Tata Steel, Hindalco and JSPL shares are top picks in Metal space for Kotak Institutional Equities

Kotak Institutional Equities prefer Tata Steel, Hindalco and JSPL as their preferred stock picks in the Metals sector. Strong commodity prices coupled with muted costs will drive record margins for metal companies in Q3 FY21E. Strong steel prices (+20% qoq) and subdued coking coal costs will likely raise steel margins to record high levels in Q3 FY21E. With 13% qoq higher aluminum/zinc prices, base metal companies, too, should see a sharp improvement in margins. Companies remain cautious on capex spends and strong earnings should accelerate deleveraging. Higher exit prices in Q3 FY21 suggest margin uptrend and earnings upgrade in metals will continue.

Steel: Strong prices and muted costs to drive margins to record levels:

Regional steel prices hit decadal high in Q3 FY21 led by strong sequential recovery in demand across regions. Coking coal cost declined 1% qoq led by an import ban imposed on Australia by China, whereas iron ore prices shot up 11% qoq due to supply constraints in Brazil and Australia. China export HRC price increased 14% qoq to US $569/ton. Domestic steel prices witnessed a sharper improvement (+20% qoq) due to a tighter market and low inventory. Further, stronger domestic demand resulted in lower exports which would further boost realizations in Q3 FY21E. Coking coal prices corrected by 1% qoq in Q3 FY21 but given the inventory lag, we estimate a US$5-7/ton cost reduction for steel companies. Domestic iron ore prices increased 46% qoq on the back of strong domestic demand and higher regional prices which would hit non-integrated players like JSW Steel / JSPL.

Non-ferrous: Commodity price tailwinds to raise margins

Base metal prices saw sequential improvement in Q3 FY21E led by strong sequential demand recovery across regions, stronger than expected demand in China and weaker US$. Zinc and Aluminum prices increased by 13% qoq whereas Alumina prices remained stagnant (+2% qoq) during the quarter.

Strong FCF to accelerate deleveraging; valuations are inexpensive; prefer Tata Steel, Hindalco and JSPL:

Kotak notes that exit commodity prices in Q3 FY21 are 5-23% higher than 3QFY21 average and uptrend in earnings/upgrades should continue in Q4 FY21E (refer Exhibit 2). Most metal companies continue to remain cautious on capex spends and a strong second half FY21E FCF would significantly reduce leverage. Despite the recent rally, metal stocks are trading below their historic mean valuations. With stronger balance sheets and upside risk on earnings, Kotak sees further re-rating potential. Tata Steel, Hindalco and JSPL are preferred stocks to play the current buoyancy.