Metal Sector upgraded to Overweight (Centrum Capital Ltd.)
Meltdown over, time to solidify
- Sector upgraded to Overweight: Our upgrade is premised on stabilizing metal prices after a sharp rally and improving business confidence. Aluminium prices have risen 16% from their Dec 2008 lows while copper and zinc have surged 59% and 43%, respectively. However, steel prices remain mostly unchanged at US$425/tonne. Prices of base metals have increased 30- 50% in Nov 2008 and are stabilizing at the current level. Besides, we believe that weakening dollar would further give support to the commodity prices going forward.
- Return of business confidence the main trigger: We believe this price stabilization is the result of arrest in demand decline and decline in inventory as a result of production cuts, destocking and the return of buyers on increased business confidence.
- Earnings unchanged, but valuations upgraded: We have not revised the earnings estimates but upgraded ratings of metal stocks within our coverage on improved business confidence over last two months, based on China’s rising Purchase Managers Index (PMI). A stable government in India and increased business confidence would lead to higher investment and consumption, which would ultimately lead to a re rating of the sector.
- Valuing stocks on underlying commodity prices: We have valued stocks on the basis of underlying commodity prices, which we expect to remain stable going forward. We have considered the ratio of stock and underlying commodity prices to arrive at our target price under an optimistic scenario.
- Top Buy – Tata Steel; Top Sell – Nalco: We have upgraded Hindalco to Accumulate (Reduce) and JSW Steel to Accumulate (Reduce) as steel and base metals prices have stabilized and we do not expect further declines from current levels. We prefer Tata Steel and JSW Steel to SAIL, given the higher sensitivity of their earnings to steel prices. We retain Sell on Nalco with a price target of Rs240.
Sector upgraded to Overweight;Business confidence returns
Our upgrade is premised on stabilizing metal prices after a sharp rally and improving business confidence. Aluminium prices have risen 16% from their Dec 2008 lows while copper and zinc have surged 59% and 43%respectively. However, steel prices remain mostly unchanged at US$425/tonne. Prices of base metals have increased 30-50% in Nov 2008 and are stabilizing at the current level.
We believe this price stabilization is the result of the arrest in demand decline and decline in inventory as a result of production cuts, destocking and return of buyers on increased business confidence. Besides, we believe that weakening dollar would further give support to the commodity prices going forward.
Earnings unchanged, but valuations upgraded
We have not revised our earnings estimates for metals stocks under our coverage, but have upgraded our ratings as we believe overall business confidence have increased significantly during the last 2 months.
Increased business confidence would lead to a boost ininvestment and consumption ultimately leading to a re rating of the sector. India, endowed with major raw materials like iron ore, coal, bauxite, chrome ore and manganese has the potential to emerge as the leading global metal producer as the cost of production is among the lowest in the world. We believe with appropriate policies in place, India would attract lot of foreign investment as industrialized nations like Japan and western Europe have lot of surplus money waiting to be invested in high growth countries having access to key natural resources as growth prospects in their respective countries are near saturation level and going to worsen only due to aging population.
We believe that these natural cost advantage would make Indian companies much more valuable compared to its global peers over a period of time and as a result also, Indian metals companies would command premium valuation compared to global peers ultimately leading to a re rating of the sector.
Downside risk – another global financial crisis
A major global financial crisis like the one that unravelled in Oct 2008 would again bring down the prices of metals to the levels seen in Nov-Dec 2008. However, we believe that was an extraordinary situation which is unlikely to happen frequently. This gives us confidence about metal prices remaining stable if not increasing.
Stocks valued on basis of underlying commodity prices
We have valued metal stocks on the basis of the respective underlying commodity prices. We have calculated the ratio of each company’s stock price and underlying commodity prices and considered the ratio under optimistic scenario to arrive at a recommended stock price. We have used this valuation methodology for all the metal stocks except Jindal Steel & Power (JSPL) which we have valued on SOTP basis as it has 50% operating profit from merchant power business.
Tata Steel as top Buys; Nalco is our top Sell
We have upgraded Hindalco to Accumulate from Reduce and JSW Steel to Accumulate from Reduce because we believe steel and base metals prices have stabilized and we do not see declines from the current levels. We prefer Tata Steel and JSW Steel over SAIL as their earnings are more sensitive to steel prices. We have downgraded JSPL to Hold from Buy because of the steep run-up in the stock price. We also believe aluminium LME prices have stabilized at about US$1,500/ tonne and do not see much decline from the current level.
Hence we have upgraded Hindalco to Accumulate with a price target of Rs90 but retain our Sell rating on Nalco with a price target of Rs240.
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