Can JSW Steel recover from the Bellary blow?

What a difference one week makes. On July 26, JSW Steel released its financial results for the three months ended June, most likely oblivious of the storm it would get caught up in just three days later.

Analysts commended the company’s quarterly performance, and some of them even rated the stock a buy.

Then, the bomb fell. On July 29, media reports said the company, along with Adani Enterprises and NMDC, had been named in the Lokayukta report for illegally mining iron ore, paying bribes and engaging in other unethical corporate practices. The stock crashed 20 percent over the next week.

On August 1, its shares plunged 10 percent and hit a 52-week low, after Citi downgraded the stock, halved its price target to Rs 612 and rated it a “sell”. In fact, in the three trading sessions until August 2, the entire OP Jindal-led JSW group lost a little more than Rs 4,800 crore, according to one report .

It was a complete turnaround in market sentiment, as investors panicked over the possible consequences of the Lokayukta report, which concluded that local government officials and companies had cheated the Karnataka state government of crores of rupees in royalties and taxes by trading in iron ore locally and internationally. In addition, companies were found to have mined in forests that were supposed to be protected under conservation laws.

JSW Steel, in particular, was supposed to have cost the Karnataka state government Rs 325 crore. The company is also accused of transferring Rs 10 crore to an educational trust run by the family of indicted chief minister BS Yeddyurappa in March 2010.

In addition, the anti-graft report said JSW Steel had illegally received 1.29 million metric tonnes (mmt) of iron ore from April 2009 to July 2010 for which it didn’t pay royalties to the state government. The company, however, clarified on July 29 that all transactions had been done in a legally-compliant manner.

The focus of the inquiry was chiefly on illegal iron ore mining in Bellary in Karnataka. Bellary is an iron-ore rich region, which produces about 35 million tonnes of iron ore annually, about 80 percent of Karnataka’s total production.

Karnataka is India’s second-largest producer of iron ore; it produced about 46 million metric tonnes of iron ore in 2009-10, of which 20 mmt was exported. More than half of the output is exported to China.

Just as the Lokayukta report focussed attention on the illegal mining issue, the Supreme Court – on the same day – added to the pressure by banning all mining activities in Bellary on environmental concerns.

Can JSW continue?

The ban has affected not just JSW Steel but several mining companies that have operations in the region. Iron ore is an important raw material for steel manufacturing and accounts for 15-16 percent of the overall cost of production, according to industry experts.

JSW Steel has a steel production capacity of 10.3 mmt per annum, and is currently in the process of expanding capacity. Until the ban, about 50 percent of its iron ore requirements used to come from Bellary while another 30 percent was sourced from captive resources. The remaining 20 percent came from purchase agreements with NMDC and Mysore Minerals.

Incidentally, iron ore mined from Bellary is supposed to be one of the world’s best grades, and therefore, cheaper to process, according to industry experts.

After the ban, about 30 percent of what was sourced from Bellary has shifted to the neighbouring Chitradurga district, while arrangements have been made to procure the balance 20 percent from outside Karnataka, the company said late last week.

But on August 2, the steel manufacturer admitted that it was running very low on iron ore inventories, adding that it had cut production at its Vijayanagar plant in Bellary by 35-40 percent.

Uncertainty over alternative sources of iron ore supply is a key reason why Citi downgraded JSW Steel’s stock to a sell. “The order to ban mining in Bellary means JSW Steel cannot get ore from its own mines or from NMDC-owned mines in the district,” its note said. Other market experts also believe that JSW Steel might have to cut down steel production this year as a result of the disruption to iron ore supplies, despite the “we are doing fine” claims of the company.

So, the big question for investors is, what happens to the stock? Even after its dramatic fall, the stock still commands steep valuations, with a price-to-earnings ratio of about 17 compared with rival Tata Steel’s 8, based on the estimated earnings for each company for the year ending March 2012. Moreover, Citi estimated JSW’s earnings per share for the 12 months to March 2012 at Rs 38, a steep drop from Rs 68 the previous year, signalling concerns over lower output.

Morgan Stanley, through its Mauritius arm, also sold about 12 lakh shares of the company on August 1.

What does all this mean? The most likely conclusion is that JSW Steel’s shares could fall further in the medium term. And Bellary’s loss might not be the only problem. Another problem could be brewing in Ispat Industries, which it acquired for Rs 1,800 crore in December 2010.

The company is talking to banks to negotiate a refinancing deal on the Rs 7,500-crore debt in Ispat. But the recent rate hikes and the negative publicity from the Lokayukta report could mean that sealing that deal could take longer than expected. However, on August 3, a news report said the company had worked out a refinancing deal worth Rs 6,000 crore with financial institutions.

In addition, Business Standard newspaper reported that the company could face problems from the Bengal government for failing to make much progress on its steel project in the state.

Yes, at the moment, JSW’s investors have a lot to worry about.