Credit Suisse: Overview of Steel Pipe Industry

Indian companies aggressively adding capacity Of the ~6.5 mn tonnes of capacity being added globally over the next two years, Indian firms are adding 1.75 mn tonnes, or 27%. Capacity of Indian firms is expected to grow by 42% from FY08E to FY10E. Thus we view Indian companies as a good play on the expected surge in new pipeline demand, as well as pipeline replacement.

Will plate capacity additions hurt? We think not LSAW pipe (longitudinally welded submerged-arc welded pipe; uses plates) is superior to HSAW (horizontally welded submerged-arc welded pipe; uses coils) in strength, and hence preferred for offshore oil and gas transportation that typically operates at higher pressure, and where leakage can be very expensive. HSAW pipe was historically used for water transportation. For details on pipe technologies, please refer to Appendix I.

While LSAW is made from plates, HSAW is made of coils. Lately, plate prices have shot up, given a global supply shortage of wide-plate: in addition, so have HRC prices, but by not as much. This has made LSAW pipes more expensive by US$200-250/tonne (mainly a pass through of the US$200/tonne differential between plate and HRC), and has forced demand to move to HSAW. New HSAW technology has also improved strength and reliability, offsetting some concerns. About 70% of upcoming capacity for Indian companies is HSAW.

Wide-plates (width 3.5-5 m) are used for both shipbuilding and for large diameter line pipe: demand is very strong in both. The sustained high gap between HRC and wide-plate has attracted significant investment - we estimate 19 mn tonnes of plate capacity will get commissioned by FY10e. This should relax the current tightness in the plate market. Any declines in plate prices could make LSAW attractive again. Does that hurt Indian manufacturers adding HSAW capacity? We think not. At this stage the line pipe demand is expected to be strong enough to keep both LSAW and HSAW capacities globally fully utilised.

Converters have limited downside Pipe manufacturers are basically converters: history suggests 8-12% as the normal range for EBITDA margins. Volumes and prices for raw material (plate/coil) and freight (together 90% of the cost) are tied up soon after the contract is signed with the customer. The quantum of this hedge varies by customer, and typically ranges from 60 to 100%. The risk of overcapacity is slightly lower, as breakeven utilisation is typically a low 20%. Current economics suggest a cash payback of six years for green-field investment. Demand therefore remains the only risk.

Stable EBITDA margins Pipe manufacturers are basically converters: history suggests 8-12% as the normal range for EBITDA margins ( Figure 26 ). The reason for stability despite the volatility in steel prices is that volumes and prices for raw material (plate/coil) and freight (together 90% of the cost) are tied up when the contract is signed with the customer. The quantum of this hedge varies by customer, and typically ranges from 60 to 100%. Thus, on both cost and price prices are more or less fixed when the contract is awarded, reducing earnings risk. They are exposed for only ~1.5 months (time taken for bids to turn into customer orders, and for them to procure raw materials). In the event of demand disappointment, we note that there is also likely to be less price The risk of overcapacity is competition, especially as fixed costs (personnel, G&A expenses and interest costs) are slightly lower, as breakeven low. In fact, breakeven capacity utilisation for manufacturers is typically 20%. utilisation is typically a low This reduces chances of aggressive price cuts should demand disappoint negatively.

Short cash pay-back period attracting investment For a green-field capacity expansion the average capex for most of the mills set up in the US is US$333/tonne. This, we estimate, leads to a cash pay back period of about six years ( Figure 28 ). The surge in new pipeline build-out and expectation of replacement demand is providing sufficient visibility for pipe manufacturers to increase capacity.

Stock picking and valuation We believe stock picking in the current scenario comes down to: 1) volume growth, and 2) cost control by vertical integration. All Indian companies are adding capacity, but Welspun and Jindal SAW are expected to see an expansion in EBITDA margins as well. The expansion for Welspun is better quality - coming from vertical integration (plate capacity) and therefore we like Welspun more than Jindal SAW. Much of Jindal SAW’s margin growth comes from divestment of the US mills. The valuation excesses of the past few quarters have now corrected: given the macroeconomic uncertainty, we do not expect an expansion in EV/EBITDA multiples, but do not expect them to contract as well, given significant EBITDA growth.

Picks: capacity growth and vertical integration We have assumed that margin-accretive price increases will not happen from here onwards, i.e. EBITDA/tonne of pipe production will not increase. Stock picking in such a scenario comes down to: 1) companies that demonstrate strong volume growth, and 2) companies that can cut costs by vertical integration (e.g. setting up plate mills).

All Indian companies are expanding capacity significantly; however, the margin expansion is expected significantly for Welspun and Jindal SAW only. Therefore, we prefer Welspun and Jindal SAW over Man and PSL. That said, while Welspun margin expansion is estimated to come from higher vertical integration (a new plate mill), Jindal SAW’s margin growth comes mainly from divestment of its US assets to JSW Steel. The margin improvement in Jindal SAW’s DI (Ductile Iron) and seamless divisions is expected to have a minor impact on overall numbers. We therefore like Welspun more than Jindal SAW. We initiate coverage on Welspun with an OUTPERFORM rating and a target price of Rs 415 and on Jindal SAW with a NEUTRAL rating and a target price of Rs 690.

Valuation: multiple to stay their course Most global pipe companies are integrated companies and therefore a like-for-like peer comparison is inappropriate for Indian pipe companies which are essentially converters only. A comparison table is nevertheless presented in . A large part of the outperformance of pipe companies in the past year came from an expansion in multiples - this has largely normalised. Given macroeconomic uncertainty, we do not expect multiples to expand anytime soon. However, given that the Indian pipe manufacturers are undergoing rapid capacity expansion and are also expanding margins, we believe it is unlikely that the multiples will contract further. We have therefore valued Welspun at 7.5x FY09E EV/EBITDA and Jindal SAW at 6x FY09E EV/EBITDA.

Industry risks is demand, not supply Given the low breakeven utilisation, relatively steady margins and a relatively short payback period, we believe overcapacity is less of a concern than a lack of demand. Pipeline projects being capital intensive, financing is critical - the disruption in credit markets and the correction in equities could likely delay projects, and though less likely, create a receivables risk as well. We also worry about incomplete pass through of costs (if the company is not fully hedged), and of potential pricing pressure on HSAW caused by plate capacity addition globally.

Financial turmoil could delay projects, receivables Pipeline projects are capital intensive. Given disruptions in the credit markets and the sharp correction in equities, some announced projects may find it hard to get financing. In an inflationary scenario, where raw materials for steelmaking are rising rapidly, this is likely to raise questions on the viability of projects. This will very likely delay projects, and could potentially create receivables risk as well.

Incomplete pass through of costs The companies we cover normally hedge 60-100% of their exposure. If, however, steel prices were to rise sharply, it is very likely the pipe manufacturers will have to take a hit on margins. This has to be monitored on a project-by-project basis. That said, past performance of the companies (steady margins) provides comfort.

Pricing pressure on HSAW Most of the capacity addition by Indian pipe players is in HSAW where the demand is currently strong due to substitution of LSAW pipes driven by high plate prices. If the plate market softens, then the LSAW prices will decline and then there could be a switch away from HSAW pipes for oil and gas transportation.

Decline in oil prices could hurt demand As we have mentioned earlier, energy capex follows the trend in oil prices. Therefore, a significant decline in oil and gas prices beyond that we currently expect could potentially slowdown the orders for oil and gas pipelines.

Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective.The information contained herein is based on analysis and up on sources that we consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it.& take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations given in this blog.

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