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Asset valuation as the lead
As another steel cycle takes shape, we would like to reiterate the following takeaways: i) earnings (analysis) invariably lags cycle turn while asset valuations are predictive. P/B (1-year forward) is a simple yet powerful heuristic for asset valuations; ii) the predictive ability of asset valuations allows one to overcome the lag impact of data flow while, at the same time, appreciate that certain policy puts also get triggered (globally) as certain asset valuation levels in the sector are reached (we have seen the same with Chinese/US/European data flow in the current cycle); and iii) as loss probability reduces and RoE expectations start to scale towards 8-9%, the bottom cycle P/B metric of 0.5x will give way to 1x P/B allowing significant upside to most of the names. This is highlighted by target prices for our top-2 BUYs in the sector (Tata Steel, JSPL). We also upgrade JSW Steel (JSWS) to HOLD.
* Data flow has improved substantially in the sector over the past month. We have seen global as well as domestic price hikes, driven by cost support / bottoming out of regional demand. Chinese forward demand projections seem a lot healthier than they were in the corresponding period of last year with many levers still to propel a healthier H1CY20, exports a lot more muted despite increased production (highlighting normalisation of rebar production taken out in 2017) and, finally, targeted winter production cuts setting in. Indian demand scenario is a lot less exciting, yet HRC prices at Chinese hot rolled band median cost has helped support export prices (which are up ~US$40/te over the past fortnight) and hence have helped domestic prices as well.
* What did we have two months back? Asset valuations were beginning to test 1- year forward P/B of 0.5x (with variations based on loss probability). Steel prices were declining thick and fast, trade war rhetoric and RMB depreciation were dominating the investor’s mind share. Some of the concerns were unique to the cycle as they are in each cycle, yet two months down the line the outcome has started to play out on familiar lines. Some of the reports that we published can be accessed through the following links (The cycle is testing 0.5x P/B across the sector and As steel cycle bottoms out, so will valuations (P/B 0.5x) )
* Probability of loss declines as price hikes take shape; increasing RoE expectations have allowed meaningful upsides in the names. As RoE expectations reach 8-9%, 1x P/B will be tested (most of them are still at a fraction now, barring JSWS where RoEs are also meaningfully higher). Yet, we feel, Indian incumbents’ fascination with capacity building in India (perhaps from a misplaced sense of higher domestic demand potential) will not allow meaningful deleveraging in the next cycle as well. Nevertheless, that concern can be shelved for the time being till the next cycle downturn hits. Also, lack of deleveraging will allow the asset valuation framework to maintain its predictive power.
* Maintain BUY on Tata Steel, JSPL; upgrade JSWS to HOLD. We increase our target price for Tata Steel to Rs628/share (from Rs631 earlier) and increase that for JSWS to Rs272/share (from Rs189 earlier).
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