The decision by steel makers to cut prices was followed by a rally in steel stocks. Not that the price cut is good news, but the markets had already priced in a sharp drop in realizations.

In that light, the lowered prices don’t really matter in the spot market because on the one hand, demand is low, and on the other, traders are dumping stock. Actual prices in the spot market are much lower already.

What the markets seem to be excited about—based on the recent relief rally—is a possible improvement in liquidity, with the slew of measures by the central bank and the prime minister’s meet with public sector banks leading to assumptions that credit may be more easily available.

Even if liquidity gets better, it’s important to note that demand has begun to contract considerably. Tata Motors Ltd, India’s largest commercial vehicle manufacturer, reported a 48% drop in sales of medium and heavy commercial vehicles. Such companies will now curtail production— and hence use less steel— rather than add to already rising inventories.

Also See Heading South (Graphic)

But as pointed out earlier, a sharp drop in prices is already factored in. In fact, the current low prices reflect some other concerns. While the share price of Steel Authority of India Ltd has fallen to one-third of its peak earlier this year, that of Tata Steel Ltd and JSW Steel Ltd has shrunk to one-fourth.

The higher drop in the valuations of the private sector firms provides a clue of what the markets are worried about, besides falling prices. Both these companies are highly leveraged. Tata Steel’s net debt of about $10 billion (Rs48,600 crore) is nearly three times its market capitalization of $3.57 billion. The worry now is whether leveraged firms will be able to service their debt.

The key to the survival of some leveraged steel firms is that both demand and prices start looking up. Otherwise, some are expected to have technical defaults on their debt agreements with lenders, depending on the terms of the loan.

One of the common clauses include a pre-defined debt to Ebitda ratio. Ebitda is earnings before interest, taxes, depreciation and amortization. If demand and prices continue to drop, the denominator in that ratio will start to shrink rapidly, leading to technical defaults. What’s heartening is that the ratio is calculated based on past 12-month earnings, and since results for the first six months of the year have been decent, the financial position for the 12 months till March 2009 should look decent.

If the pain continues beyond that, both lenders and investors will get jittery all over again.

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