While the run-up in prices have made metal stocks expensive, medium term prospects are unattractive due to weak demand and inventory pile-up.
The rally in domestic metal stocks is backed by the rise in metal prices, ranging from 30-100 per cent, since February 2009. Signs of a global economic recovery, surge in Chinese imports and weakness in the dollar had fuelled the rally in metal prices. This helped metal stocks move up higher than the broader markets. The BSE Metal index has gained 157 per cent against the 73 per cent rise in Sensex since January 2009. However, analysts now believe that the fortunes of the sector, although they remain intact from a longer term perspective, do not look attractive from the medium-term standpoint as metal prices are expected to correct following the recent rally and notably, the piling up of inventories (of non-ferrous metals at the London Metal Exchange; LME). Besides, there are worries regarding the recent global economic recovery, which may not be as strong as anticipated and might get prolonged. Last but not the least, metals stocks, too, are not attractive at current valuations. The BSE Metal index is trading at a price to book value of 2.37 times and PE of 15.18 times, which is higher as compared to its five-year average of 2.33 and 7.7 times, respectively. At current levels, share prices indicate that a lot of positives are already factored into valuations.
Industrial metals
Consequent to the demand destruction as a result of falling global economic activity, prices of non-ferrous metals dropped below their respective marginal cost of production and most companies opted to cut output. As a result, global non-ferrous metal production was cut by 10-15 per cent during April 2008 and February 2009. However, since then, demand has shown signs of revival on account of recovery in global industrial and economic activities. “People did not buy anything till 2008 and beginning of 2009, but as most government started spending too much of money to revive their economies, people have again started to buy and pile up inventories,” says Jim Rogers of Singapore-based Rogers Holdings and author of Hot Commodities.
The demand for industrial metals is closely linked with economic activity, which is why analysts believe that buying in metals started in the hope of an economic revival. The IMF, in its recent World Economic Outlook report, has projected world GDP growth of 3.1 per cent in CY2010. While it is significantly higher as compared to the 1.1 per cent decline projected in CY2009, it is still far from 5.2 per cent in CY2007. According to the data, the US, Europe, Japan and Russia are expected to see a strong recovery, but only in CY2010.
This is also a reason that most analysts believe that the long-term fundamentals of the metals sector are promising. However, from the near-term perspective as Tarang Bhanushali, analyst who tracks metals at India Infoline says, "Metal prices from here could consolidate within a range of about 10 per cent for some time given that China, which was earlier importing and building capacities have stopped doing so. Also, the new supplies (plants) which were earlier closed have (or will) come on stream due to the rise in metal prices.” This should restrict any rise in prices, unless global economic growth surprises on the upside.
"China’s imports are coming down, but in the rest of the world restocking is still happening in metals. As far as prices are concerned we do not think they will go up from these levels significantly, but at the same time there is little downside considering that metal prices are still trading at reasonable levels, which is marginally above the cost of production," says Rakesh Arora, who tracks the metals sector at Macquarie Securities.
“It is very unlikely that commodity prices will correct towards the low levels seen at the beginning of the year. This is mainly due to a combination of stabilising demand, ongoing stimuli, tight fundamentals and a weak dollar versus emerging market currencies," says Diego Parrilla, managing director and head of commodities-Asia Pacific, Merrill Lynch in an interview with Business Standard, last week.
Aluminium
Amongst the most widely used non-ferrous metals, aluminium has an edge over others as it will benefit the most in case of any revival in the global economy. Asia accounts for 43 per cent of world consumption, wherein economic growth is expected to be faster. According to IMF estimates, developing Asia’s GDP is expected to grow at 6.2 per cent in 2009 and 7.3 per cent in 2010. Also, the revival in automobile, packaging and construction sectors, which are the largest consumers of aluminium, as well as the demand from the power sector, would augur well for this metal. However, most of these benefits are seen accruing in CY2011, as major global economies are expected to see revival by end of CY2010. During 2009, despite an expected 6 per cent decline in world aluminium production to 37.25 million tonne, the surplus is expected to remain as consumption is expected to be lower at 34.63 million tonne. Also, analysts fear that spare capacities might be put to use in the near term if metal prices rise further. Any meaningful recovery in aluminium prices is seen only beyond CY2010; per tonne prices are expected to average at about $1,900-1,930 in CY2010 and $2,200 in CY2011, as compared to the current price of $1,850.
