Hindustan Zinc: SELL

The ongoing correction in global metal prices has hit the share price of many mining majors. Among the select few that continue to shine is Hindustan Zinc, a leading domestic producer of zinc, lead and silver.

In the September 2014 quarter, the company’s earnings increased 33 per cent to ₹2,183 crore, helped by better realisations and higher other income.

The company’s net margin is over 50 per cent, thanks to its low cost of production and debt-free status. It has a large cash hoard of ₹27,000 crore as of September 2014, which works out to around ₹65 per share.

The company’s earnings have grown at 15 per cent annually in the last five years.

The company has large reserves and an estimated mine life of over 25 years. Revenue from zinc, which accounts for 80 per cent of its sales, is expected to be robust.

The infrastructure and automobile sectors should help drive metal demand for rust-proofing (galvanising) steel.

Tight supply situation due to global mine closures is likely to support higher prices. Lead sales, accounting for 10 per cent of the company’s revenue, is also set to benefit, helped by higher prices. Estimates by the International Lead & Zinc Study Group shows that demand will outpace supply. Add to these fundamental strengths, the stock is also attractively priced.

The current price of ₹157 discounts the company’s trailing 12 months earnings by nine times compared with 10-11 times in the last five years.

Yet, the company faces uncertainties about its future ownership structure.

Rather than fundamentals, two factors — an impending stake sale by the Government and promoter actions — may have a larger influence on the stock price. This makes the risk-reward trade-off unfavourable. In May 2013, we had given a buy call on the stock when it was trading at ₹120.

The stock has gained from the buy price and investors can book profits.

The Government owns 29.5 per cent stake in the company and has long pending plans to sell its stake to raise money.

There are reports that the Government is taking definitive steps to divest.

This impending stake sale may limit the stock’s upside. The Vedanta Group, which owns the majority stake of 65 per cent, had made an offer to buy-out the entire Government stake at around ₹170 per share, not much higher than the current market price.

If the Government accepts the offer, promoter holding will increase to 95 per cent.

But rather than selling to the promoters, it is more likely that the Government will divest to the public.

Going by precedents, the pubic offer may be priced at or below the market rate. This could put pressure on the stock price due to the sharp rise in the stock’s free float.

Additionally, Vedanta recently indicated that it is considering a merger of Hindustan Zinc and Cairn India with Sesa Sterlite.

A likely motivation is that Sesa Sterlite can then reduce its gross debt of ₹80,500 crore as of March 2014, by accessing cash holdings of Hindustan Zinc and Cairn India. That would be manna from heaven for Sesa Sterlite, but a big negative for the minority shareholders of Hindustan Zinc. One, the company may lose its cash. Also, the merged entity will have diverse interests — iron ore, copper and aluminium in addition to oil and gas. This, along with an opaque holding structure may limit earning growth momentum.

While the prospects for Hindustan Zinc’s output — zinc and lead — are expected to be upbeat, the same cannot be said of Sesa Sterlite. Iron ore and copper prices are under pressure and are not expected to pick up soon; its aluminium business faces operational issues. In short, a merger, if it happens, is unlikely to benefit Hindustan Zinc’s minority shareholders.

Even an absence of a merger brings risks. Going by the recent example of cash-rich Cairn India lending $1.25 billion to a subsidiary of Sesa Sterlite, a similar cross-lending of Hindustan Zinc’s cash reserve cannot be ruled out. These concerns may limit stock price growth.

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