These are not good times for steel stocks. Riding on the back of an upturn in global and domestic steel demand and hence steel prices for the better part of the past three years, the tide is apparently turning for steel companies. And the markets as usual have been quick to pounce on steel stocks, giving them the cold shoulder, while rewarding most
others.

Compared to a near 47 per cent rise in the Sensex in the past year, leading steel stock returns pale in comparison. The Tata Steel [Get Quote] stock has appreciated by 10 per cent during the period, while that of SAIL [Get Quote] (Steel Authority of India) has actually declined by 3.38 per cent. Other steel stocks are not doing any better.

With the outlook on steel prices getting duller, things are not going to improve in a hurry too, say analysts. While Indian steel has its own advantages, being among the lowest cost producers in the world for starters, the future is going to be determined by how well they are able to adapt to changing realities.

While steel prices are under pressure, industry leader Tata Steel is ensuring future growth and expanding into new areas. It recently announced a 50:50 joint venture with the Australian major BlueScope Steel.

The JV will enable Tata Steel's foray into the business of zinc and aluminium metallic coated steel, painted steel and roll-formed steel products. The company will invest capital cost of Rs 1200 crore (Rs 12 billion) on four manufacturing locations in India and a network of sales offices across the SAARC region.

The revenues from the JV are expected to cross Rs 1,200 crore (Rs 12 billion) by 2010 and Rs 2,000 crore (Rs 20 billion) when the capacities are fully utilised. The new venture puts the company's plans for a global presence into focus. There is more.

Going global

Tata Steel, the country's largest private sector steel company, is in talks with Anglo American of South Africa to acquire its 79 per cent stake in Highveld Steel. While the Highveld acquisition is still going through the evaluation process, Tata Steel managing director, B Muthuraman admitted that it is not the only company Tata Steel is eyeing.

"There are several other companies on our radar," he remarked on the sidelines of a press conference to formally announce the company's joint venture with BlueScope Steel.

According to analysts, if the acquisition of Highveld Steel comes about, Tata Steel's production capacity will go up to 6 million tonne from the current level of 5 million tonne. Highveld, the largest vanadium producer in the world, manufactures steel, vanadium products, ferro-alloys, carbonaceous products and metal containers and closures.

Analysts observe a clear trend in Tata Steel's plans to expand capacities. But Highveld will not be the first global acquisition for Tata Steel.

In February 2005, the company completed the acquisition of Singapore's largest steel company, NatSteel Asia, which has a two-million tonne steel capacity with presence across Singapore, Thailand, China, Malaysia, Vietnam, the Philippines and Australia.

As per the deal, the enterprise value of NatSteel Asia was pegged at Rs 1,313 crore (Rs 13.13 billion). Tata Steel has plans to establish steel manufacturing units in Iran and Bangladesh too.

With a stated vision to become a 20-25 million tonne company by 2015, the company has also signed a few joint ventures and announced organic expansion plans.

In June, Tata Steel signed a memorandum of understanding for setting up a five-million tonne green field integrated steel plant in the Bastar region of Chhattisgarh. With the company's one million tonne expansion programme at Jamshedpur nearing completion, the company has also initiated a further two-million tonne expansion programme at Jamshedpur.

Plans are also afoot for setting up a large integrated green field steel plant in the state of
Jharkhand. The proposed steel plant will have an initial capacity of 5 million tonnes per annum, and will be completed in four years time.

This capacity will be expanded to 10 million tonnes per annum in the subsequent five years. The capital cost is expected to be approximately Rs 15,000-20,000 crore (Rs 150-200 billion) in the first phase and in the range of Rs 30,000 crore to Rs 35,000 crore (Rs 300 to 350 billion) on completion of the second phase.

It is not just the capacity expansions the company is interested in. Tata Steel is integrated backward with owned iron ore mines and collieries.

To further enhance its competitive advantage in raw materials the company has also signed an agreement to buy a five per cent interest in the Carborough Downs Coal Project located in Queensland, Australia. It also plans to develop a deep-sea port in Orissa to facilitate flow of inbound and outbound materials.

Growing concerns

Despite the company's impressive credentials and strong fundamentals, some analysts have expressed doubts about the future prospects. The reason? A likely fall in steel prices. With steel capacities on the rise across the globe, there are fears that it could lead to over capacity a few years down the line, thus softening prices. The trends are already
emerging.

Current landed price of imports of hot rolled coils are down two per cent in October to Rs 19,845 per tonne compared to September. The prices were ruling at Rs 24,510 per tonne in May. Heightened production, especially in China and a lack of growth in demand are the main reasons for the decline in prices, say analysts.

