These sectors look good: IT in the near term, metals over the long term
Munira Dongre 01 September 2010

Over the past month, the BSE Metals and IT indices have been sluggish performers. In the last few sessions they have actually slipped into a bearish mode. Is there an opportunity here? Or are IT and metal stocks best avoided?

CLSA, one of Asia's main brokerages, throws some light on the IT and metals sector in India. For metals, there is very little clarity about pricing. However, one thing is certain, says CLSA - "Indian metal firms are about to enter a phase of strong volume growth over the next three years as multiple projects get commissioned, which should drive faster earnings accretion for most."

The firm evaluated companies on six parameters - volume growth, gearing, product-mix improvement/cost-reduction measures, resource ownership, conversion costs and  commodity-price support and came up with Hindustan Zinc, Sterlite, Hindalco, Jindal Steel and JSW Steel as getting the best composite scores. "These companies are reasonably valued at 8.1-13.9 x FY12CL earnings," the report says. However, it believes that these stocks will offer superior returns only over 18 months. This is not a short-term bet.

CLSA prefers base metals to iron ore and steel. Among non-ferrous metals, it prefers aluminium to zinc on a relative basis and expects iron-ore prices to decline from the current $148/tonne to $90/tonne by 2011. Its resources team believes that seaborne iron ore supply will grow faster than demand from 2H10 and break the decade-long trend of undersupply.

This will also put pressure on steel prices. While it accepts that oversupply still exists in nonferrous metals, it prefers aluminium to zinc, based on cost support and because aluminium benefits from renminbi appreciation (Chinese smelters are not as cost effective).

According to CLSA, volumes will actually average a 15% compounded annual growth rate (CAGR) over 2011-13, compared with 5% in 2008-11 - a threefold jump. Most of the capacity is coming up in steel and aluminium. Take a look at the timeline below (Source: CLSA report dated 30 August 2010).

Of the projects above, CLSA envisages delays for SAIL, Sesa Goa, Sterlite Energy and Vedanta Aluminium. Vedanta Aluminium has been denied approval to start mining bauxite at the Niyamgiri hills.

Sterlite Energy's first 600MW unit has seen a six-month delay and there could be some delays at the remaining three units as well.

Within the steel expansions, the most competitive one is by JSPL at $602/tonne against global average costs of $1,000/tonne while Tata Steel and SAIL will prove to be the most expensive at $975/tonne and $1,000/tonne. However, most are relatively lower than the global average and hence, competitive. The aluminium expansions are at a much lower cost than the global average: BALCO at $2,328/tonne, Vedanta Aluminium at $2,336/tonne, and Hindalco at $2,761/tonne against a global average of $4,000.

While volume growth is expected to accelerate for most metal companies, the highest will be experienced by Sterlite (26%-48% volume CAGR), Sesa Goa (20%-25% CAGR), Jindal Steel (10%-25% CAGR) and JSW Steel (7%-40% CAGR).

CLSA does not foresee any supply off-take problems. It points out that "India is a net importer (of steel) but is a net exporter in aluminium and zinc. However, Indian aluminium and zinc producers feature lower on the global cost curve and it is highly unlikely that they will face a problem selling their output in global markets." The broker also points out that companies like Hindustan Zinc and Sesa Goa will acquire global scale after expansion. In fact, Sesa could become the world's fourth-largest iron ore company in four years (even though it will still be far behind the top three) while Hindustan Zinc is set to become the world's largest zinc producer.

As mentioned earlier, CLSA ranked Indian metal firms on six parameters to come up with favourites. In terms of volume growth, Sterlite, Sesa Goa and JSW Steel were the best. In terms of gearing, Bhushan Steel and Tata Steel scored the lowest while Hindustan Zinc, which has net cash of $2.5 billion, Nalco with $600 million and SAIL with $1.2 billion scored the best. In product mix and cost-reduction measures, Bhushan Steel and JSW Steel scored the best. Hindustan Zinc, Sesa Goa and JSPL got the best scores in resource ownership while Hindustan Zinc, Sesa, Bhushan and JSW scored highest in conversion costs.

Turning to IT, CLSA has a near-term positive view. It believes that with order-book trends pointing up and IT budgets improving over the next couple of months, stocks should do well. It prefers Tier-I stocks over Tier-II ones and reiterates Infosys and TCS as top picks.

It says, "Over 52% of the 118 CIOs surveyed this month indicated that their 2011 IT budgets could be up y-o-y in 2011 with 41% indicating that services outsourcing to low-cost locations will rise through 2011."

CLSA does not expect the kind of industry-wide pricing pressure seen in FY09. It expects attrition to reduce, going forward. It believes that "protectionist noises (from the US) have been driven by the mid-term senate elections in the US and should go down post Nov 2010."

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