But Jefferies analyst Bhaskar Basu warns against too much optimism towards Indian steel makers. Basu has six reasons why caution is warranted:
1. Iron ore rally unlikely to sustain: Iron ore prices are up 14% and Chinese steel prices up 4% in the last two weeks led by restocking post inventory draw down, better Chinese PMI data and news flow around induction furnace closures. Most investors concur with our view that iron ore prices should weaken as restocking ends and due to higher supply. This should drag regional steel prices lower again.
2. Can Chinese supply reforms support better prices? We believe supply reforms should support better spreads, but regional steel price levels rather than spreads are more important for Indian steel cos. We believe Chinese steel spreads are already near peak levels and could possibly correct. Also, closure of IF (induction furnace) capacities have mainly affected longs rather than flat products and longs account for ~85% of fall in Chinese exports.
3. Domestic steel price weakness seasonal or likely to sustain? Many investors view the fall in domestic steel prices as seasonal weakness and expect prices to improve post monsoon. Note, domestic steel prices softened even in April/May (before monsoon). We believe domestic steel prices would be driven by import parity and unless regional prices rally, domestic steel prices should sustain at lower levels as prices (ex-mill) are 5-7% premium to Anti-dumping duty (ADD) based import parity (FTA). Investors appear to be focusing on Chinese import parity, but import parity based on FTA (fair trade agreement) countries (lower due to nil import duty) is more relevant, in our view, as a large proportion of flat product imports (45% of imports) are from FTA countries. Recent rise in regional prices and de-stocking ahead of GST have led a few mills to announce price hikes, but we doubt this would sustain.
4. Will improving domestic demand supply help better pricing? Many Investors expect domestic steel prices to be supported by ADD and expect prices to firm up due to improvement in domestic demand supply. We highlight that domestic steel prices were below ADD/ Minimum Import Price (MIP) for most of FY17 despite support from ADD/ MIP. We believe better domestic demand supply may not help in pricing as unlike cement, imports would come in capping prices if mills hike prices above import parity. Domestic prices (esp. flat products) have historically been driven by import parity and even in periods of stronger demand / deficit, domestic prices have not sustained at a premium to import parity. We believe domestic steel prices are unlikely to rise unless regional steel prices rise.
5. Margin outlook at domestic steel mills: With volume growth likely to be muted, investors expect margin expansion to drive EBITDA growth at companies like Tata, JSW. We believe this is unlikely unless domestic steel prices rises due to higher regional steel prices or coking coal prices collapse more than our expectation (a risk to our view). We believe margins at vertically integrated steel mills like Tata India should fall due to lower domestic steel prices and as gains from lower coking coal prices should be lower. Converters like JSW are better placed, but margin expansion is unlikely as price decline would offset cost decline.
6. Can higher valuation multiples sustain? Tata, SAIL (Steel Authority of India), JSW are trading at 7.2-17x FY18E EBITDA vs. historic average (6-6.2x FY1 ex post). While many investors now hope for valuations re-rating, we believe higher valuation multiples are unlikely to be sustained unless backed by earnings upgrades which we think is unlikely.
Basu has underperform ratings on Tata Steel, SAIL and JSW Steel (500228.IN). He sees between 25% and 38% downside for the stocks.