Multi Baggers

Hindustan Zinc

Company profile:

Hindustan Zinc is India’s sole integrated zinc producer with more than 80% of the market share. The company is currently the second largest integrated zinc-lead producer in the world. It is in the process of expansion after which it will become the largest integrated zinc-lead producer globally, surpassing mining major Xstrata. However, in terms of pure smelting it will be the third largest after Nyrstar (1,030Ktpa) and Korea Zinc (940Ktpa). Post expansion, its Rampura Agucha mine will also be the largest zinc-lead mine in the world with a capacity of 6mtpa of ore, surpassing the Red Dog mine in North America.

Currently, HZL operates four mines, two of which are open pit –Rampura Agucha and Sindesar Khurd. In FY08, the company mined nearly 5.8 million tonnes of ore, of which 4.1 million tonnes came from RAM. RAM is not just one of the largest mines in the world, it is also one of the lowest cost producers. With an average zinc grade of 13.9%, it is the second richest after Red Dogwhich has a zinc grade of 18.2%.

Financial Position:

The net revenues of the company declined by 28% from Rs 78,778 crore in FY08 to Rs 56,753 crore in FY09. The company has net cash of $ 1.9 billion, or Rs 236/sh (35% of market cap). It is on course to become the largest integrated zinc company, with a 50% increase in capacity expected by mid-2010 at an estimated capex of $ 750 million. We estimate that cash levels will reach Rs 375/sh by 2012 despite this capex.

While FY10 earnings are likely to be subdued due to low zinc prices, the situation is expected to take a turn for the better in FY11. We expect an earnings CAGR of 4.8% over the next two years. EBITDA margin will be under pressure at 47% in FY10 before returning to the normal levels of 50% in FY11. The tax rate is likely to be favourable even in FY10 due to the export oriented status of its new smelter. This tax benefit can continue even further but we have not considered any benefit beyond FY10.

Investment Positives:

On the cost front, power & fuel takes up 20–25% of the total cost, a bulk of which is towards coal purchased to fire captive power plants. This cost is expected to come down substantially as coal prices have declined and the company’s captive coal mine is expected to start operations in a few years.

After touching a low in December ’08, zinc prices have staged a smart recovery and the worst seems to be behind us, even though a full recovery may be protracted.

Positive news expected on government stake buyout. Though HZL’s parent company has not exercised its call option on a 29.5% stake held by the government, we expect a decision on the issue to be taken as soon as the new fiscally challenged government gets down to task.

Key concerns:

Shrinkage in overseas demand:

About 25–30% of HZL’s output is exported. With the current meltdown in overseas demand, the company may be looking to divert some of its output to the domestic market. But HZL already commands more than 80% of domestic market share, making it harder to push extra volumes. Recently, the company has been selling concentrates rather than metal in the overseas market, indicating that it is easier to push concentrate to custom smelters with higher Tc/Rc rather than sell the ingots directly.

Rupee appreciation:

HZL’s final products (zinc, lead) are priced in dollar terms, whereas its costs are in rupee terms. Over the past year the company has benefited from a depreciating rupee, but with a strengthening local currency, profits may be hit. According to our estimates, every 1% rupee appreciation from our base case (Rs 48.5/US$) will lead to an EPS decline of 1%.

Increase in royalty rates:

Currently, the company pays 6.6% of the prevailing market price for metal contained in the ore mined. At the current price of zinc, this amounts to US$ 96/t or 15% of total cost of production. The government may consider revising these rates under various circumstances such as the local government asking for a bigger share of royalty proceeds. This would lead to an increase in costs and decline in margins for HZL.

Valuation:

In our view, Hindustan Zinc is one of the least risky stocks, with low-cost operations, strong growth and a cash-rich balance sheet. HZL’s price multiples have historically been inversely related to zinc prices. With zinc prices trading at their lows and earnings expected to be depressed, we feel the company should command a multiple premium over its historic average. We have therefore valued HZL at 8x FY10E EV/EBITDA. At our target price of Rs 800, the stock will trade at 12x FY10E EPS and 2x BV. We recommend HZL as a Buy and the safest exposure to base metals.

*Price adjusted for bonus and split

Disclaimer : The share finds a place in the Portfolios of several PMS clients of P.N.Vijay Financial Services P Ltd of which P.N.Vijay is the Managing Director. It is also a part of his personal holdings.