Higher input costs and softening steel prices to sequentially impact profitability of steel companies from Q3 FY2022: ICRA

11 Jan 2022 , 10:40 AM

ICRA, in its latest research on the steel sector, has said that industry earnings are expected to trend downwards from the current quarter, Q3 FY2022, with higher input costs, especially for coking coal, creeping into the P&L of steel companies following spot prices skyrocketing to record levels. Further domestic steel prices have started to soften from the second quarter highs, which will also adversely impact the industry’s profitability. Nonetheless, the industry’s absolute profitability metrics will still remain at healthy levels in the next twelve months, leading the ratings agency to maintain a ‘Positive’ outlook for the sector.

During the last quarter, Q2 FY2022, despite a sequential moderation in steel spreads due to cost pressures, the domestic steel industry was able to record another all-time high quarterly profit, largely supported by higher deliveries following the recovery in economic activity post the second wave. Input cost pressures for domestic mills could moderate somewhat towards the later part of Q4 FY2022, as seaborne coking coal prices have declined by 20% since the highs of mid-November 2021, the benefit of which would slowly get reflected in mill margins after a lag of 2-3 months.

Elaborating on this, Mr. Jayanta Roy, Senior Vice-President & Group Head, Corporate Sector Ratings, ICRA, said, “Our calculations suggest that consumption cost of coking coal is expected to increase by around 65-70% sequentially in the third quarter. Though price of iron ore has been coming down, it will not be able to entirely compensate for the steep rise in coking coal costs. On the realisation front, taking a cue from the correction in Chinese export offers, domestic steel prices have witnessed corrections in the last fortnight. We therefore believe that the gross spreads for a primary steel producer, who is dependant on market purchase of raw material, would be sequentially lower by around 10% in the current quarter, and the industry’s third quarter earnings would be lower than the high-watermark achieved in Q2 FY2022.”

While China led the first leg of the recovery in global steel markets till the early part of CY2021, going forward, the sustenance of the upcycle in the second leg would hinge on the healthy demand momentum continuing outside of China. The World Steel Association’s latest short-range outlook forecasts a strong steel demand recovery in the ex-China steel markets of India, Japan, South-Korea, USA, Europe, and the CIS countries in CY2021 and CY2022, benefitting from higher vaccination rates and Government fiscal stimulus measures.

The post-monsoon demand recovery in India has been showing positive signs, with the monthly finished steel consumption in October 2021 reaching a seven-month high of 8.8 million tonne (mt) and representing a sequential uptick of around 7% over the previous month. However, if the rapid spread of the Omicron variant leads to an un-anticipated disruption in economic activity in the key steel-producing hubs as mentioned above, then the industry could see an accelerated process of mean-reversion of spreads in FY2023, much sooner than what is anticipated today. This remains a key risk which could well determine the durability of the current upcycle.

Following the metals meltdown of FY2016, and a prolonged downturn which persisted for several years, both lenders and steel mills became cautious on new investment projects. Between FY2017 and FY2021, the average annual capex for listed steel companies[1] was less than half (~42%) of the average annual capex seen during the previous five-year period spanning from FY2012 — FY2016. However, after a gap of eight years, with the industry’s capacity utilisation poised to touch 80% in FY2023 again, new investment activity has seen a rebound as lenders redraw their negative list for sectors following the earnings surge of steel companies.

“Unlike the last several years, where only the top 4-5 players were doing bulk of the new investments, this time around, we are seeing that even smaller steel players are considering investment in new projects as banks are willing to make fresh lending. Our estimates suggest that in FY2022, the capex spend for listed steel companies is expected to increase by around 70% year-on-year, albeit on a lower base. This uptrend in new investment activity would continue in FY2023 as well, when the industry is expected to report a 10-15% annual growth in its capex spend. However, if one puts the current capex cycle in perspective, the annual capex spend will still be much lower than the decadal peak achieved in FY2014,” Mr. Roy added.      

Given the strong earnings growth and capex curtailments following the pandemic related uncertainty, steelmakers started to aggressively deleverage since the second quarter of FY2021. This trend is reflected by the industry’s consolidated bank borrowings declining by 26% in a short span of eighteen months (March 2020 to September 2021). The industry’s consolidated borrowings today are at its lowest levels since March 2012. To put things in perspective, the domestic steel sector’s consolidated borrowing per metric tonne of installed capacity stood at US$ 176/MT[2] in September 2021, shrinking by almost half from US$ 350/MT prevailing in November 2008, when the last steel super cycle ended following the global financial crisis. This suggests that domestic steel companies are now significantly less leveraged than in FY2009. Given two back-to-back years of strong performance, the credit metrics of the domestic steel industry are expected to witness a significant improvement, with total debt/ OPBITDA reducing from 4.4 times in FY2020 to around 1 time in both FY2022 (F) and FY2023 (F). This makes the steel industry more resilient to withstand any future exogenous shocks in ICRA’s opinion.