Analysts also expect China to turn net exporter in 2006, and thus contribute to the already excess steel supply in the Asian region. International steel prices have already fallen by 30 per cent from the peak level touched in March this year.

According to a recent report by a foreign brokerage house, Tata Steel has cut its long steel product prices by an average six per cent in the current quarter. The report also warned that there is a strong likelihood of the company cutting flat steel prices again by 5-6 per cent to bring its prices at parity with landed prices.

Will earnings growth slow down?

Worries on lower prices have also led to many analysts downgrading the Tata Steel's EPS estimates. Tata Steel posted a 12.46 per cent growth in net profit to Rs 1045.42 crore (Rs 10.45 billion) in the quarter ended September 2005 as compared to the corresponding quarter in 2004.

Net sales grew by only 3.39 per cent during the quarter to Rs 3865.10 crore (Rs 38.65 billion). The earnings growth was well below analyst expectations. Operating profit growth was limited to a mere 1.4 per cent at Rs 1651.6 crore (Rs 16.52 billion) in the September quarter.

Though the quarterly results are not strictly comparable with September quarter of FY04, considering the merger of NatSteel Asia with effect from February 2005, there was a decline of 84 basis points in the operating profit margin of the merged entity. Sequentially too, operating margins fell 311 basis points in the September quarter.

According to analysts, a key factor that contributed to the squeeze on margins was a 19.53 per cent y-o-y growth in raw materials costs consumed in the last quarter. The increase was largely on account of higher coke cost. Also, other expenditure grew about 6.9 per cent y-o-y.

The company also suffered on account of lower prices. Spot HRC prices were down about 12-15 per cent on a y-o-y basis in the second quarter of 2005-06 and that was largely due to surging steel output in China. For the first half of 2005-06, net profit stood at Rs 1969.53 crore (Rs 19.69 billion), an 18 per cent increase from September 2004.

Given the huge capex plans that Tata Steel has lined up, the worry is that cash flows, among the company's strong points may take a hit going forward.

According to an estimate Tata Steel is likely to implement a capex of Rs 18,500 crore (Rs 185 billion) over 2006-07 and 2007-08. One foreign brokerage firm recently estimated that free cash flows at Rs 1046.80 crore (Rs 10.47 billion) in 2004-2005 will turn negative from 2006-07 onwards.

The brokerage goes on to add that there is a risk of the balance sheet getting stretched as the capex plans roll out. This combined with a falling steel prices are what makes analyst fret.

However, there is another school of thought. Tata Steel management itself has stated that steel prices are likely to be stable going forward. With the company's inherent strengths of a contained cost structure, better product mix and higher sales of branded products, Tata Steel is expected to achieve much better operating margins than its peers.

The company plans to improve its product mix further, while reducing costs by higher usage of domestic coal, higher coal injection and a lower coke rate. The company also intends to increase usage of sinter, while reducing usage of sponge iron and purchased metallic.

An improvement in margins of NatSteel should also augur well for the future. These steps should enhance the company's status as one of the lowest cost producers of steel in the world.

Tata Steel's stated plans for the future include de-integrated dispersal of facilities in select geographies, ownership and development of raw material sources, access to captive ports and other dedicated logistics facilities, branding and value added products while pursuing strategic acquisitions.

Best of the lot

According to a leading domestic brokerage, the company's revenues are likely to grow by above 8 per cent to Rs 15,800 crore (Rs 158 billion) in FY06, while bottomline growth is slated to be around 23 per cent at Rs 4340 crore (Rs 43.4 billion). The stock is currently valued at a P/E of 5.3 on a trailing 12-month basis at Rs 342.

Global peer group valuations, which include companies like Arcelor (3.7x), Baoshan Iron & Steel (5.3x), Blue Scope (5.4x), Posco (4.6x) and Thsyssenkrupp (7.2x) are comparable. Closer home, analysts pick Tata Steel as the best bet in the steel sector.

According to Vijay Bhambwani, CEO of Mumbai-based BSPLindia.com the uptrend seems to have fractured in Tata Steel. "Rs 320 level are a crucial support levels for the stock. If the stock goes below these levels, we could witness medium term bearishness in the stock.

Buying conviction will emerge at the counter only if the stock goes above Rs 385 levels," he notes. Analysts are of the opinion that steel stock performances could depend on international steel price trends. However, even if the short-term outlook is murky, the consensus is that Tata Steel has the wherewithal to emerge a winner in the long run.