Why investors have fallen out of love with steel sector

What a colossal disappointment. Tata Steel’s 89 percent fall in quarterly net profit to Rs 212 crore from Rs 1,979 crore, mainly attributable to poor European operations, disappointed investors who then proceeded to pound the stock nearly 4 percent lower on Friday.

Clearly, the ongoing sovereign debt turmoil sweeping across Europe took its toll on the company’s operations there. While the European arm of Tata Steel posted a 19 percent growth in sales to Rs 21,160 crore, operating profit slumped a sharp 43 percent to Rs 505 crore. Furthermore, Rs 290 crore from the Rs 505 crore came from “other income”.

[caption id=“attachment_129172” align=“alignleft” width=“380” caption=“Operations in Europe suffered because of lower realisations. Reuters”]  [/caption]

Operations in Europe suffered because of lower realisations and higher raw material costs.In contrast, the Indian operations of Tata Steel, because of captive access to raw materials, reported better operating profits. While the company posted an operating profit of $360 per tonne in its Indian operations, its operating profit for European operations came in as low as $30 per tonne.

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As a result, European operations, which contribute more than 70 percent of the group’s consolidated sales, brings in only around 17 percent of the group’s operating profits.

So yes, it would be right to blame Europe for Tata’s Steel’s abysmal performance.

Sadly, things aren’t expected to get much better going ahead.While raw material prices have come down, steel prices have also softened, so margins are likely to remain under pressure.

Local demand is also slowing to a crawl, as evidenced by the Index of industrial production (IIP) for September , which grew by a dismal 1.9 percent. Capital goods production (for which steel is a major component), in particular, provided the biggest shock by contracting nearly 7 percent.

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According to ratings agency ICRA, growth in steel consumption slowed significantly to around 2.5 percent in the first six months of the current financial year (April to March 2012) from around 14.5 percent a year ago. Not surprisingly, the margin outlook for Indian steel companies has also weakened.

Indian companies are not the only ones grappling with demand issues.

A global phenomenon

Posco, one of the biggest steel companies from South Korea, saw its net profit margin contracting to 1.4 percent, while revenues remained flat from the previous quarter.

ArcelorMittal, the largest steel company in the world accounting for almost 7 percent of global steel production, also took a big hit.The Luxembourg-based company said its operating profits fell 29 percent in the third quarter (September-ending), which was at the lower end of its guidance.

The company has almost $25 billion in debt and recently, ratings agency S&P gave negative outlook, which means that its debt is just one step away from being labelled as junk.

Japanese steelmakers JFE and Nippon Steel, two other global giants, have also put up dismal performances this quarter. Nippon Steel, Japan’s largest steelmaker by output, posted a 56 percent drop in net profit while JFE posted a net loss of 34 billion yen.

While both steel-makers had been hopeful about increasing demand from reconstruction work post the earthquake, warnings of an global economic slowdown and floods in Thailand pose threats to the performance for the rest of the year as well.

A Standard Chartered report points out steel margins are not likely to recover in the near term, and might even slip further. With slowing demand and falling margins, steel companies won’t be firing up investor enthusiasm any time soon.