The rally is broad-based all right. Old economy scrips have been especially glowing with the bulls showering attention on them. But even amongst equals, there are bull favourites: Steel is hot.

The market capitalisation of steel stocks has risen by nearly 180 per cent since January 1, 2003, with steel scrips bettering their 52-week highs month after month.

Top steel scrips like SAIL (Rs 43.00, up 323.64 per cent), Tata Steel (Tisco) (Rs 358.70, up 137.57 per cent), Jindal Vijayanagar Steel (Rs 16.37, up 200.36 per cent) and Ispat Industries (Rs 14.09, up 147.19 per cent) have been among the biggest winners during the period.

Can the rise in steel stocks be sustained? The run-up has been driven by two main factors.

Firstly, the industry has seen an improvement in the demand-supply scenario and steel prices have been improving steadily, enhancing the industry's price realisation.

Secondly, a significant reduction in interest rates over the past three years has enabled many debt-laden companies to restructure their borrowings and save on interest costs.

Both these factors seem to hold potential for further improvements in the fundamentals of steel companies. Steel prices continue to be buoyant on the back of strong domestic as well as global demand.

The run-up is simply a function of the huge surge in demand and prices, say analysts. This has resulted in a near billion dollar investment spree by the country's steel manufacturers with leading companies bracing themselves to meet present and future demand.

Steel companies have also managed to put in improved financial performances during FY03 and the first quarter of the current fiscal, adding fuel to the run-up in prices.

"Good quarterly numbers by previously loss-making companies, the jump in international prices and a couple of price hikes in the last six months have been the main reason for the surge in steel counters," says Bhavin Chedda, analyst with domestic securities firm Pioneer Intermediaries.

For the financial year 2002-03, Tisco recorded a 394 per cent rise in net profit to Rs 1,012.31 crore, while SAIL pared losses from its previous year to Rs 304.31 crore.

Jindal Steel and Power and Jindal Iron and Steel (JISCO) also put in impressive performances during the first quarter with the former posting a net profit of Rs 50.30 crore (as against Rs 31.60 crore in first quarter last year), while JISCO reported a y-o-y increase of 109 per cent with net profits at Rs 20.30 crore.

According to analysts, the better performances by steel companies have come on the back of higher exports and workforce rationalisation.

The industry also benefited from reduced interest costs, thanks mainly to the comprehensive debt restructuring programmes undertaken by many major companies.

With cash flows improving, companies have also seen a reduction in working capital. Interest costs could fall further as Jindal Vijayanagar, Essar Steel and Ispat are planning to refinance a substantial portion of their remaining debt at lower cost.

As compared to previous years, big companies have seen a major reduction in their interest costs. Tisco and SAIL have seen their interest costs fall 19.06 per cent and 23.84 per cent respectively in FY03 as compared to FY01.

More cheer has come in the form of news that the government is likely to ease restrictions on external commercial borrowings (ECB), which will allow companies to access cheaper funds from abroad.

"The debt restructuring exercise has improved their balance-sheets. High interest rates had weighed on financial performances in the past, but now lower rates have meant that earnings have gone up," notes Kunal Mittal, analyst with Mumbai-based securities firm Pranav Securities.

According to Anant Katare, analyst with Khandwala Securities, domestic companies are much healthier now.

Thanks to improved realisations, companies are also improving capacity utilisation, says Mittal. The highly capital-intensive nature of the industry means that even small increase in capacity utilisation lead to better margins.

"Domestic consumption has been on the rise and exports have also gone up, leading to healthy bottomlines. Demand has also picked up this year, especially for long-products, which is good news for Tisco and SAIL," adds Chedda.

What is driving demand?

"With global and domestic demand improving, steel prices are now hovering around their all-time highs," says Katare.

"Domestic demand has been high mainly because of public infrastructure demand. The housing sector has also seen a boom because of the low interest rate regime," adds Mittal.

As for global demand, the answer lies in one word: China. "Global steel production has gone up significantly in the last three years. Nearly 80 per cent of the increase in steel production in 2003 has come from higher demand in China. China has been witnessing huge construction activity during the past year, mainly on account of the Beijing Olympics in 2008," notes Mittal.

Chinese demand today accounts for 29 per cent of Tata Steel's exports, 35 - 40 per cent of SAIL's and 35 per cent of Essar Steel's.

Chinese demand had a direct impact on India's steel performance in the first quarter of FY04 (April-June 2003), with exports jumping up by 40 per cent in comparison with last year.

According to analysts, steel exports to China will contribute around 33 per cent of India's steel exports in FY04. China's steel demand is expected to rise this year to 257 million metric tonnes, up 22 per cent from 2002. And that market is not in any danger of drying up.

