>INDIA STEEL: Global weakness a concern, but India stocks discounting a distress scenario

■ Action: Stocks are building in distress; we recommend buying

After the recent correction, India steel stocks are factoring in steel prices of USD550/t (current prices ~USD630/t), at which close to 50% of global capacity should turn unprofitable despite the fall in raw material prices, as per World Steel Dynamics. We don’t expect such a capitulation in steel

prices to be sustained and hence remain positive on the sector. We prefer integrated steelmakers such as TATA Steel and SAIL in our coverage universe, although TATA Steel is our top pick, given near-term catalysts such as 2.9 mtpa expansion by FY12.

■ Catalysts: Q3FY12 to be weak, but a recovery likely from Q4FY12

We expect Q3FY12 to be a weak quarter on: 1) a seasonal slowdown and 2) companies still using high-cost raw materials. However, with lower raw material costs and seasonal improvements in the demand scenario, Q4FY12 should record an earnings rebound, in our view.

■ Valuations: Stock price correction sharper than earnings downgrade

We believe steel stocks in general have been de-rated as stock prices have come off more than the cut in consensus earnings estimates. Current multiples for global peers are close to 10.5x P/E and 5.6x EV/EBITDA, while India steel stocks are trading at 5-6x P/E and 4.5-4.7x EV/EBITDA.

India steel stocks have generally traded in the range of 8-12x P/E and 5-7x EV/EBITDA (during the past five years).

In this report, we cut target prices for steel firms under our coverage by 20- 30%, driven by the 15-25% earnings estimate cuts and 5-10% cut in target multiples as we believe stocks should trade near the low end of historical multiples, as we don’t expect a significant recovery in the steel cycle given headwinds from global economic uncertainties (although nor do we expect a deterioration in the steel cycle from current levels).

• We don’t expect utilization issues for India firms as even 5-6% demand growth would keep domestic steel demand-supply balanced.
• While coking coal prices have fallen to USD240/t (from USD300/t in Q2FY12), iron ore prices have rebounded to USD140/t (from USD120/t in Oct-11). This is an ideal scenario for India steelmakers, in our view, as they are dependent on imported coking coal, but source iron ore locally.

To read the full report: INDIA STEEL

RISH TRADER