Hupsteel @ 43 cts (Steel / Singapore) 2 comments
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1.Industry over-supply due to market flooding by China exports
2.Inventory may be worth less than book value
I find myself coming back to commodity plays rather frequently in my coverage of not to buy stocks. There has been HG Metal (steel as well), STX Pan Ocean (shipping), China Paper (paper), and now this. Perhaps it is because they are often misunderstoood to be good investments due to seemingly low valuations (especially PE) when they are not.
Hupsteel, like HG Metal benefited greatly from the high steel prices in 2004 and early 2005 when it saw its pre-tax profit margins clear 10% easily when in previous years it struggled to cross 5%. It had corrected from a peak of 49-50 cents to 36 cents due to a poor set of 1Q06 results (profit down 40% y-o-y) but in the recent rally which fuelled an oil and gas surge it has rebounded ~20% to 43 cents.
One must be clear: Hupsteel does serve the oil and gas sector but it mainly provides steel pipes and fittings, nothing more. These are typically low-margin products; I would be more bullish on instrumentation and engineering services providers to the sector which would have pricing power by virtue of their greater value-add. What the booming oil and gas sector does provide is a ready source of demand growth. There is also the local shipbuilding industry which is in full swing producing the vessels pencilled down in the order book from 2003-2005. That is another ready source of demand. Yet, why did Hupsteel's profit fall 40% on a 30% growth in turnover (probably fuelled by the above two sectors)?
Demand grows but one must also consider the supply side. Chinese steel imports have swung downwards so dramatically in the last two years due to massive domestic investment in the industry that it is now a net exporter flooding the world markets with crude steel. In 2004-05 alone, its production had reportedly grown by 30%. Its change from net consumer to net supplier has led to 40-50% price correction in the past year.
Such a tendency to over-invest in capacity seems to be a chronic problem that afflicts China in particular, and that is why I am often hesitant of buying China manufacturing stocks. Back to the main topic -- I had been observing the Asian steel price index (try www.crumonitor.com) and prices had apparently stablilised in August 05 after a sharp fall, but then it has started declining again in September. Such price weakness is suggestive of supply growth overwhelming demand growth.
I have been arguing my case on a macro basis because I think such a viewpoint should be adopted for a commodities industry where products from Company A and that from Company B are essentially the same (provided they adhere to certain quality standards); it is basically perfect competition and hence the important thing is to assess the tide, not the individual boats. I would avoid steel companies.... it takes a long time to work off all that excess production capacity, and meanwhile prices are just going to drop as producers try to clear off inventory.
Speaking of inventory, some might view Hupsteel's price support at 40 cents since its NTA per share is 40 cents. However, one should note that inventory comprises 50% of that (S$64M inventory in 1Q06 out of S$120M NTA) and that inventory has probably shrunk singificantly in value since then (note the abovementioned renewed fall in steel price index since Sep 05). Remember that this inventory was probably purchased at high prices in 2005: the sale of its previous cheaply-purchased batches was probably what had given it record profits in FY04 and FY05. HG Metal is now trading below NTA after losing money in 2H05: I would not be surprised if Hupsteel suffers the same fate.
(1) International Herald Tribune Jul 20 2005 article: China's demand for steel slows, but the mills keep churning