Identifying a steel stock: Do's and don'ts

Steel stocks have been the object of heavy reviews off late in discussions about the Indian equity markets. And this is not without reason. In recent times, steel stocks have gained tremendously on the bourses. Whether this is a factor of rising speculation or fundamentals of steel stocks, is a different story altogether. However, in this article, we try to elucidate factors one should keep in mind before investing in a steel sector company.

Profile
Steel industry plays an important role in the economic development of a country. India, being the 9th largest steel producer in the world, has a share of about 3.2% in world steel production of a little over 900 million tonnes (MT). Despite this, the per capita steel consumption in India is one of the lowest, thus providing the domestic industry with a huge potential to scale greater heights.

On basis of scale of operations and level of integration, steel makers can be categorized into the following two types:

• Integrated Steel Producers (ISP)/Primary producers:  These have manufacturing facilities right from the iron ore (raw material) stage to the finished steel stage. They use the blast furnace methodology for manufacturing steel.

• Secondary producers/Mini Steel Plants:  This segment uses scrap and sponge iron as raw materials to produce steel. Their production method comprises mainly of Electric Arc Furnace (EAF) and induction furnace units.

As far as the steel products are concerned, they can be classified into three categories. Semis, which are intermediate products, are cast from liquid steel for further rolling into finished products (longs and flats). Longs are primarily used in construction, infrastructure and heavy engineering. Finally, flats are used in automobiles and consumer durables. These are high-value products and thus enjoy higher margins.

Now let us proceed with the various parameters indicated in the flowchart above:

Revenues
Revenues are a function of volumes and realisations. Lets look at the volumes side first.

Volumes
The demand from steel comes both from the domestic and export fronts. Also, this being a core sector, its volume performance is directly linked to the economy. This is because the demand for steel is derived from spending in infrastructure, housing, automobiles and consumer durables sectors. Fortunes of the steel sector are, thus, linked to the prospects of these sectors. Competition also plays a significant role in determining the prospects of the steel industry. Domestic steel producers face intense competition from global majors, chiefly due to the latter's larger scale of operations (giving them benefits of economies of scale). Going forward, this sector is likely to face competition from aluminium, which is not only as strong but substantially lighter than the former. This could create a threat for steel, as user industries like auto, railways, etc. where fuel efficiency is an important factor, could switch their preferences to aluminium.

Realisations
Apart from the cyclical nature of the industry, realisations are also dependent on the following:

• Contract sales:  Company's policy pertaining to its sales has an impact on realisations. Ideally, steel companies, to avoid uncertainty regarding realisations created due to volatility in global steel prices (due to cyclical downturns or unexpected events), get into forward sale contracts with their customers, which could be anything from a month to a year. However, at times of cyclical upturns, companies over exposed to long-term contracts are not able to fully exploit the benefits of rising steel prices.

• Value added (CR):  Realisations are also dependant to a large extent on the products profile of a steel company. Companies with a larger presence in value added segments (like Cold Rolled (CR) products) are able to realise higher prices (about 20%-25% higher) for their products.

• Competition:  Competition plays a major role in affecting realisations, as international steel companies with huge capacities (thus an appetite to bear lower realisations) tend to offload their produce in the markets at lower prices, thus making Indian steel exports price uncompetitive. Indian companies also face international competition on the domestic front when lowering of import duties result into international majors flooding their products into the domestic market. In this case, cost efficiency plays a major role for survival.

Expenses
As said above, in face of increasing competition, survival would depend on cost efficiency, more so in times of a downturn. It is, thus, imperative for these companies is to keep a strict check on their expenses and maintain (if not improve) their standards of efficiency. Some of these expenses are pertaining to raw materials, power, employees and interest cost.

On raw material and power fronts, companies with captive facilities have an added advantage as purchasing these requirements from the market is expensive relative to their sourcing from internal (captive) facilities. Employee efficiency also plays an important role due to the large number of employees employed by this industry. Finally, as steel companies are capital-intensive in nature and have significant exposure to debt, managing interest cost is of utmost importance.

Key parameters to be kept in mind while investing in a steel company:

• Cyclicality of the sector:  This is a very important point, which should be remembered, before investing in a steel stock. This is because; this very factor can make or mar the fortunes of the sector and steel companies. Investments into a steel stock near the peak of its cycle could result in a huge chunk of the investment being wiped it. Nevertheless, identifying the bottom of the cycle is not an easy task.

• Integration advantage:  Whether the company is backward integrated (ISP, as discussed above) or not, is a key factor for consideration. Backward integration has various advantages as have been mentioned above (captive facilities).

• Operating performance:  The operating performance of a steel company is dependant to a large extent on the cyclicality factor. However, steel players with larger presence into contract sales and value added products are insulated, to a relatively greater extent, from the steel cycle. In this regards, operating profit margins (OPM) is one parameter to consider. OPM is also dependant on various internal parameters such as power cost per unit and production per employee. However, it must be noted that in the case of production per employee, the numbers could be skewed to the extent of the companies' presence into mining of raw materials.

• Valuations:  Two important ratios to look at in a steel company could be the Price to Earnings (P/E) ratio and the Price to Book Value (P/BV). Since steel is a core industry and its performance is linked to economic growth, the P/E multiple of steel stock should more or less hover around the country's GDP growth. However, at the same time, companies with greater exposure to international markets (exports) could command a higher valuation. The P/BV ratio can also be used as a parameter for comparison.