Steel stocks had been on a rampage across the global markets during 2003, beating not just the benchmark indices but also outperforming practically every other existent sector. The scenario on the Indian bourses, of course, was no different, as the rise in steel stocks was not just registered in percentage terms (%) but more so in the number of times (x times).

However, after staying in the news during the last 6-8 quarters for positive reasons like regular hike in steel prices and exponential growth in profits for steel companies, the recent headlines have been more in terms of setbacks for the steel industry.

In the last couple of years, strong demand and stronger realisations have helped steel companies improve their financial condition considerably.

Dedicated efforts at improving operational performance (see chart above) has strengthened cash flows and earnings, which has helped these companies retire and restructure much of their debt, further augmenting their bottomline growth. However, while steel companies were raking in the moolah, there was a concern building up on the other side, that of inflation.

It must be noted that manufacturing (which includes base metals like steel) forms the most important component of our inflation index by virtue of its highest weightage.

While the entire blame of the current near 8% inflation cannot be put on the manufacturing sector, as oil prices have also had their share (not to forget the third component, primary articles), the fact remains that commodity prices 'have contributed' in pushing up inflation.

This had prompted the government representatives to come out in the open, just a fortnight ago, partially blaming the rising commodity prices for aiding higher inflation. And presto, we had India's largest private sector steel company announcing a Rs 2,000 per tonne reduction in steel prices, forcing others to follow suit.

While it may be premature to say whether this move by steel companies is a factor of some pressure behind government's closed doors, it is also difficult to completely rule out this possibility.

It somehow does not seem logical that in times when global steel prices are ruling comfortably above the Rs 30,000 per tonne mark, Indian steel players are happy with a reduction in prices. Further, this move by Indian steel players has come despite the two major global steel producers, Arcelor and Posco, intending another hike in prices with effect from September onwards, which would only fuel a spate of hikes across the globe.

However, with Tisco already making an announcement of refraining from announcing any price hike till March 2005, one can be sure that none of the domestic steel players would be in a position to rake in the additional benefits, even if the buoyancy in steel prices continues well into the second half of FY05.

It must be noted that this is not the first time that the government has intervened, keeping a tab on steel prices.

Earlier, in order to keep a check on rising steel prices and to entertain the request of downstream producers, who had claimed that higher steel prices were the result of a shortage of the base metal in the country owing to higher exports by steel manufacturers, the government had withdrawn all export benefits available to steel producers under the duty entitlement pass-book (DEPB) scheme. However, this was restored in the Budget last month.

Apart from the above, there were other measures taken by the government in the form of restricting domestic steel producers from raising prices at regular intervals, which coincidently coincided with the general elections!

The steel producers gave effect to a hike only post June 2004. Further, consistent reduction in peak customs duties and duties on various steel products was also aimed at curtailing the rise in domestic steel prices and also reducing the buffer for raising steel prices.

Considering that all of the above measures are/have been setbacks for the domestic steel sector, it comes as no surprise that the markets have reacted negatively towards steel stocks on these news flows during 2004 (see table above).

However, akin to every sector, there are stocks within the sector that are better placed to face the shock of decreasing realisations and at worst, a cyclical downturn. And in our view, we feel that Tisco is relatively the best placed in such a scenario.

There are various reasons to support this view. The biggest advantage for Tisco is its backward integration in the form of iron ore mines and meeting more than 50% of its coke requirements internally.

Further, unlike most other players in the industry, Tisco's sales are largely bound by medium to long-term contracts with only about 15%-20% sales in the spot markets compared to 40%-50% for other players. This would delay the adverse impact of the reduced prices, as these would come into effect only in phases as and when the contract comes up for renewals.

Further, as has been seen in the chart above, Tisco's operating margins at 44% are the highest among its peers, which, apart from strong realisations, is an effect of improved raw material consumption and higher employee efficiencies over the years.

This is advantageous for the company, as it would be able to protect a sharp fall in its margins even during a downturn.

Apart from this, though we reckon that such high levels of margins cannot be sustained, in order to protect its margins as much as possible, Tisco is constantly improving its product mix by targeting growth in the value added and branded segments.

These products tend to garner better realisations for the company apart from creating a loyal user base for its products. Thus, all in all, Tisco remains the best performer in the sector.

To conclude, while we accept the fact that the steel cycle has extended beyond our expectation and we believe that in the near term the buoyancy in prices is likely to sustain, we continue to remain apprehensive about the medium term growth prospects of the sector as a whole. At the current juncture, the risk-return ratio in the sector is against the investor.

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