Cost of production that affected quarter expected to ease; there is strong dividend security; however, valuations are at peak
At Rs 30.2 billion (in-line) Hindustan Zinc’s (HZL’s) 2Q Ebitda rose 46% y-o-y on higher volumes and LME prices; offset in part by higher costs. Volumes were in-line — mined metal production increased 14% y-o-y but declined 6% q-o-q on lower ore treatment (to be recovered in the next quarters). Refined metal production growth was higher at 27% y-o-y (HZL utilised 60kt of concentrate stock in 1H). HZL expects mined metal production to be higher y-o-y, refined production to rise ~17% in FY18. CoP expected to ease — Zinc CoP ex royalty was stable q-o-q at $984/t. Management expects CoP to decline in 2H – HZL should receive linkage coal from Coal India (coal 20% of CoP). HZL had won linkages from CIL to meet 40% of coal requirements. Domestic coal is currently ~35% cheaper than imported coal for HZL. FY18 CoP est. at $900-950/t in FY18 ($980/t in 1HFY18). Note that 1H production is close to the highs of the last few years.
Hedging: 28% of zinc volumes + 18% of lead — HZL has hedged 220kt of Zinc and 30kt of Lead at $3,084 and $2,418 respectively. These would be realised in Jan-Jun’18. Management indicated that decision to hedge was due to the high volatility in prices. Note that hedge price is close to our FY19 LME price assumptions — zinc $3,100, lead: $2,350. Spot zinc LME is $3,100 and lead $2,500. Cash balance at Rs 46/share — HZL has net cash of Rs 194 bn as of Sep’17. Cash balance coupled with FCF of Rs 23-30/sh provide strong dividend security. We est. dividend at `20/sh for FY18 implying an yield of 6% (interim dividend of Rs 2/sh announced). Implications — HZL’s stock correlation with zinc LME is 80%. Our commodities team does not expect significant upside to spot Zinc prices; valuations at 8.6x EV/Ebitda are at peak (peers at 5-7x). Neutral (upside largely from dividend).
We value HZL at 8x EV/Ebitda Mar19, at a premium to peers such as Boliden, Korea Zinc, Teck Resources (5-6x) and around the midpoint of recent trading range of 7-10x. We think a premium is warranted on ore integration, stable fundamentals, and visibility on the use of cash.
Key downside risks that could cause Hindustan Zinc shares to trade below our target price include: (i) Lower-than-expected zinc, lead and silver prices, (ii) Higher-than-expected rupee appreciation, (iii) Lower volumes than we expect, (iv) Higher royalties. Key upside risks include: (i) Continued rally in zinc, lead and better than expected silver prices. (ii) Faster than expected ramp-up of mines. (iii) Rupee depreciation. Every 1% change in zinc-lead LME impacts Ebitda by 1%; 1% change in `/$ rate by 1%.