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We initiate coverage on Refractories, riding on the current boom in the steel industry. Heavy financial stimulus for infrastructure projects - domestic and global - is expected to keep demand for refractories robust in the near future. Historically, refractory companies have been steady revenue compounder with stable margins, net cash balance sheets and superior return ratios, a remarkable contrast to its customer steel sector, thereby largely obviating the severe cyclicity of commodity companies. We expect recycling and localisation to support margins for refractory players. We initiate on IFGL Refractories and RHI Magnesita India (RHIM) with a BUY rating with IFGL being our preferred pick.

* Demand drivers at peak for refractory industry: 75% of the refractory demand is driven by steel and rebound in steel demand post pandemic is already evident with 28% growth in 1HFY22 in steel production. We expect this trend to continue due to robust government spending on schemes like National infrastructure projects, PLI scheme, Jal Jeevan Mission, housing schemes, etc. New steel capacity worth ~38mnt in the next 4years will also drive additional demand for refractories. Strong export demand for Indian steel due to production curbs by China will further accelerate refractory demand. Historically, revenue growth of refractory players has been ~1.5x of growth in steel production and therefore we expect at least 12% CAGR revenue growth for refractory manufacturers over FY21-24E.

* Refractory a consumable; does not face commodity-like volatility: Despite 75% of the demand for refractories being driven by steel and hence perceived as susceptible to commodity price risks, our long-term study of refractory companies concludes that its gross margins vary within a very narrow range, unlike a typical commodity company. Their revenue growth has seen continuous compounding unlike declines seen by metal companies. Refractory companies also have a commendable track record of net cash balance sheets over the last 5years, superior and stable return ratios compared to a commodity company, and consistent FCF generation. As a steady consumable business, it deserves a higher multiple than commodity companies.

* Localisation and recycling to support margins; discourage imports: Recycled material which saves 30% of the cost is expected to increase as companies set new recycling plants (E.g.: RHIM). This will also reduce dependence on China. Advanced R&D expertise will further result in localisation of several products like Magnesia bricks (RHIM) and precasts (IFGL) thereby discouraging imports and controlling cost. However, high sea freight and shortage of RM from China can pressurize costs in medium term, partially compensated by higher realisations. We expect export demand to improve on recovery in steel production in EU and US. We expect consolidation to continue in the industry with smaller players being acquired by the large manufacturers that currently hold a 56% share in the domestic market.

IFGL our preferred choice between the two BUYs: We initiate coverage on IFGL Refractories Ltd. (IFGL) and RHI Magnesita India Ltd. (RHIM) with a BUY rating on both the stocks (Upside IFGL: 109% ; RHIM: 19%). IFGL is our top pick as it is highly undervalued as compared to peers and we expect it to substantially improve its operational and financial performance making a case for re-rating.

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