Copper & Zinc
Lower demand, a sharp cut in China’s copper imports recently, higher inventory at LME and over 100 per cent increase in copper prices since March 2009, are near-term concerns for copper prices. In CY2009, global copper production is expected to be lower by 3.6 per cent, but consumption is seen falling by 4.6 per cent. Copper fortunes are only seen improving in CY2010 when production and consumption are expected to grow at about six per cent each.
In CY2008, Zinc’s global consumption grew by 0.5 per cent as against 9.1 per cent rise in production. Even during January to July 2009, consumption fell by 10.77 per cent, while production slipped by a lower margin of 7.17 per cent. Thus, inventories have piled up from a low of 70,000 tonne in September 2007 to about 436,000 tonne currently. Despite this, zinc prices have been rising as China, which consumes about 30 per cent of global zinc production, continued to import and accumulate its inventory. However, as zinc prices are up 73 per cent since March this year and inventories have risen sharply, prices are expected to remain subdued going ahead. Also, slowing imports from China and incremental supplies coming at higher prices might cap zinc prices. Analysts estimate prices to trade at current levels of $1,855 per tonne during CY2010 and CY2011. Any recovery is only seen in CY2012, when prices are seen at about $2,125 per tonne.
Sterlite industries
Sterlite Industries’ edge is its low cost of production and any recovery should mean relatively more gains for the company. In copper, while refining margins have improved from their lows, it has signed long-term contracts at 67 per cent higher rates as compared to CY2008. This year, revenues are expected to drop by about 4-5 per cent given the lower realisations; in 2010-11 though, realisations are seen improving by over 25 per cent. More importantly, operating profit margins are expected to improve from 22.2 per cent in 2009-10 to 30 per cent in 2010-11 due to cost reduction, better realisations and contribution of power business. Sterlite will be commissioning a total of 2,500 mw of merchant power capacities by July 2010; of this 600 mw capacity is being commissioned in October 2009. The power business would contribute almost 30 per cent of earnings in 2010-11. Overall, revenues will also be aided by expansion of its zinc capacity by 2,10,000 tonne per annum and doubling of aluminium capacity at Balco, both by October 2010. On the sum of parts basis, analysts value the stock between Rs 750-850 per share due to its stake in different subsidiaries and cash in the books.
Hindalco Industries
Hindalco is a leading aluminium producer and among the low cost producers globally. The performance of Hindalco’s US subsidiary, Novelis (accounts for about 70 per cent of the consolidated sales), is seen improving as demand in two of its biggest markets (US and Europe) is stabilising. Due to steps towards lowering costs and the recent improvement in realisations, Novelis’ EBDITA per tonne is expected to improve from $83 per tonne in Q4 2008-09 to about $180 per tonne in 2009-10 leading to higher consolidated profitability. Overall, aluminium business is expected to do well with higher prices and volumes on account of expansion of capacities and higher shipments recorded by Novelis. Its copper business (26 per cent of revenues) is expected to report revenues in line with last year’s levels, given the lower demand and realisation (refining margins). Overall, while fundamentals are improving for the company, most of the gains are already reflected in its rich valuations.
