Bulk prices are set to increase sharply with iron ore and coking coal prices to touch near historic highs in 2010, at a time when demand in Europe continues to be approximately 25% below 2007 levels. We believe this lukewarm demand environment will make it difficult for Corus to pass on and sustain, the entire hike in raw material prices.
However, domestic operations will see their cost advantage widening and will continue to be the significant contributor to consolidated earnings. Valuations do not provide any comfort and leverage at 2.3 times could entail further dilution. We retain sell.
Graphic: Yogesh Kumar / Mint
Tata Steel Ltd’s backward integration will translate to an increase in the company’s cost advantage as raw material prices increase. We expect earnings before interest, tax, amortization and depreciation/tonne for stand-alone operations to increase by approximately $50 to $315. This translates to an increase of 45% in our FY11 earnings per share estimate, to Rs60. Brownfield expansion at Jamshedpur will start in the second half of FY12, somewhat later than the previously targeted commissioning date of April 2011.
Prices of steel-making raw materials have skyrocketed in recent years. Iron ore prices have risen from $20 per tonne in FY03, when the strong rally in steel was yet to start, to $62 per tonne in FY10. Over the same period, coking coal prices have increased from $48 per tonne to $129 per tonne. A look at prices in the spot market suggests that metal prices are poised for another surge in FY11. We expect iron ore prices to increase by at least 60%, to hit a new 10-year high, and coking coal prices by 55%, to their second highest level in the past 10 years.
According to industry estimates, approximately 80% of steel production comes from non-integrated steel mills which depend on third parties for their supply of metallic supply. Blast furnaces without backward integration account for 50% of global steel production. A further 30% of steel production comes from electric-arc furnaces, which depend on scrap. Under normal market conditions, scrap prices move in line with prices of iron ore and coking coal. This implies that over 80% of steel-making capacity is likely to face a cost increase in FY11. We estimate production cost of non-integrated blast furnace to increase by $100 per tonne to $120 per tonne.
Since a large part of the industry is likely to see a cost push, we expect steel producers to pass on this increase to their customers. Steel makers’ margins have historically not suffered much even as when raw material costs increased, as they usually passed on the bulk of the price increases.
In earlier years, when metallic prices were spiralling, the steel industry’s capacity utilization was running high at over 90%. Additionally, during 2002-2007, steel demand globally grew at 8% annually, enabling steel makers to pass on the steep increase in metallic prices to their customers. The continued strength in demand resulted in a sustained increase in capacity utilization. Globally, capacity utilization of the steel industry rose from sub-90% till 2003 to over 94% during this period of strong demand.