FY22 with additional cash flow from the capacity ramp at Dolvi phase 2 expansion. That said, the high capex intensity through FY24 makes the company significantly vulnerable to a steel price downturn. Besides, we see challenges for the company owing to relatively lower reduction in debt vis-à-vis peers and higher valuations.

JSPL | Rating: Hold | Price target: Rs 445 | Upside: 11%

JSPL at crossroads with imminent expansion in EBITDA (earnings before interest tax depreciation & amortization)/tonne owing to better steel prices and higher share of value-added products. Volume ramp-up should continue particularly with expansion in value-added products as the company has received further approvals from railways. On deleveraging front, good progress was made in FY21. That said, not impressed with the valuation and consideration in the divestment of Jindal Power. Besides, the falling steel prices in China are likely to be mirrored in India as well, resulting in margin compression for the company

SAIL | Rating: Hold | Price target: Rs 140 | Upside: 16%

SAIL’s EBITDA (earnings before interest tax depreciation & amortization) to increase to Rs 15,450/tonne through to FY22E as volume and realisations improve. On the leverage front as well, net debt is expected to reduce to Rs 32,300 crore by FY22E. However, post the magnificent run, we expect steel prices to cool off, mirroring the fall in domestic and export price. SAIL is likely to suffer more due to its higher fixed cost structure compared to peers.

NMDC | Rating: Hold | Price target: Rs 185 | Upside: 3%

NMDC is getting benefitted by potentially higher iron ore prices in the domestic market post bidding process of merchant mines. Sales volumes growth is likely to be spurred by the additional volumes from the Karnataka sector. The stock is trading at discount to global peers. Commissioning/divestment of steel plant as additional triggers for the stock.

(Disclaimer: The recommendations in this story are by the respective research and brokerage firm. Money9 & its management do not bear any responsibility for their investment advice. Please consult your investment advisor before investing)