Nalco
Nalco, another low cost producer of aluminium globally, has been able to grow in terms of volumes despite the depressed LME metal prices. The company reported 20.46 per cent growth in its production volumes in June quarter. It has increased its alumina and aluminium production capacities by 31 per cent to 2.1 million tonne, and by 28 per cent to 0.46 million tonne, respectively. Revenues are however, expected to be lower by about 9-10 per cent this year, due to lower metal prices. Analysts estimate LME prices to trade lower, which will also mean lower realisations for Nalco as it mostly deals in primary aluminium products, wherein prices closely track the trend in LME aluminium prices. Operating profit margins, too, are seen lower at 26.5 per cent as against the 32.9 per cent in 2008-09. Analysts expect its aluminium volumes to grow by about 10-15 per cent in 2010-11. Nevertheless, the stock is over-valued and more than factors in the positives.
Ferrous metal—Steel
Globally, about 60 per cent of steel is consumed by the US, Europe and China. The recent recovery in industrial activities of these countries is some good news for the sector. This is also evident from the increase in steel production from the lows of last year. “Globally, the demand has improved partly due to the fact that most of the inventories were depleted and people are once again buying to build their inventories led by marginal recovery seen in the end user industries,” says Manoj Kumar Agarwal, MD, Adhunik Metaliks. The recovery however, is not strong as global steel demand in CY2009 is expected to be lower by about 9-10 per cent and is seen recovering only in CY2010 by about 4-5 per cent.
The results are also seen in global steel prices, which corrected from $1,100 per tonne in July 2008 to a low of about $400 per tonne in May 2009, and are now up to $550 per tonne levels. However, prices are not expected to move up fast and are seen hovering around $600 in CY2010 as demand is yet to pick up on a sustainable basis. Steel companies also believe that only if coking coal and iron ore prices move up sharply (earlier levels of $300 and $200, respectively), then prices will move higher.
Tata Steel
While Tata Steel’s European subsidiary, Corus (accounts for almost 80 per cent of consolidated revenues), incurred losses in June 2009 quarter, on the back of an expected revival in European economies, it is likely to do well. Corus’ capacity utilisation is expected to go up from 53 per in June 2009 to 70 per cent this year and about 80 per cent in 2010-11. Besides, recovery in steel prices along with measures to curtail production costs by $1.2 billion at Corus should help improve margins. While Corus reported an operating loss of $117 per tonne, it is now expected to report profits in 2009-10 and 2010-11 adding significantly to Tata Steel’s consolidated performance.
Tata Steel’s domestic operations are growing with strong volumes, however realisations are lower compared to last year. Its advantage of low cost of production and focus on long products has helped tap the emerging demand from the domestic infrastructure sector. Its steel volumes were up by about 22 per cent in quarter ended June 2009. Though fundaments are improving, analysts feel that the share price is up significantly and the stock can only be considered from a two year perspective on the hope that global economies recover as anticipated.
SAIL
SAIL largely sells its produce in the domestic market, which is also a reason that it is relatively insulated from the slowdown as local demand has been relatively better. However, its realisations will be lower this year, and thus, its revenues are expected to fall by 10-12 per cent. Positively, lower raw material costs (average coal cost was over $250 per tonne in 2008-09 and is expected to be $150 per tonne in 2009-10; it was $185 in June 2009 quarter) mean that operating profits should be slightly higher this year. The larger benefits will be post 2012, as its current capacities will go up from 11.4 million tonne to 20.2 million tonne by March 2012. Analysts believe valuations are not cheap.
JSW Steel
The recent recovery in steel demand and prices along with higher production and cost savings (led by lower coking coal and iron ore prices) have proved positive for JSW Steel, whose share prices has risen by 250 per cent since January 2009. JSW has recently added 2.8 million tonne of new crude steel capacity, taking its total capacity to 7.8 million tonnes. It is further expanding its capacities by 10 million tonnes by March 2011. Due to higher capacity JSW Steel has projected a 78 per cent growth in sales volumes at 6.1 million tonne for 2009-10. While analysts expect the volume growth to range 60-65 per cent, they believe it will not translate into revenue and profit growth, as realisations would be lower compared to last year. In 2008-09, average realisations were Rs 37,117 per tonne and are projected to come down to Rs 26,000-28,000 per tonne in 2009-10, due to lower steel prices. At the current levels, the stock is expensive.
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