Tata Steel, JSW Steel Downgraded To 'Sell' By CLSA Despite Strong Volume Growth

CLSA reiterates its cautious stance on the Indian steel sector given that profit pools are moving from steel mills to miners, valuations do not reflect trough spreads, and there is a risk of stimulus from China.

The foreign research firm has cut Tata Steel Ltd. and JSW Steel Ltd. to 'sell' as it believes margins will be weighed down by weaker spreads. It stated that volume growth for both companies "is likely to be strong, helped by capacity expansion over the next two years."

CLSA lowered the socks' Ebitda estimate by -6% to +5% for FY24-26CL on lower spread assumptions and hence cut target prices on Tata Steel and JSW Steel by 7% and 10% to Rs 135 apiece and Rs 730 apiece, respectively.

"We raise our target price for Jindal Steel & Power Ltd. from Rs 820 to Rs 840 and maintain underperform, as we believe it is relatively better off because weaker industry spreads will be more than offset by the margin expansion projects," CLSA said.

Domestic Profit Pool To Shift From Steel Mills To Miners

• The sharp increase or ramp-up of blast furnace-based steel capacity in India over the next three years is likely to weigh on spreads and shift incremental margins from steel conversion to raw materials. As supply outstrips demand growth and reliance on exports rises, domestic steel prices are unlikely to trade above import parity.

• Higher steel production is likely to drive higher demand for iron ore and coking coal. The ramp-up of captive iron ore mines may not be adequate to cater to this demand, particularly in a rising export environment.

• "Hence, we expect the discount to import parity to narrow. With a 20%+ contribution to global imports, India is a key player in the coking coal  balance," the note said.

• A rise in blast furnace-based production in India would partly offset the impact of China avoiding Australian coal.

Valuations Do Not Reflect Trough Spreads

• Historically, the sector has given positive returns if bought at trough spreads, which are generally accompanied by low valuations. However, unlike in the past, valuation multiples for Indian steel companies have risen in the past 18 months while steel prices/spreads have corrected.

• This is likely driven by a better demand outlook, the expectation of a stimulus in China, and overall elevated valuations in Indian markets.

• "Consensus estimates are implying FY25/26 profitability in line with or above 3QFY24 levels, which we find unjustified. While spreads have compressed further in the past two months, 3Q numbers have been insulated due to the lag effect of cost  inflation," it said.

China Stimulus A Key Risk

A sustained higher demand in China, driving up spreads, is the best outcome for Indian mills given the self-sufficiency of iron ore in the country, CLSA said. However, if China production remains elevated with weak demand, spreads could remain lower for longer, it said.