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The new threat of substitution
The trend-line growth of alloy steel should start concerning the conventional steel players. In our note dated “March 18, 2019” titled “The investibles: Part 1” we have highlighted a distinct possibility of Indian steel demand peaking at ~140mnte. The overestimation of potential demand has allowed incumbents (Tata and JSWS) entering an endless capacity competition, increasing leverage and thereby, allowing valuations to bottom out at 0.5x P/B at every cyclical downturn. Since our report, auto consumption has dipped, many steel players have openly started discussing volume weakness and Arcelor’s entry is delayed into an overcongested space. What comes as an additional portentous sign is the increasing share of alloy steel in the mix. Maintain SELL on Tata Steel, REDUCE on JSW Steel and BUY on JSPL.
* The rise and rise of alloy steel. Alloy steel’s share in the steel consumption mix has moved up from 5% 10 years back to ~10%, currently. The trend line of demand growth (Chart 3) is ~15% p.a. over the past four years and remains significantly above carbon non-alloy steel. We believe, apart from selective government capex and a low base, the factor which is working in favour of the stainless steel sector in India is the low cost of imports. This is helping in generating additional demand and perhaps, driving the growth as well.
* As steel demand slows, we fear substitution of alloy steel into non-alloy space is a real possibility. Typically, the increase is driven by substitution in government projects as well as cheap availability of nickel-heavy series 304 given heightened exports from Indonesia. Indian private/public consumption is hence fueled by lower lifecycle costs and higher and cheaper availability of nickel pig iron (as compared to historically produced 200 series in the country through the EAF route). Private producers have also responded accordingly, with > 50% of Jindal Stainless’ Odisha plant producing SS-300 series of product.
* Lower lifecycle costs, cheaper imports of SS-300 series and the possibility of peaking demand for carbon steel – a potent combination. As Table 1 highlights, India is already ranked third last in the list of 30 countries where historical data is available, and at a period where their GDP per capita was similar to that of India, currently. This raises the fear of substitution as steel demand growth is perhaps, always overestimated in the country context, unless cheap imports from places like Indonesia are not addressed. Furthermore, import duty imparity between carbon steel and stainless steel will further accentuate the trend.
* Maintain SELL on Tata Steel, REDUCE on JSW Steel and BUY on JSPL. The overestimation of domestic demand has allowed a mindset of competitive capacity buildup by incumbents. While consolidation was expected to help, Arcelor’s entry will further impact the competitive landscape. Sector leverage is worryingly high and has been historically so which readjusts valuation to 0.5x P/B (1-year forward) in every cyclical downturn. The possible trend of demand substitution by alloy steel can be a new source of worry for incumbents
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