We believe Zinc prices have peaked, and we find Hindustan Zinc Ltd (HZL) fully valued, despite the planned volume growth in Zn, lead and silver after a lull of many years. We, however, see 60% upside in the ex HZL stub, driven mostly by volume growth in oil and Zn International, and improved profitability in Al.
A leveraged play on Aluminum
Al remains a large part of the capital employed for Vedanta and also has the weakest profitability, making it the most important for Vedanta’s incremental profits, and ex-HZL RoCE. The ramp-up of the VAL and Balco smelters is nearly complete (FY18 exit rate 2mtpa). Over the past decade, surging Chinese exports had pushed gross smelting margins (Al price minus alumina and energy costs) below $700/t from $750-900/t a decade back. As Chinese exports stagnate (more upside to Al if they decline), ex China capacities could see higher margins. The recent rise in alumina and energy has pushed up the Al cost curve—this is also positive for Vedanta due to its partial vertical integration. The expansion in the partly built Lanjigarh refinery could also boost capital productivity.
Volume-driven upside on the ex HZL businesses
A heavy debt burden had driven a sharp capex slowdown across the group in the past few years, leaving some projects half-done. However, post the completion of the Cairn merger, and the spike in Zn and oil prices, both cash accretion and fungibility have improved. Stalled expansion projects are re-starting, particularly in higher-margin businesses like Zinc and oil. The ex HZL upside that we see is, therefore, purely execution-dependent; our price forecasts remain conservative. While our volume projections are below company guidance, this remains the most significant risk to our rating, together with a potential unexpected diversification. We also initiate coverage on HZL with NEUTRAL and Rs 325 TP on high EV/Ebitda multiple and expected price declines in FY20.
Opportune volume growth across businesses
Al: Better outlook in the weakest segment — Aluminum remains a large part of the capital employed for Vedanta and also has the weakest profitability. It is thus the most important for Vedanta’s incremental profits, now that the capacity expansion is nearly complete. Global ex China Al demand has stayed steady for several years, and may surprise positively as the long-delayed investment cycle picks up in the US/EU. At the same time, Al supply is being curtailed in China, which has already led to their exports flat-lining, and may even lead to a drop going forward. Chinese net exports of aluminum now meet 12-13% of ex-China demand — this has depressed gross smelting margins (Al price minus the cost of alumina and energy) to below $700/t vs $900-1,000/t earlier, and thus deterred supply addition elsewhere. Higher smelting margins are thus necessary for supply growth. Warehouse inventory, which used to be an overhang over the London Metal Exchange (LME) Aluminum price, has declined meaningfully from its peak, driving stability in the physical premium. Furthermore, Chinese capacity for alumina and coal has been curtailed as well, driving up costs of inputs. This should help Vedanta take the refinery and the power plants to their full utilisation, and help profitability as well as return on capital employed. We build in 2mtpa of output (exit-rate for FY18e: start of 300ktpa pot line could create upside), and slightly better Ebitda/t as CS global forecasts are for Al prices to fall slightly after a few quarters.
Zinc and Oil: Volume growth targetted — In businesses like Zinc and Oil, where the company has among the lowest operating costs in the world, and prices are elevated, incremental profitability depends on volume growth. In both volumes are starting to grow after a long lull. HZL is now expanding volumes after nearly seven years, as the Agucha underground mine shaft nears completion. With costs expected to moderate (better ore grade, more underground output, improvements in energy supply), healthy FCF generation should continue despite our current forecast of moderating Zn prices by 2020. In addition, silver output is expected to continue to grow, reaching 600tpa by FY20, and could add $300mn-plus to Ebitda every year. When the Zinc International business was acquired, the mines were nearing their end-of-life. Output fell by two-thirds (~300ktpa) over FY12-17, largely as expected. But with the Gamsberg expansion now completing, we expect a rebound to 400ktpa by FY20. Oil volumes stagnated as well, as the then-cash-starved company sharply curtailed capex. With capex ramping up to $300 mn/year, Vedanta guides to volumes rising from 190kbpd currently to 300kbpd by FY20.