Hindustan Zinc: Buy

Investors could consider picking up shares in base-metal producer Hindustan Zinc whose operations are poised to receive a significant boost from expansion plans. Over the next two years, the company's earnings and top-line will benefit from trebling silver output, doubled lead production capacity and improved zinc output. This should enhance the company's competitive position to cater to the expanding domestic flat steel and automotive market.

At 11.3 times the FY-11 earnings, the stock appears cheap, given it is at a discount to less integrated global peers such as Nyrstar and Korea Zinc. The company's EV/EBIDTA of eight times, which is also lower than peers, fails to capture its more lucrative operations which stem from an integrated mines-smelter operating structure.

Through four mines and smelters across India, Hindustan Zinc mines and processes zinc, lead and silver metal. The company also monetises sulphuric acid which is a by-product of smelting. It enjoys near-monopoly domestic status in zinc, dwarfing peers in FY-11 with its 7 lakh tonnes of zinc. It also produces 57 tonnes of lead, 150 tonnes of silver and over a million tonnes of sulphuric acid. At current rates of depletion, the company's reserves provide visibility for between 25 and 30 years.

BUSINESS

Hindustan Zinc mines zinc and lead ore, which it processes into concentrate and, finally, into usable metal that it sells at prices linked to those of the London Metal Exchange.

Buoyant metal prices translate into better quarters for the company. Case in point, the fourth quarter of FY2011; the company's sales grew by 28 per cent to Rs 3200 crore, while profits grew by a whopping 43 per cent to Rs 1,770 crore. The company was aided by increased yields of silver in the company's Sindesar Khurd mine. Silver prices have doubled in one year. To capitalise on the higher silver content in the SK mine, the company plans to ramp up concentrate produced from the mine and hopes to produce 500 tonnes of silver by FY-2012. This trebles the company's output of silver for a ready domestic market which imported over 3,000 tonnes of the metal in 2010.

The fortunes of zinc are linked to steel and automotive sales, given that more half the zinc produced globally finds application in coating steel. A global rebound to the tune of 15 per cent in steel consumption had pushed zinc demand by a similar degree in 2010.

Hindustan Zinc managed a 23 per cent increase in zinc off-take during FY-2011 on stronger domestic and Chinese off-take. Higher volumes and realisations made for a tidy FY-2011 performance, as sales and profits grew at 23.6 and 21.7 per cent to Rs 10,000 crore and Rs 4,900 crore respectively. The improved utilisation rates and higher off-take have also helped the company outpace its 4 and 8 per cent compounded growth rate over the last three years.

CATALYST for ZINC

Going forward, the catalyst for increased zinc demand is domestic demand from galvanised steel, which is expected to add capacity at a compounded rate of 12 per cent over the next two to three years.

With 100,000 tonnes in slack capacity and a new 210,000 tpa smelter, the company is gearing up to meet demand. Zinc prices have cooled by 12 per cent over the last few months. Renewed fears of global weakness resulting in reduced metal off-take were among the causes. Other concerns include the high inventory levels of zinc, at 850,000 tonnes (roughly nine per cent of annual consumption). This may exert pressure on zinc prices, resulting in muted realisation growth over the next few months. However, working in favour of Hindustan Zinc is its cost structure which would enable the company to absorb any downside in zinc prices far more effectively than global peers. Operating margins, excluding other income, have hovered between 51 per cent and 60 per cent since FY09 with FY11 registering margins of 56.5 per cent.

LEAD PLANS

The company's lead mining and smelting operations had a muted year, with annual realisations 13 per cent higher in FY-2011 compared to the previous financial year; however the company witnessed a 12 per cent drop in lead metal output owing to an outage of capacity late last year. The company is betting big in this segment by more than doubling its lead smelter capacity. The lead market is reported to be tightly supplied. Indian lead consumption grew by 7 per cent in 2010 to 380,000 tonnes with surging automotive sales fuelling growth for products made by Exide, Amaron, among others, which consume 90 per cent of India's lead.

However, the key competitive advantage in the lead smelting business comes from the company's captive power additions, reducing critical power costs. This will be a handy edge over secondary recyclers which operate on single-digit margins, resulting from the high cost structure of importing lead scrap and smelting it.

The company's massive cash and investment position of Rs 15,000 crore should prove handy in lead and silver expansion plans. The company has near-zero debt levels.

RISKS

About 94.5 per cent of the company is held by controlling parent Sterlite (64.9 per cent) and the Government (30 per cent). The resultant limited free float could result in high impact costs on the stock. Parent company Sterlite's acquisition of the government's remaining stake in the company is under a cloud.

The second risk stems from the volatile price scenario where any global weakness has an immediate impact on realisations. Operational hiccups include the slip in the grades of ore witnessed at its largest mine, Rampura Agurcha; this is expected to be remedied by the addition of mining ‘seams' at the mine.

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