- In FY2019, India is predicted to replace Japan as the world’s second largest producer of steel
- Demand will be largely driven by domestic demand, with significant constraints on domestic supply
- Raw material cost can be upto 70% of the total cost of steel producers and is a bigger risk than a global tarrif war
- Operating leverage will not mitigate raw material risk, price is not expected to spike and as a result realizations per tonne are not expected to change dramatically
- Value may be found in distressed companies or leading steel makers but the rest could be value traps
Metals and mining was the best performing sector of 2017. Further upstream, carbon rod manufacturers like HEG have created enormous investor wealth. Further upstream, investors are now looking at steel companies to lead the next wave of wealth creation.
Steel is used in many aspects of everyday life – from kitchen knives to housing sariyas -and the primary demand for steel comes from construction, automobiles, white goods, railways and heavy machinery.
The margins are highest in white goods and automobile applications but construction is where the volume growth is anticipated to come from. CRISIL expects demand for steel to increase by 80% from demand in the past few years. There is also a new National Steel Policy that gives preference to Indian steel makers in government construction and infrastructure projects.
There are broadly two types of steel products:
Flat steel products – Include thin plate steel which includes auto-grade steel for automobiles, railways etc. These have higher margins.
Long steel products – Includes steel wires, billets and bars used in housing and construction. These have higher volumes. Alloys and custom made long products can also have higher margins.
No new capacities have been added by Indian steel companies in the past 3 years due to industry depression and bad debts. In 2017, government imposed duties in the form of MIP or minimum import price on steel products imported from China and also an anti dumping duty for 5 years on certain products. This creates supply constraints for the coming pickup in demand.
Supply constraints of higher-grade steel may be more severe than commercial grade steel as there are fewer suppliers to address the demand from sunrise industries in defence, ship-building, windmills that is expected to pick up in 2018 and beyond.
Raw Material Risk
Raw materials range from 35 to 70% of cost of steel production and can upset the favorable demand supply equation. Raw materials are used in both the steel manufacturing process and in the final steel alloy products. These raw material inputs include scrap steel, natural gas, chromium, carbon, iron, coal and power.
Government can subsidise availability of natural gas and steel companies can negotiate rates of utilities like power but a lot of raw material is currently imported (including steel scrap). The import of material like chromium can put an upper limit on using all available capacities as inventory days are lengthened.
Further, the contribution margin in steel can be as low as 20%, which can make manufacturing unviable if raw material prices rise considerably as is expected to happen in 2018.
In light of raw material price risk, we must challenge the market’s current investment thesis that Operating Leverage will kick in for steel companies and make them hugely profitable.
With increased demand and corresponding use of capacities, the breakeven in terms of fixed costs may be reached by the sales but variable costs, which can be a huge portion of total costs, are also expected to rise considerably and will eat into margins and realization per tonne.
The other hope of the market is that the price of steel will go up, increasing realization per tonne. This may be partly true with constraints on supply and rising demand, however the margins seen before 2010 may never come again as Indian steel companies were operating in a cocoon and protected from foreign competition.
Where to Look for Value?
So is steel a lost cause? I argue that value will be found in companies with some combination of the below traits:
- Large and ready capacities for use
- Low EBIT/Debt
- Lower cost of raw material as % of COGS
- Lower days in inventory
- Vertical integration and power subsidiaries
- Sticky domestic customers (for e.g. auto companies)
- Good mix of flat/long and commercial/high-grade steel products
One can be flexible on EBIT/Debt as most companies are expected to come out of distressed conditions, if other conditions are met. Avoid companies which have historically never used more than 70% of their available capacity as it could be because of dependence on imported raw materials that put a limit on how much they can address demand. Avoid small cap steel companies with large working capital cycles.