Category: Sector

The Scoop on Steel: Boom times or Value Trap?

  • 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.

Robust Demand

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.

Supply Constraints

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.

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In 2017, India has achieved self-sufficiency in commercial grade steel (Source: Hindubusinessline)

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.

Operating Leverage

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.

Investing in Road Infrastructure stocks? Here’s one strategy.

This post is not buy/sell/hold advice. Please see the disclaimer at the end before reading further

While the goose of private capex has been cooked, the Government of India is taking every step to boost public spending on infrastructure.  The focus is currently on roads. In 2015-16, NHAI awarded about 50 projects to build 2,624 kilometres of roads. A budget of US$22.35 billion has been set out by the Indian Government for infrastructure projects, for which highway construction will play a major part.

As Bala writes in this brilliant piece infrastructure companies have many moving parts that make them unsuitable as buy and hold investments, not least of which are – cyclicity, incalculable extraneous and confounding factors such as commodity prices and the lumpy, often misleading nature of their earnings.

On the other hand Infrastructure is one of the handful of sectors in this market that shows earnings visibility and a clear growth highway ahead.

So how to negotiate this paradox?

Proposed strategy: PROTECT DOWNSIDE RISK (And the upside will take care of itself)

Since the opportunity size is so large, if we can find companies where the downside risk is protected, it should be profitable. Let me lay the downsides for you and the mitigating techniques while researching potential Infrastructure companies to invest in.

Risk 1: Uptick in Commodity Prices leading to Working Capital Problems

Commodity prices are cyclical and have been in their trough for the past two years. It is expected that the uptick in key commodity prices will begin from 2018. Steel, cement are some critical inputs for the construction sector.

Steel – In the recent years India has imposed anti-dumping duty on steel and China has rolled back on capacities. This suggests domestic steel may go up in price.

Cement – Cement is priced by a cartel of producers in India. Further the government has put it in the 28% GST category.

This is sure to increase burden of raw material costs on Infrastructure companies.

Mitigation: Find Companies with Low Leverage and low P/B

Like any sector emerging from a multi-year downturn, most infrastructure companies are currently saddled with debt. Take the following precautions:

  1. Consolidated earnings – When screening companies, check both the standalone and consolidated balance sheet. Construction/Infrastructure companies in India tend to be conglomerates with diversified interests in power, real-estate and (sometimes) loss making foreign subsidiaries. Always check the consolidated financials to get a real picture of financial health.
  2. Price to Book value – use this metric for relative valuation as P/E can be misleading, given that earnings are lumpy (more on this later) and P/E does not capture bloat in balance sheet
  3. Mix of project/order type with the company – While leverage is not a disqualifier in itself, too much debt on the books puts some companies out of the competition for BOT (Build-Operate-Transfer) projects. BOT projects have higher risk of exposure to commodity price related working capital problems. On the other hand BOT projects have higher entry barriers than hybrid and EPC (engineering, procurement and construction) models that require upfront commitment from the government to take on 40% of the burden of costs. It follows logically that EPC models (where the government takes on the full burden of working capital) will face more competitive bidding than BOT projects, which will enjoy higher margins. Companies with low leverage and healthy balance sheets will enjoy a huge advantage to bid and successfully execute BOT projects.

Risk 2: Lumpiness in Earnings

The public infrastructure sector has one key buyer: government. The project lifecycle is long with 100% buyer concentration. This impacts the nature of orders – sometimes you win the bid, sometimes you don’t.

Additionally, infrastructure companies can record “revenues” as time of the order or at time of complete transfer of ownership and risk. Accounting distortion is common in this sector.

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“Lies, damn lies and statistics”

Mitigation: Look at Cash EPS and Execution History

While the EPS of the company can be misleading. Cash EPS, which is a measure of Cash Flow from Operations / Dilute Equity outstanding would be a better measure of the health of the company. Again, due to the lumpy nature of infrastructure orders – do not look for consistency in Cash EPS but rather, its relative value compared to EPS.

Execution history is important. Companies that have suffered cost overruns in the past due to poor capital allocation or working capital management can be avoided. A leopard and management, rarely change their spots.

In Sum: The past is not the future

Road Infrastructure itself is a Rs 7-lakh crore opportunity. NHAI has 62000 crores worth of bids up in the next 6 months. Funding for Infrastructure is cheaper than it was in the past – interest rates are lower offering companies with debt significant relief in their existing interest payments while taking on new projects. Further, the Reserve Bank of India (RBI) has allowed companies in the infrastructure sector to raise External Commercial Borrowings (ECB) with a minimum maturity of five years and with an individual limit of US$ 750 million for borrowing under the automatic route.

Further, risk of input costs and overruns have been transferred from the building company, to the government under the Hybrid Annuity Model (HAM) and the EPC (engineering, procurement and construction) model. So the company executes and keeps the money, which is not trapped in working capital. We may be at the cusp of a unique wealth making opportunity in the stock markets. Stay vigilant.

DISCLAIMER:

This post is not BUY/SELL/HOLD advice but a statement of my personal analysis and opinion. I hold road infrastructure stocks so my views are biased.

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”. No BUY/SELL/HOLD advice is offered on this blog, in any form whatsoever. Views expressed are my own and not of my employer. Stock Markets are very risky and can cause a permanent loss of capital. You should seek professional advice.

Cinderella at the Ball – Are Airlines still a Value Trap?

Once dismissed as a “death trap” by Warren Buffet, Airlines saw frenzied buying in 2016. In third quarter Buffet’s Berkshire was seen accumulating stocks of not one but multiple airlines. In India, airlines listed on the exchanges saw buying by marquee institutions and funds. In 2016 the much maligned Airlines business caught the fancy of the investment community. What changed? Continue reading “Cinderella at the Ball – Are Airlines still a Value Trap?”