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Steel: Will the big bets pay off?

Sunil Nayanar | May 16, 2005

This is not the first time that Indian steel companies have announced grand plans to increase capacities.

They did so with a vengeance in the mid-nineties, and the result was a steel glut that depressed steel prices and led several steel producers to the brink of bankruptcy. Are we going to see a repeat of that story?

According to conservative estimates, the total outlay for the country's steel expansion plans is likely to be above Rs 75,000 crore (Rs 750 billion).

That outlay is justified on the grounds of an anticipated doubling of demand in the next eight years and strong internal cash flows of steel companies.

However, recent reports suggesting a slowdown in steel prices are a cause for concern. Also some industry experts have pointed out that steel capacity is increasing all over the world, which could lead to global over capacity a few years down the line.

The expansion boom

The latest Indian companies to announce capacity expansion plans include Rashtriya Ispat Nigam, Gujarat NRE Coke and the Ruchi group.

While RINL's plans for a Rs 8250-crore investment to hike its capacity by over 50 per cent to 6.5 million tonnes is reported to be awaiting approval from the union steel ministry, the Ruchi group's greenfield project is coming up with an investment of over Rs 580 crore (Rs 5.8 billion).

Gujarat NRE Coke is also planning to set up sponge iron, pig iron, steel making and rolling mill projects in Kutch district of Gujarat.

While these are some of the recent announcements, India's big steel players had already declared their plans long ago. Steel Authority of India is set to augment its production to 20 mt by 2010-11 at a cost of Rs 25,000 crore (Rs 250 billion), while Tata Steel is planning an outlay of Rs 23,000 crore (Rs 230 billion) to increase its capacity to 10 mt from the current 4 mt.

Jindal group of companies, Ispat and Essar group also have plans to increase their capacities going forward.

Several smaller private sector players like Bhushan Steel and Tata Metaliks are also eyeing bigger capacities. What was once thought to be the biggest investment of all -- a Rs 55,000 crore (Rs 550 billion) project in Orissa by the international player Posco of South Korea -- has hit a roadblock due to differences between the company and the Orissa government over the mining lease for iron ore.

Not that Indian companies are content sitting at home and expanding local capacities. As evidenced by Tata Steel's recent acquisition of Singapore-based Nat Steel, they, too, are harbouring global ambitions, though as of now acquisitions remain an exception, rather than a rule.

However, according to analysts, acquisitions are unlikely to be for the purpose of catering to global demand, but rather for producing downstream products and catering to local markets.

Also steel companies are taking the M&A (merger and acquisition) route for forward integration and for cheaper raw material supplies.

Recent examples are Ispat group's acquisition of iron mines in Nigeria and Essar group's plans to pay $500 million to buy out its UK-based partner Stemcor's 51 per cent stake in a pellet plant that feeds one of Essar's steel plants.

According to government estimates, domestic consumption of steel will go up to 60 mt by 2010 from the current 35 mt, and to 100 mt by 2020.

"The current expansions will lead to a capacity of 70 mt in the next 15 years. So if 100 mt is the estimated steel consumption in that period, we will still be short by 30 mt," says an analyst with Mumbai-based Refco Sify Securities.

"Assuming a CAGR growth of 6 per cent in steel demand, the domestic demand should be around 90 million tonnes by 2020. So these capacity expansions are justified. Also most steel companies have strong balance-sheets, which will help them carry on with their expansion plans. For example, companies like SAIL are almost debt free," he points out.

The story so far

The Indian steel industry has been on a recovery path for the past three years, after being burdened with low steel prices and rising interest rates previously.

However, the cycle has turned in the wake of an upsurge in global and domestic demand as well as a sharp fall in interest rates. Also, the steel companies who were caught in a debt trap took advantage of the lower interest rates to restructure their debt, which put their finances back on an even keel.

And with the steel cycle turning again, thanks mainly to the surging Chinese demand and rising prices, Indian steel companies are now confident enough to think big again, gearing up to meet the expected quantum jump in both global and domestic demand.

The impetus for the surge in investments has mostly been the result of the improving outlook on both global and domestic steel industry.

Global firms are also looking at consolidation, which has resulted in the formation of large companies such as Arcelor, JFE and Nippon Steel, apart from Mittal Steel, which became the largest steel maker in the world through a series of global acquisitions.

Coupled with strong demand growth, led by China, this has reduced the need to close down unviable capacities and led most steel manufacturers to look at capacity expansions.

Another factor has been the need for Indian companies to integrate backwards. India, which contributes nearly 3 per cent to overall global steel demand, is among the major suppliers of iron ore to the global steel industry.

Concerns over the availability of iron ore and coal, and the resultant volatility in prices, meant that most Indian steel producers had to integrate backwards in order to have greater access and pricing power over these commodities.

This explains the big investments in backward integration projects (Bhushan Steel & Stripes, Bhushan Steel and SAIL) announced in the recent past.

