The Hindu Business Line : Mettle only in frontline metal stocks now

SPURRED by bullish forecasts from global investors such as Marc Faber and Jim Rogers, commodities and commodity stocks have become the hot new investment destination for those seeking to diversify their portfolio. Stock prices of steel and non-ferrous metal companies have shot through the roof over the past two years, only to correct sharply in recent months. The prices of metals, especially steel, have cooled from their peak levels and there are signs of a slowdown in demand in the near term.

Will the metal stocks continue to shine? Are valuations stretched? How does one play the metal sector now? This article looks at these aspects and recommends a portfolio of stocks that appear promising from a two-to-three year perspective. While the big-ticket gains they enjoyed over the past three years are unlikely, there may be double-digit returns for patient investors.

Life beyond the peak levels

Having suffered due to sluggish demand, rock-bottom prices and over-capacity for five years till 2001, the global steel cycle turned around in 2002, driven by the upturn in the commodity cycle and China's growing appetite for metals. With a combination of measures spanning restructuring, technology upgradation and downsizing, Indian steel companies have improved their operational efficiency, profitability and balance-sheet strength considerably.

Lower interest rates along with an upsurge in economic activity have gone a long way in improving the financial profile of steel companies. Banks, wary of their huge exposure to the sector until two years ago, are taking a more benign view.

Steel prices, after having shot through the roof in 2004, have fallen about 30 per cent from their highs by now. Production cuts by several global and domestic players in the last quarter and an inventory build-up are casting serious doubts on the companies' mega expansion plans.

China, which accounted for more than half the incremental consumption growth in base metals over the past few years, now faces a glut as newer capacities have gone on stream; it turned a net exporter of steel early this year. In this backdrop, how does one play the steel sector?

Be selective in steel

There is still a case for being invested in domestic steel stocks, but you need to be selective. This stand is, however, underpinned by two assumptions; One, industrial growth has moved into a higher trajectory and is likely to stay there for a few years, at least. In particular, the Chinese economy, which clocked a growth of about 9.5 per cent in 2004, is expected to grow, albeit at a more modest pace over the next few years. This is likely to translate into higher steel demand on a sustained basis.

Two, global economic growth may not falter too badly, barring shocks such as those arising from skyrocketing oil prices. Capacity expansions planned now are also likely to happen in a phased manner that will not disturb price stability at higher levels, as steel companies have learnt lessons from the previous crash. A meltdown in prices of the mid-1990s kind appears unlikely.

Within the domestic steel sector, large integrated players are the better options than ones in the secondary segment. With the battle for securing mining leases for iron ore hotting up and global players announcing big-ticket investment plans in India, ensuring long-term supply of iron ore will be critical for steel companies, both in terms of controlling costs and executing expansion plans.

The ownership of low-cost iron ore and coking coal and an enriched product mix with increasing focus on value-added products puts Tata Steel in a more comfortable position to weather a cyclical downturn than its peers.

After its merger with IISCO in June this year, the country's largest steel maker, SAIL, is better positioned to take on the competition. SAIL is planning to acquire Neelachal Ispat, while a proposal for its merger with Rashtriya Ispat Nigam has also been doing rounds for some time now. If these moves fructify, they would give a strong push to its revenues, making it a Rs 35,000-crore plus company in terms of turnover with a production capacity of over 30 million tonnes.

If the merger of SAIL with the steel-producing PSUs takes shape, we might see consolidation in the domestic sector, in line with what is taking place in the global arena. This could change industry dynamics substantially, apart from making prices more stable.

Even as the industry dynamics are changing, we prefer Tata Steel at this stage of the business cycle. As far as SAIL is concerned, concerns about the terms of consolidation and influence of the government, detracts from its case as compared to Tata Steel. Another way to play the sector is to invest in proxy plays on steel.

Proxy play in mining

If the steel industry witnesses steady demand and firm prices, raw material suppliers appear well-placed. The market for the principal raw materials — iron ore and coke — is going to remain tight for another year or two — a reality that the steel producers have to contend with. The higher degree of concentration in the mining sector, compared to metals, may impart greater pricing power to players in the mining sector.

