Pedal To The Metal... Or Not?BloombergQuintOpinion
There are polarised views around on metals sector. There remains the overarching trend of global trade being slow amid a series of lockdowns, impacting businesses. The counterview points to markers of valuations being at the kind of lows from which these stocks have traditionally bounced back; opening up of economies which may help companies post better numbers; how individual companies may have balance sheet strength and raw material supplies.
The investment argument, if any, is for the investor who plays cycles, and not looking at the short-term moves, on companies can stay in a sideways zone for a considerable period. The potential danger signs include any large increase in debt, large negative free cash flows, and any major reduction in book value which is a crucial metric in a bear market. Companies that can navigate these might give returns in a post-Covid world, goes this argument. While having a few fissures in the fabric, it is not entirely untenable.
China’s steel inventory had risen significantly over the normalised levels in March but has started to come down since April. The resilience and recovery of China’s steel demand would be key for the global steel market. Domestic steel capacity addition in India will likely moderate, given the balance sheet health and FY21 estimated capacity utilisation at around 75 percent. There’s also the usual argument that the government focus on infrastructure would keep India’s medium-term commodity demand outlook is intact. Even before the recent call for self-reliance, we have seen policy intervention in the past to ring-fence domestic steel.
Economies Reopening And Prices
ArcelorMittal has guided for April-June shipments to be 28 percent lower quarter-on-quarter. While there is an absence of clear visibility on changes in demand, the world’s largest steel company points to the resumption of activities in the United States, European Union, and earlier in China, to suggest that demand troughed the April-June quarter. Can this help prices? Depends on the extent of the demand bounceback.
In specific product segments, Credit Suisse says in a note that it found resilience in rebar prices, relative to hot-rolled coil prices in China, pointing to a recovery in construction activity. As auto demand improves over the coming months, Credit Suisse believes that HRC prices should catch up as well. It adds that Indian steel prices are currently at the anti-dumping duty level, and so the risk of imports remains low. India has been a net exporter since August 2019. All of this points toward a pricing outlook that, even if not bullish in the short-term, is not negative.
Innovative Cost Controls
Arcelor Mittal expects to “variabilise” fixed costs, cutting them by 25-30 percent in the April to June quarter. This would be driven by temporary labour cost savings and reductions in all other operational and ancillary expenses, as per a note by Credit Suisse. If companies can show such flexibility, it might help them tide over the issues in the short-term.
Valuations, Now And Past
Comparing the enterprise value per tonne or price-to-book valuations versus the historical averages show that the large private sector steel and aluminum companies in India are trading close to the cyclical lows witnessed during the 2008 financial crisis and the China growth concerns in the second half of 2015.
But... Stretched Balance Sheets
Weak margins combined with high-interest costs and unavoidable capital expenditure would result in negative free cash flow and an increase in debt for most metal companies in FY21. A Kotak Securities note last week noted: “In our stress-case scenario, Tata Steel and JSW Steel see net debt/EBITDA >10X due to negative FCF with weak domestic margins, losses in the international business and incomplete growth capex. However, both enjoy comfortable liquidity with cash on books and undrawn credit lines. Vedanta’s standalone net debt/EBITDA would increase to 6x but liquidity is strong.”
Vedanta is also exposed to several commodities like zinc, oil, aluminium that are currently in a commodity down-cycle. Its earnings are likely to be the most volatile in the pack, even though on the liquidity front it seems comfortable.
JSPL’s gross debt has come down from $6.5 billion in FY16 to $5.3 billion currently. Notwithstanding this, its net debt/EBITDA leverage is in line with peers and net debt accounts for 80 percent of EV versus 60-75 percent for peers, as per Macquaire calculations.
While there are various ways to make an omelet and buying metals may be one way to make money in these markets, such cyclical plays are risky unless you can time them well. Manish Chokhani of Enam told BloombergQuint on March 17, “When supply chains come back, you may see commodity prices go back to the 85 percentile of the cost curve. Today, a lot of these prices are 40-50 percentile of where the cost curves are. When stock prices react further and true fear sets in, it could be a good opportunity to buy for a big bounce, even though commodity producers are not sustainable wealth creation”. The biggest headwind to any such investment is the alternate array of opportunities. For, in a bear market, everything resets, and metals may not be the first port of call. It will be interesting to see if value wins here or other growth sectors take precedence.
Niraj Shah is Markets Editor at BloombergQuint.