High earnings visibility and huge cash hoard guard against valuation risks

Hindustan Zinc?s (HZ) stock price has corrected by 19.3% in the last four months (Sensex correction of 4.5%), primarily on account of a fall in LME (London Metal Exchange) zinc prices; however, the market has failed to recognise that INR depreciation has kept HZ?s realisation intact and since most of its costs are in INR, HZ should see stable margins, in our view. At the same time, HZ has cash of R42/share, which provides strong support to the stock price. With its fundamentals remaining intact, we upgrade the stock to Buy and raise our TP (target price) to R141, from R139.

Catalyst: Along with stable earnings in a difficult operating environment, the potential sale of the government of India?s 29.5% stake to Sterlite Industries could be a key trigger for the stock.

Valuation: After a 19.3% correction, HZ currently trades at 8.4x FY13F (forecast) P/E (price to earnings ratio) and 1.6x FY13F P/B (price-to-book value). The stock is trading at a discount to its long-term average multiple of 10x (times) P/E despite strong earnings visibility and cash position. We value the stock at 10x FY14F EPS (earnings per share) of R14.1. We build in higher royalty from FY14F (on account of the new mines and minerals Act) and a likely gradual rise in the tax rate. We also expect zinc realisations to remain at current levels. There could be 10-12% upside to our FY14F estimates if the mining Act is deferred.

Favourable risk-reward? earnings visibility and cash support the key: We believe that HZ is among the most transparent and clean companies in the Indian metal space with: (i) focused business areas without any baggage; (ii) one of the best mining assets globally in terms of reserves and cost of mining and (iii) disciplined expansion and capital outlay. In addition, HZ has total cash and equivalents of R179.5bn (R42/share), which we believe provides a strong downside support to the company. We believe the current stock price levels provide an attractive level to invest in the stock. We remain positive on HZ (apart from being structurally positive) as: (i) INR depreciation has nullified the impact of a fall in global zinc prices; and (ii) silver volume ramp-up has been faster than our expectation.

As a result, we see strong earnings visibility and despite assuming royalty doubling from FY14F on account of the proposed new mines and minerals Act, we estimate FY14F EPS growth of 1%. Please note that HZ pays a royalty of close to 15% of its net profit.

Zinc: Smelters making losses at current prices: We expect zinc prices to stabilise at about $2,000/t going forward given: (i) despite a weakening demand environment, zinc surplus continues to narrow and (ii) at current prices, half of the global zinc smelters are unprofitable despite an increase in treatment charges. As a result, we expect downside support to zinc prices at current levels. We estimate net INR realisations for HZ at current levels of R1,05,000/t in the near term.

Stable Chinese and improving US demand likely to compensate for weaker European scenario: Zinc demand has remained stable during the January-April period supported by strong Chinese and the US demand which has made up for the weakness in European demand. Chinese zinc demand has been driven by: (i) strong auto and white goods demand; and (ii) 11.9% production growth of galvanised steel. Even the US demand was supported by strong auto growth, recovery in residential property-starts and more galvanizing of steel. We expect 4.3% global demand growth in 2012F and 5.3% in 2013F.

The stock is factoring in a weak LME: While LME zinc prices have come off by $150/t to $900/t, INR?s depreciation has more than compensated for the above. As a result, HZ?s realisations should actually improve from Q4FY12 levels. However, the stock has corrected with the fall in LME zinc prices without accounting for the benefits from the INR depreciation. We have built in the current zinc realisations going forward as well.

We have factored in higher royalty from FY14F to factor in the proposed hike in the new mines and minerals Act. We build in royalty payments to go up by R8.85bn from FY14F which is close to 15% of HZ?s total profit.

At the same time, we are building in a gradual increase in the tax rate from 17.8% in FY11 and 20.4% in FY12 to 21% in FY13F and 21.5% in FY14F. EOU (export oriented unit) benefits enjoyed by HZ have been withdrawn from FY12, which led to a tax rate increase in FY12. We expect the tax rate to increase marginally going forward given that prior-period benefits will gradually come down.

Despite building in higher royalty and tax rate, we see earnings growth of 6.9% in FY13F and 1% in FY14F. This is on account of stable zinc realisations and the ramp-up of silver and lead volume.

Key risks: (i) Lower-than-expected zinc-lead prices: we estimate zinc lead realisations for HZ to remain at current levels in the near term. If prices fall, there could be a risk to our estimates.

(ii) Slower ramp-up of silver/lead expansion: the company has already commissioned its 100ktpa lead smelter and 300tonne silver smelter. They operated at close to 30% utilisation in FY12 and we expect utilisation to improve to above 80% in FY13F. Any slippage here would be a risk .

(iii) A delay in mining expansion: production ramp-up would depend on the mining expansion and any delay on this would be a negative risk to our estimates.