"Demand from China is expected to continue even after the Olympics. Further, there's a big housing boom happening in China, which will also drive demand" says Mittal.

While exports look a definite bright spot, domestic demand is not expected to slacken either.

"Domestic consumption is showing positive trends. No new capacities are being added, which will ensure better utilisation. Demand is slated to grow by 5 to 6 per cent," says Chedda.

Price trends look robust

Domestic prices of steel products have more-or-less followed global trends and have witnessed a rise starting in the last fiscal.

Even though prices saw a correction in the first quarter of this year, mainly due to slackening demand in China due to the SARS scare, analysts don't expect that to continue.

Compulsory licence logjam

What is going right Improvement in demand-supply scenario and upturn in steel prices Reduced costs due to corporate debt restructuring Domestic demand as well as exports (mainly to China) are rising Global and domestic prices are expected to sustain at higher levels What can go wrong Old capacities in countries like Japan, US and CIS countries, which have been shut down, may come up again Possibility of reduction in steel import duties If the US economy fails to pick up, new tariff structures may come in place, restricting trade

As long as Chinese demand stays robust, domestic prices are likely to remain firm. Low inventories and increases in the prices of raw materials are also expected to keep domestic prices buoyant.

"International prices have been showing an uptrend and are expected to sustain for the next two quarters at least," notes Chedda. Mittal is of the view that global prices are likely to sustain at the higher levels at least for the next one year.

According to reports, prices of steel are rising in the US and Asia as demand is outpacing supply. A 7.4 per cent rise in worldwide demand for steel is expected next year, compared with an estimated 5.5 per cent this year.

Indian companies have been quick on the draw. In early August, steel producers, including SAIL, Tisco, Essar, Jindal and Ispat, had increased prices on an average by Rs 700-800 per tonne for flats, with another Rs 500-700 per tonne increase taking place on August 14. And there is more to come.

Some leading domestic companies had said during the last week of September that they expected domestic steel prices to soar in the coming months as global prices were likely to firm up through the next quarter.

Outlook

With things looking rosy, sector watchers are generally bullish. "The big construction activity happening in ports and roads, and higher demand from the automobile sector, will keep demand high in the foreseeable future. India also has a cost advantage because of the rupee's appreciation against the dollar," notes Mittal.

India is one of the lowest-cost producers of steel globally mainly due to easy availability of raw materials like iron ore and coal, and cheap and skilled labor. "The industry outlook is positive," concludes Mittal.

The international outlook is looking good, too, with global steel output slated to grow by 4 to 5 per cent, driven mainly by China and India.

And worries about a demand-supply mismatch seem to be out of place, since worldwide consumption of steel is expected to increase to 90 per cent of global capacity from 86 per cent during the current calendar year.

What are the possible downsides to what looks like a win-win scenario for steel companies?

"I don't see any particular downside at the moment for the sector. However, if the US economy fails to pick up and even goes down further, that could prove a dampener, cautions Mittal. An imbalance in global demand-supply equations could also upset the applecart, warns Katare.

"In Japan, CIS countries and several South American nations, capacities have been shut down in the past. With demand and prices running high, these capacities may again come back on stream, which could in turn disturb the demand-supply balance."

Chedda expresses concern about the possibility that international prices could weaken, but even that is not likely to happen for the next three to four quarters.

There are worries on the domestic front too, like a reduction in import duties during the next Budget. But, according to Chedda, that is unlikely to happen with the government already denying any such move.

The markets, meanwhile, remain extremely bullish on steel. "The order book position for many Indian companies is robust for the next few months. The markets are discounting the expected better performances of steel companies, but even so the overall positive scenario is likely to keep steel scrips strong in the immediate-term," says Chedda.

Chedda picks Tisco (P/E - 10x) and SAIL (65x) as his favourites among peers, mainly because of their strong fundamentals and earnings potential.

According to Mittal, stock prices could see a small blip in the short-term, but over the longer term they are expected to outperform. Mittal puts Tisco among his top picks, apart from Jindal Steel and Power (8x).

Are the markets happy with the valuations? "The P/Es of domestic steel companies are in a band between eight and 25," notes Katare.

However, valuations of certain second-rung companies have run ahead of their fundamentals. Some market watchers believe that most of the good news has already been factored into stock prices.

Being a commodity sector, steel's valuations cannot run way beyond projected long-term economic growth, warn some. With the GDP growth rate expected to be around 6-7 per cent, their view is that steel scrips should ideally be trading in single digit P/Es.

But the bull run in these counters has ensured that most of the smaller companies already have stretched valuations.

"While strong, integrated companies with a good product portfolio like Tisco are still running in low P/Es, several second-rung companies have astronomical P/Es," says Katare.