Apart from this, Indian companies are gearing up to meet the increased demand going forward. With the GDP growth projections for the next few years hovering around 7 per cent, and a huge influx of funds into infrastructure and housing segments, steel demand and consumption are set to grow rapidly, say analysts.

Also end-user industries like auto, consumer durables and infrastructure are expected to show an increasing appetite for the metal in the years to come.

"The domestic demand continues to be strong, mainly driven by infrastructure spending, with construction, engineering, auto and auto ancillary sectors likely to be key growth drivers," notes Kanan Shah, analyst with Mumbai-based securities firm Networth Stock Broking.

What makes most analysts believe in a stronger demand and consumption growth in the future is the fact that average domestic consumption in India is abysmally low as compared to other countries.

India has a per capita consumption of steel of around 30 kgs against 180 kgs in China and an average of over 400 kgs in the developed countries.

Analysts point out that India's steel consumption has stagnated at around 30 kgs, despite increasing steel production, mainly because of an increasing population.

Heading for over capacity?

While growing demand and the need for ample capacity to service are is not in question, what has cast a shadow of doubt over the steel industry is the spectre of over capacity as well as the feeble outlook on prices.

According to a recent report by Organisation for Economic Co-operation and Development, world steel supply is likely to expand dramatically over the next two to four years.

According to the report, much of this unprecedented investment is occurring as a result of decisions by governments to support the expansion of domestic steel-making capability.

"These state-supported expansions will likely lead to growing steel trade disputes and a return of over-capacity conditions within the next few years," warns the report.

It also noted that the planned capacity expansions will represent a structural problem for the global steel industry to the extent that production exceeds the projected increase in demand for steel between now and 2008.

The OECD report projects Indian steel consumption to grow by only 3.5 per cent in 2005 from the levels a year ago.

It says the gap between demand and supply would mean that the vast majority of India's new production capacity will be for export.

"We think that there will be a demand-supply mismatch if the capacities continue to grow at this rate, which could also impact prices negatively," says Mats Lindstrand, director and global head of McKinsey's basic materials practice (see page 3 for the full interview).

Some analysts have pointed out that it is too early to say whether all capacity additions that have been planed in India will materialise.

"We are seeing a lot of companies announcing plans to expand capacity. However, apart from those announced by the big companies like SAIL, Tata Steel, etc. it remains to be seen whether all these capacities actually come into existence," notes Tejas Doshi, head of Research at Sushil Finance Consultants.

Worrying price outlook

It is not just the excess capacity that analysts are worried about. According to some analysts, demand from the US, Japan and China is expected to slow down, which, coupled with the tightening availability of raw materials, will lead to softer prices in the short to medium term.

They note that the long-term outlook also remains a concern, mainly because of additional capacities coming on stream, which could skew the demand-supply scenario further.

However, there are others who don't see any drastic impact on prices because of over capacity, though they do note that there could be a drop in prices three-four years down the line when new capacities start coming on stream.

According to Shah, new capacities will come into play only around 2008. "So there could be a drop in prices around that time. But in the short-term I don't expect any impact on prices. HRC (hot rolled coil) prices are likely to hover around $480-500 range in the short term," notes Shah.

But there are worries about the long term. "Even though short-term prices are likely to be around $500-550, one has to wait and see how the long-term price trends develop. It will depend on how Indian companies manage the cost pressure on the raw material front, which will impact margins. Also, demand in US and Europe is coming down, though Chinese demand is still going strong," notes an analyst.

However, industry trackers point out that Indian steel companies are in a much better situation vis--vis their global peers, considering that they are among the lowest-cost producers in the world, which provides them a hedge against a fall in prices.

Valuations

In such a scenario, integrated players like SAIL, Tata Steel and Jindal Steel & Power emerge as the best picks in the sector, as per analysts' consensus.

"India's wealth of raw materials like iron-ore has enabled the integrated players to withstand the recent sharp run-up in iron-ore prices," says Doshi.

The advantage on the raw material front, coupled with higher volume growth and a stable price scenario, augurs well for future. According to Shah, Tata Steel looks attractive among steel stocks.

"The fact that the company is integrated means that even if prices fall, better capacity utilisation and control over input prices will help it tide over difficulties. Also the company's NatSteel acquisition is likely to play out in FY06, increasing production manifold. Our FY06 EPS estimate for Tata Steel is pegged at Rs 69, which will discount the prices by 5x," notes Shah.

JSPL is another company that analysts are backing. "JSPL is adding capacities at a low cost and is a fully integrated player much in the mould of Tata Steel. It is also getting into power, which should help bring down costs considerably. Our FY06 EPS estimates are for JSPL will give it a valuation of 4x," notes one steel analyst.

SAIL is also expected to do well. The company's market leadership (25 per cent market share in domestic steel industry) and cost competitive operations (SAIL has integrated operations which include captive mines of iron ore, dolomite and limestone) make it an attractive option.

On an estimated FY06 EPS of Rs 16.20, the stock commands a valuation of 3.9x.


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