Steel companies and the metals universe fueled Nifty/Sensex’s post-Covid earnings recovery, driven by rising commodity prices. But due to the recent 180-degree shift in the global macro environment, including rising bond yields/lending rates, inflation, and economic outlook, a closer view of steel stocks may be warranted. We analyzed Tata Steel, JSW Steel, Steel Authority of India Limited (SAIL) and Jindal Steel and Power (JSPL) on all four parameters for comparison. Tata Steel’s higher spreads (revenues and costs), better access to European markets and lower relative valuation make it a better stock among the lot. However, against the grain, SAIL and JSPL have the opportunity to improve the product mix and achieve better valuations in the future. But the bumper profits of FY22 can only be repeated beyond FY24 in the current commodity situation.
Efficiency measure: Variance or EBITDA per ton, is the difference between achievement (per ton of sales) and cost (operating cost per ton) where operating cost is a function of raw materials ( about half) and employees (6-10%) and other related expenses (about 40 percent).
Stand-alone operations account for over 95% of SAIL and JSPL’s consolidated operations and 82% of JSW Steel’s operations, but only 52% of Tata Steel. We compare on a stand-alone basis to focus on operations in domestic markets where, Tata Steel followed by JSW Steel have better achievements (₹70-73,000 per ton in Q4FY22) compared to SAIL and Jindal Steel (65-66 ₹000 per ton). A higher mix of value-added products leads to better realizations, which SAIL is currently implementing by improving the contribution of long steels compared to the mix of semi-finished products. For comparison though, in Q3FY21, the quarter after Covid hit and the companies recovered their production schedule, the average realization was around ₹48,000 per ton with very little variation between the four companies.
On the cost side, Tata Steel and Jindal Steel are operating at a lower cost per ton (about 48,000 per ton in Q4FY22) compared to the other two at ₹56,000 per ton. Coking coal, which accounts for 60-65% of raw material costs, has increased significantly. As a result, operating costs increased by an average of 40% between H1FY22 and H2FY22 in the four countries. The conflict between Russia and Ukraine has added to higher coking coal prices, with reduced import duties offering only minor cost compensation to businesses.
The spread outlook appears to be narrowing for corporates. With the implementation of steel export duties, spot prices in the domestic market have already fallen by 8% to ₹65,000 per ton in May for hot rolled steel coils and on s expect a further decline. On the cost side, coking coal imports are expected to be higher even in Q1FY23. With the gap narrowing to ₹8,000-9,000 for the weakest of the four biggest players (SAIL at Q4FY22), the government’s implementation of export duties will also need to consider the effectiveness of other smaller players. steelmakers, which puts a clock on the duty calendar. But overall, in the longer term, the rise in steel prices should be higher than the last cycle, given the reduction in Chinese participation in steel exports (environmental concerns) and less dependence on Europe vis-à-vis Russian imports of coking coal.
Rising export demand and prices have helped businesses over the past year, which has been tempered by the imposition of duties. Jindal Steel has had the highest exposure to the export market, averaging around 33-35% over the past two years. The company indicated that its export mix could continue similarly by focusing on product pockets without export duties. Similarly, JSW Steel plans to maintain its exports at 15-20% despite the duty. But the companies, having to bear the export duty, will appeal to the export-domestic mix according to the prices emerging in the next periods. Tata Steel with a strong European presence (with Corus Steel) with stand-alone operations contributing only 52% of consolidated revenue and SAIL with a low export revenue contribution of 9% are well positioned with respect to the imposition of export duties.
But weak domestic demand and its ability to accommodate higher allocation, even with lower prices, appears to be a major hurdle for all producers until export duties are lifted. Automakers, OEMs and infrastructure companies are the biggest consumers of steel.
Capex and leverage
Steel companies have significantly deleveraged from an average net debt/EBITDA of 4.8x in March 2020 to 0.9x in March 2022. Although the amount of debt is lower, the increase in the cost of debt and lower operating margins can cause interest expense to be 15-18% of EBITDA, up from 10% previously (when realizations were higher and operating costs were lower) , unless companies continue to deleverage consistently. Tata Steel with the highest spreads is better positioned among the lot to keep interest charges at 8-9% of EBITDA. SAIL and Jindal Steel’s goals of being debt-free by FY23 could be complicated by shrinking spreads.
On the other hand, the investment plans are at a higher level and few companies reiterated the plans even after the announcement of import duties and lower spread outlook. China’s lower participation in steel exports may have encouraged such positioning. SAIL, JSW Steel and Tata Steel have planned between ₹8,000 crore and ₹20,000 crore for investment next year alone with a significant production increase of 15-20%. Considering the volatile environment, Jindal Steel with an investment schedule spread over three years (₹18,500 crore) might be better placed among the four. If spreads continue to decline, companies may need to cut capital expenditures in light of deleveraging targets.
Companies are trading at a discount in steel bull cycles and this cycle is no different with 35% revenue growth across all four companies in Q4FY22. Measured at a premium to the past five-year EV/EBITDA average minus 2 standard deviations, SAIL, JSW Steel and Jindal Steel are trading at a 13-15% premium. Only Tata Steel is currently trading nearly two standard deviations below the average. In addition, one must take into account the higher input prices seen by the industry, integrated with lower EBITDA expectations, providing an additional cushion to valuations.
June 04, 2022