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“India does not matter much because India is a miniscule proportion of the global trade and global demand. Our demand-supply balance does not really change much,” says Rakesh Arora, Managing Partner, Go India Stocks.com

We heard from Mr Seshagiri Rao of right now and we got a sense from Mr Narendran of that they do not expect the steel cycle to reverse very sharply. What is your understanding?

It is difficult to say anything or add on to what Mr Seshagiri Rao says. He is a thoroughly knowledgeable guy on steel but see my true sense here is that there is a 30 million tonne of export of steel which happened from Ukraine and Russia to rest of the world and if you exclude China, rest of the world demand is around say 1,000 billion tonnes and 30 million tonne is like 3% supply reduction that happened and which led to a spurt in steel prices.

Now the other side of the equation is coming into picture which is demand. Everybody knows that the US Fed is probably slightly behind the curve and they are likely to go overboard in terms of tightening. People are talking about a recession in the US in six to nine months. Europe because of the Ukraine war is already kind of getting pushed into recession and China with its zero Covid policy, does not inspire any confidence that demand will really pick up meaningfully; plus the real estate sector in China is going through deep correction. Whether people in China would have confidence to go and buy houses is yet to be seen. So we are seeing demand destruction happening at a much faster clip and that is what is getting reflected into the stock prices right now.

The third part of the equation is cost and here coking coal prices have sustained at very high levels whereas steel prices started to come off in line with demand destruction. So margins are getting squeezed. Overall, when I look at it, I am not too confident that steel would do too well here. The only plus point is that balance sheets have been repaired and stocks are not looking that expensive. So, a gradual decline is likely.

The way steel prices are going down, aluminium is down 30% from the highs. Have metals topped out?
Metal stocks have kind of peaked out for the moment and they are already on a declining mode. We have seen a sharp correction in aluminium stocks. Steel companies were already going through a time correction because steel margins came under huge pressure because of coking coal prices. But now, steel stocks are also declining slightly. But as I said valuations are on their side. So I do not see massive declines.

Usually what happens is that these stocks trade between 0.5 and 2.5 price to book, depending on the balance sheet situation. Now the balance sheet is strong and they are unlikely to go below one time book.

Secondly, currently the margins are very high. The long run margins for steel companies like JSW historically have been like Rs 8,000 per tonne. They are doing 20,000. It is too high. The profitability is still too high and I think stocks will sustain slightly better valuation and more so because there have been structural changes. China, which used to encourage exports by giving export duty, has removed all those incentives. Around 13% reduction in incentives have happened in steel price which is going to reflect in long run margins for steel companies.

So from historical to now, probably steel companies will be valued at a much higher margin and higher valuation, but the current margins are way too high and there is enough scope for these margins to correct to nominal levels once inflation or growth declines. When margins are declining, I do not see stocks performing against that. So I will be a little cautious on the steel stocks here.

What are you expecting from the steel counters – diversification, capacity addition?
Steel companies have made money and they will expand. It is just a matter of time. JSW has capacity coming up but everybody is going to expand and that is why it is a cyclical business. Most of the companies tend to do expansion together. But in any case, India does not matter much because India is a miniscule proportion of the global trade and global demand. Our demand-supply balance does not really change much.

It is China which is a big brother. China’s exports have been kind of static at the moment at around 60 million tonne per year. If China wants to export a little bit more to support the domestic economy, the correction in steel prices would be much faster than what we are building in. China is the black box. I do not know what is happening there in terms of lockdowns and possibly exports. But that is what is going to define how steel stocks trade. Valuation-wise on current margin, they look cheap but there is a possibility that margins can erode.


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