Iron ore prices, which rose by 71.5 per cent in 2005, may not see any significant decline over the next couple of years.

There has been a scaling up of steel production in China, which will sustain the demand for iron ore. Even if the negotiated prices for iron ore (iron ore prices are usually negotiated every year between December-April) suffer a modest decline or remain flat, they would still be higher by about 30 per cent compared to the levels in FY 05.

There appears to be a tough posturing in recent months on the part of steel producers such as Arcelor and Mittal Steel as well as the Chinese steel mills; this indicates that they may try to negotiate lower contract prices. But with mining producers having the clout, they may well end up with a moderate rise. A few new mining facilities are also likely to be commissioned and become fully operational from FY08 onwards.

In this backdrop, we remain sanguine about Sesa Goa's prospects. The country's largest exporter of iron ore in the private sector is likely to maintain earnings over the next couple of years at close to FY06 levels. Though the growth rate is likely to be tempered considerably, this aspect appears priced in at current valuation levels.

Low P/Es, but..

In terms of valuations, the metals spaceappears less expensive in the stock market. While Tata Steel is quoting at a multiple of six times its expected FY07 earnings, its larger counterpart SAIL is trading at about 4.5 times on a consolidated basis. Hindalco and Hindustan Zinc are available for about 8-10 times their likely FY07 earnings.

Commodity stocks tend to trade at low price-earnings multiples when investors take a less-than-positive view of growth prospects at the upper end of a price cycle. Such valuation indicates that the market expects a sharp slump in earnings or a protracted period of flat earnings. However, the demand and price outlook at this juncture does not seem to justify this expectation.

Frontline companies such as Tata Steel, Hindalco, Hindustan Zinc and Sesa Goa may manage modest growth or, at worst, record a flat earnings curve. This may be an appropriate time to take modest exposures in quality stocks in the metals space. This is the reason why we have narrowed the focus to just these four stocks, though there are several listed plays in the sector, especially in steel.

Sitting on the huge pile of cash-flows generated over the past couple of years, and anticipating similar accretion over the next two years, these companies are comfortably placed to fund their growth without the risk of substantial equity expansion. Also, a healthy dividend yield on three of the four (with the exception of Hindalco) offers a margin of safety.

The non-ferrous space

COMPARED to their counterparts in the ferrous metals space, companies in the non-ferrous segment appear more attractive in terms of sector fundamentals, demand-supply equation and outlook for growth. China's emergence as a guzzler of these commodities, coupled with under-investment in mining capacities, has resulted in a global shortage of raw materials for non-ferrous metals. We believe this is likely to continue for another 18-24 months, till new mines start making a difference.

The fundamentals in the zinc, aluminium and copper sectors thus remain strong, on the back of robust demand and a firm pricing environment. Indian companies, particularly aluminium and zinc producers, derive advantages from the country's large reserves of bauxite and zinc concentrates. A large quantity of copper concentrates is, however, imported as India has limited reservesGoing forward, sourcing of raw materials is going to be strategic for Indian companies.

The availability of inputs and the extent of control over the supply chain is likely to be a key driver of profitability. Hindalco and Hindustan Zinc, which have a presence across the entire value chain, remain our preferred picks. The synergies arising from Hindalco's merger with Indal will be reflected in earnings over the next few years; its proposed expansion in aluminium and copper is expected to boost volume growth apart from enabling it to attain greater scope and competitiveness.

The close-to-three fold rise in the equity base to fund the expansion plans could act as a near-term dampener, but appears to be mostly priced in.

With low debt levels, a competitive cost structure and comfortable level of cash flows from operations, Hindustan Zinc is well placed to fund its expansion without widening its equity base. With its recently completed capacity expansion, it is now the fifth largest zinc producer in the world and has headroom for volume growth.

Graphic: K. Balaa

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