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S. Vaidya Nathan

Rising demand for steel in China is likely to ensure that iron ore prices remain at high levels.

AN INVESTMENT can be considered in the Sesa Goa stock, as the outlook for earnings growth over the next couple of years appears attractive. The stock, which now trades on ex-bonus basis (the bonus offer was in the ratio of one share for every share held), is attractively valued, leaving room for sizeable gains. Even if we conservatively assume that iron ore prices rise by about 35 per cent, the stock trades at a price-earnings multiple of about six times its expected earnings for FY-06.

Business Line had a buy recommendation outstanding on the stock at Rs 736 (cum-bonus price) in October 2004. Though the stock has more than doubled, we remain bullish. Any weakness linked to the broad market in the post-Budget period can be used to accumulate the stock. Earnings growth may be more moderate on the high base of this year. The level of earnings and cash flows are likely to be healthy and provide a cushion to the valuation level.

Iron ore prices have been firm over the past couple of years, riding on the strength in the steel sector. The gains in iron ore prices have, however, been outpaced considerably by those in steel. The disparity has narrowed to an extent after the 71.5 per cent hike negotiated for various grades of ores by global majors — Rio Tinto of the UK and CVRD of Brazil — for supplies to Japanese steel producers in FY-06. This would be a significant spurt compared to the 9 per cent and 18 per cent hikes negotiated for the preceding two years. The average rate is likely to settle at levels that provide at least a 50 per cent hike compared to prices of FY-05.

If ocean freight rates remain stable or rise about 20 per cent, the effective price increase that Asian steel producers would have to bear for iron ore would be 30-40 per cent (ocean freight accounts for a substantial part of the landed cost of iron ore). Even if this is only partially passed on to consumers, steel producers are well-placed to absorb the rest in FY-06 due to high prices and healthy margins that they enjoy. Even if price increases in iron ore recede to more moderate levels in the subsequent years, the rise in FY-06 provides a high base that is likely to be largely retained. This points to encouraging prospects for Sesa Goa.

As domestic prices of iron ore are also likely to rise from April, the business environment appears conducive for continued buoyancy in revenues and earnings of Sesa Goa. A healthy rise in volumes — the pace is likely to be moderate compared to those of the past two years — is also likely to bolster revenues. The merger of Sesa Kembla (its 100-per cent subsidiary), which is also riding the momentum of firm trends in prices of metallurgical coke, would be accretive to the per share earnings.

Sesa Goa's investments in logistics and the imminent completion of a railway line that would provide a better link to the Paradip port in Orissa are also likely to improve profitability levels. As also the increase in the proportion of ore exports from Karnataka and Orissa as they are of superior quality. If Sesa Goa manages to secure more mining licences across several States, it could remove capacity constraints over the long term.

At the global level, steel prices may not post increases of the magnitude seen over the past couple of years. A degree of stability at the higher levels is, however, likely, unless there is a sizeable decline in Chinese demand. The latter, at the moment, does not appear to be a major risk despite China's efforts to slow down the economy. A gradual decline is expected to be a positive for commodity markets. In this context, Sesa Goa's supplies to Chinese producers, which have exhibited impressive growth over the past couple of years, augurs well.

Between 2005 and 2007, global majors such as CVRD, Rio Tinto and BHP Billiton are poised to invest aggressively in capacities. When they go on-stream, it could have a sobering effect on price increases and levels.

The higher degree of concentration in the mining sector compared to metals is likely to place the former in a position of strength when it comes to pricing power; mining majors could also temper production levels to maintain prices at higher levels that could shorten the payback for the big-ticket investment underway in capacity expansion. These factors could ensure that Sesa Goa's earnings levels are not dented by sharp decline in prices.

A substantial appreciation in the value of the rupee, infrastructure constraints that could curtail volume growth and lead to higher logistic costs, and restrictions on export of higher quality ores, could affect profitability and represent principal risks to our recommendation.

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