JSW Steel: Sell

Investors can sell their shares in steel maker JSW Steel. Soaring raw material costs and heavy gearing as a result of under-performing subsidiaries such as JSW Ispat are likely to weigh on its performance over the next one year. The company's share price (Rs 816) has risen by a third since late-December, pegging the price to consolidated earnings ratio at 33 times.

While a stronger rupee will make the valuation seem more attractive, JSW would still remain at a premium to peers such as SAIL and Tata Steel. This is hard to justify as it faces several uncertainties - from patchy and more expensive iron ore supply to increased domestic competition from more integrated peers. Its near-term margins maybe hurt by cost pressures and slow ramp-up of brownfield and JSW Ispat's ancillary capacity.

Overview

JSW Steel has the capability to produce 11 million tonnes of steel in a year: Ten million tonnes per annum in a single location in Karnataka and one million in Tamil Nadu. In addition, it owns a 49.3 per cent stake in JSW Ispat which operates 3.3 million tonne per annum plant in Maharashtra.

Indian steel production has had a sedate ten months during the fiscal so far; JPC estimates that steel consumption grew by 4.7 per cent during the period.

The most recent quarter ending December 2011 was a mixed bag for JSW Steel. Consolidated sales rose by 41 per cent to Rs 8,404 crore, thanks to 20 per cent increase in standalone steel sales and realisations.

JSW Ispat saw HR coil sales more than double, while net sales tripled to under Rs 3,000 crore. But the company slipped into losses owing to increased raw material costs.

It reported a consolidated net loss excluding extraordinary items of Rs 48 crore from profits of Rs 291 crore during the same period a year ago. The losses would have been more severe if not for Rs 141 crore tax credit. Its operating margins slipped by eight percentage points to 9 per cent.

Raw Material Troubles

When viewed as a percentage of sales, raw material costs account for 55-65 per cent of JSW's sales. This is higher than both Tata Steel (standalone) and SAIL, both of which have integrated mines for a chunk of raw material requirements. Over the last year, the prices of two key raw materials — iron ore and metallurgical coal — have soared.

Coking coal prices first spiked in early-2011 and just when they showed signs of easing, the rupee depreciated by over 15 per cent.

This meant the company had to shell out more rupees for its iron ore, negating the effect of a correction in coal prices. Similarly, thermal coal prices averaged over 23 per cent higher during the quarter ended December 2011.

While the company had managed to keep the freight costs low – its iron ore supplies come from Mysore Minerals, NMDC and other local miners in the Bellary belt – it took a hit over the last six months following the illegal mining fiasco, which led to a ban on iron-ore mining in Karnataka.

As a result, utilisation rates plunged. A State-sanctioned compromise resulted in iron ore inventories being electronically auctioned. Ore-starved steel producers bid up the prices at these auctions, driving up the blended cost of iron ore for the company. Total consolidated expenditure spiked by 52 per cent during the nine months ended December 2011.

Uncertainty continues in the Sate as a Centrally Empowered Committee has submitted a set of recommendations which will be reviewed by the Supreme Court. Reported recommendations include a cap on mining in the state, e-auction of mined ore and cancellation of several mining licences. Recent reports indicate a possible investigation into JSW Steel's alleged role in procuring illegally mined iron ore.

Even in the event of an outcome favourable to JSW Steel, the imminent MMDR Bill, e-auctions and recently instated 30 per cent export duty may result in higher iron ore prices. While the company's Chilean mines have been ramping up output of ore, it could be a while before this proves to be an effective hedge. In contrast, thanks to integrated mines, both Tata Steel and SAIL have seen raw material costs spike far less aggressively.

Rising Interest Expenses

JSW consolidated net debt levels stood at Rs 17,734 crore as on December 2011; debt/equity of 1.1 times. While not worrisome by itself, consolidated interest payouts rose by 27 per cent to Rs 925 crore. Reports indicate that JSW Ispat will require over Rs 2,000 crore in upgrades such as coking coal oven and other equipment to get more competitive and generate returns. A chunk of that spending is likely to come from borrowings. A triple whammy of high raw material costs, rising interest expenses and uncompetitive operations (JSW Ispat and the American pipe mill) could leave its consolidated operations gasping for profits.

The current valuation does not factor in the uncertainties surrounding iron ore supply and execution risk in improving JSW Ispat. The company held mark-to-market losses on loans and credit of Rs 989 crore as on December 31, 2012. This however could reduce significantly if the current rupee strength holds.

COMMENT NOW