“Blast furnace” can sound so hot and dramatic, and lately the performance of Nippon Steel & Sumitomo Metal Corp.’s shares ( 5401.JP ) has been full of heat and drama.
Japan’s largest steelmaker saw its beaten-down shares jump 5.3% last Friday. Some people might attribute this surge to Bank of Japan’s surprise announcement that it is firing up its monetary easing program, but Nippon had outgunned Japan’s Topix benchmark by a full percentage point. No, Nippon’s thrust was also helped by the positive second-quarter results it reported Thursday, and Friday’s BOJ announcement had merely provided added ballast.
Why are investors warming up to Nippon Steel’s highly cyclical business? First, it exports nearly half of its output, so expectation of a further weakening yen helps those exports stay competitive against China’s seemingly never-ending production of the metal. Second, the Japanese central bank’s commitment to lowering financing costs should help boost construction spending, a boon to domestic demand.
Created in 2012 by the merger of Nippon Steel and Sumitomo Metal Industries, the steelmaking giant saw net income come in at 112.2 billion yen for the first half of fiscal 2014, which beat analyst expectations. Second quarter “recurring profit” came in at JPY102.0 billion, far exceeding the JPY78.5 billion expected by analysts.
The result would have been significantly better had it not been for four power failures since January, and one fire accident in September at the company’s Nagoya plant, which supplies automakers including Toyota ( 7203.JP ) and Suzuki ( 7269.JP ). Additionally, market expectations were boosted as management, surprising analysts, kept its forecast for fiscal 2014 recurring profit at JPY400 billion, despite the Nagoya accidents.
More important, profits growth was largely driven by high-margin products such as heavy plate and seamless pipes for energy applications. Such high-margin, value-added products are important in a world of excess global steel capacity, where China continues to produce and export significant amounts of low-margin, commoditized crude steel. As a result Nippon Steel’s operating margins are 5.4% - better than roughly 4.8% for POSCO (005490.KR), 4.2% for JFE Holdings ( 5411.JP ), and 4.3% for China’s Baoshan Iron & Steel (600019.CN).
Despite last Friday’s pop, Nippon Steel’s shares are down nearly 18% this year. JP Morgan analyst Kazuhisa Mori thinks the Japanese steel sector is attractive with sales to shipbuilders, and exports. “Swelling in demand for construction steel should offset the weakness of demand from automakers,” so that recent share price weakness and pessimism over the sector is probably overdone.
The stock’s valuation also still looks cheap. According to JP Morgan’s calculations, Nippon Steel should trade at 1.2 times book value, instead of its current 0.9 times. The firm gives it a December 2015 target price of JPY370, 28% higher from Friday’s close.
Credit Suisse also expects the share price to perform well given the company “appears capable of booking solid profits even in the face of difficult fundamentals,” such as the slowdown in China and difficult steel price environment in Asia.
But it’s not all smooth sailing. While Nippon Steel’s “metal spread” – the difference between steel and raw-material prices - improves with falling prices for iron ore and coking coal, what NSSMC gains in one hand, it gives back somewhat in the other. The company’s Robe River iron-ore joint venture with Rio Tinto ( RIO.AU, RIO ) ensures that it is partially hedged against fluctuations in raw materials prices. As Jefferies notes, Nippon Steel has higher exposure to natural resources than steel rival JFE Holdings. Thanks to the recent fall in oil prices, Jefferies also thinks there is a risk of “lower demand for seamless pipes or buyers negotiating lower prices.”
But for those who believe the BOJ is determined to drive Japan’s economy forward, Nippon Steel ultimately is a good bet. The company’s high quality product mix, and further synergies from its 2012 merger are important factors that give the company an edge over rivals. Add to these the possibility that China’s reforms may help install some discipline in its own steel sector, which would tighten up the regional market, and you’ll have an even hotter and dramatically more bullish outlook for the Japanese steel giant.
Source: online.barrons.com
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