HINDUSTAN ZINC PRICE: RS.120 TARGET PRICE: RS.155 FY15E P/E: 6.9X; EV/EBITDA: 2.6X

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1 COMPANY UPDATE Saurabh Agrawal HINDUSTAN ZINC PRICE: RS.120 RECOMMENDATION: BUY TARGET PRICE: RS.155 FY15E P/E: 6.9X; EV/EBITDA: 2.6X Just keep focus on turnaround in zinc industry fundamentals and ignore government stake sale delay - Zinc market might have just begun its multiple year bull run - Earning upgrades likely over next few months - Upgrade to BUY with higher TP Zinc markets burdened by consecutive years of surplus and high inventories, went through a long, long period of largely sideways grind. Sentiment is now slowly turning positive/bullish and it has likely sustainable fundamental merit which we have tried to highlight in this note. It is the core of our investment appeal to turn aggressive buyers in Hind Zinc to play the zinc bull story in coming years. We see a reasonable probability of management improving its volume guidance for FY15 and FY16 during annual result declaration towards end of April 2014, more so given government stake sale in HZL again seems to be in back burner now. We also see gradual and sustainable recovery in global macro health from hereon which has turned us positive on cyclicals like industrial metals. So, we believe there exists a strong case for significant earning estimate upgrades for Hind Zinc in coming months. Summary table (Rs mn) FY13 FY14E FY15E Sales (Rs. mn) 126, , ,842 Growth (%) EBITDA (Rs. mn) 64,816 71,875 74,549 EBITDA Margins (%) PBT 78,377 81,615 88,633 Net Profit (Rs. mn) 68,995 69,581 73,365 EPS (Rs.) Growth (%) CEPS (Rs.) BV (Rs./share) Dividend /share (Rs.) ROE (%) ROCE (%) Net Cash (debt) 214, , ,877 NW Capital (Days) EV/Sales (x) EV/ EBITDA (x) P/E (x) P/B (x) Source: Company, Kotak Securities - Private Client Research We at this stage, have been conservative by only marginally improving zinc price estimates and tweaking volume estimates for HZL. We have raised our EBITDA estimates for FY14 and FY15 by 3% and 6.2% respectively to Rs bn and Rs bn respectively while EPS estimates for FY14 and FY15 is raised by 2.7% and 4.9% to Rs and Rs respectively. At CMP of Rs. 120, stock is trading at an attractive multiple of 6.9x P/E and 2.6x EV/EBITDA on FY15 estimates. We upgrade our recommendation on the stock from ACCUMULATE to BUY with a higher TP of Rs155 (vs. Rs141 earlier), which offers c.30% appreciation from these levels. Outlook for zinc appears excellent to us and lead would follow it for structural reasons We are starting to see fundamental change occurring in the zinc market. This is a supply story. Zinc demand which ILZSG calculates grew by 7.4% Y/Y in 2013, has outpaced supply and we have begun witnessing deficit in refined zinc since 2H2013 after several years. What's made story even more interesting is that we might see a 10% decline in zinc ore supply within next two years which could turn even ore market into deficit and can help zinc prices spiral higher and surely outperform other base metals. Global zinc mine supply growth has braked sharply from over 3% in 2012 to just 1% in Indeed, mine production outside of China contracted marginally last year, according to industry association, ILZSG. Lead mine supply growth also slowed last year but much more moderately to a still robust 6.4% globally. Visible inventories on the London Metals Exchange, as well as on the Shanghai Futures Exchange, are down about 30% over the last year. And zinc demand is increasing steadily. There are some suggestions that we have a small zinc deficit already. The global zinc market fell into its first supply deficit in six years in 2013, according to the International Lead and Zinc Study Group (ILZSG). Latest figures from the International Lead and Zinc Study Group (ILZSG), assesses both zinc and lead markets (sister metal as found along with zinc in mines) shifting to production-usage deficits in It was the first year of lead deficit since 2009 and the first year of zinc deficit since ILZSG calculates that the refined zinc and lead markets recorded a production-usage shortfall of 60,000t and 20,000t, respectively, in These though would appear as marginal outcomes in what are 13mt and 10.5mt global markets but its worth noting that both markets are somewhere along the path from chronic oversupply to supply shortfall. Kotak Securities Limited has two independent equity research groups: Institutional Equities and Private Client Group. This report has been prepared by the Private Client Group. The views and opinions expressed in this document may or may not match or may be contrary with the views, estimates, rating, target price of the Institutional Equities Research Group of Kotak Securities Limited. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 2

2 Considering other estimates, The World Bureau of Metal Statistics reports the market was in a small surplus last year, specifically 78,000t between Jan-Dec 2013, but that is down from a 343,000t surplus the previous year. At the same time, stocks have fallen, the firm reports, by 459,000t, mostly as falling LME inventory; LME stocks represent over 63% of the global total as best as can be estimated. Chinese demand remained robust, rising 11.1% Y/Y while production of refined metal in China rose by 9.8%. Outside China, global refined production rose by 5.7% and consumption rose by 8.1% compared with the levels recorded one year earlier. Zinc has been disliked metal for decades. As a result, there has been very little investment, which means that six major mines in operation for decades have or will soon end production. The imminent closure of major mines, notably Century, Brunswick, Perseverance and Lisheen over the next few years was expected to push the market into an early and significant concentrate deficit. The first two, in Canada, closed in The next major shut down, scheduled for mid-2015, is MMG Inc.'s Century mine in Australia, the world's second-largest zinc mine. Industry estimates are that approx. 10% of the global supply ( industry major Nyrstar view of11% loss shared later) would be lost as a result. Since the sister metals are normally found in the ground together, every zinc mine that closes takes out a bit of lead supply as well. China's MMG - Dugald River mine, which was intended to be a partial offset against the closure of the giant Century mine next year has run into technical problems which has led it to defer its mine development. But it's not the only player facing such issues. Last month problems have arisen at another important new mine, Perkoa in Burkino Faso. Glencore-Xstrata, which owns 62.7% of Perkoa and needs it to help compensate for zinc mine closures in Canada, has challenged minority shareholder and operator Blackthorn Resources over the mine's economics. Blackthorn has already ceased open-pit operations at Perkoa and is now considering a number of "schedule, cost and capital scenarios". One scenario is to place the whole mine on care and maintenance until the zinc price improves further. To sum up, Zinc and lead have same bullish story to some extent as both markets would see depletion of some of the world's largest zinc mines, a lack of replacement supply and problems with the few new mines that are coming on stream. So prices of both zinc and lead should see as upward curve structure in coming years with zinc outpacing lead. Zinc premium reaches six year high as inventories shrink Zinc for immediate delivery reached the highest premium in 6 years to the three month contract on LME amid shrinking stockpiles, financing accords and moves to roll bearish bets forward. The gap expanded to $38/t this week on LME. That is the widest backwardation since August 13th A fee to borrow the metal for a day (reached $15/t) reached a three year high (most since Nov 2010). Generally the market has been running short and this is the result. The shorts have to cover and the longs don't. We understand that markets are taking its sweet time to adjust to the view that refined zinc markets can structurally turn from surplus to deficit on sustainable basis. We believe either the zinc prices would improve even from hereon in coming quarters whether we remain in backwardation or turn into contango. Backwardation, or higher prices for earlier deliveries, usually signals limited supplies of metal. Zinc inventories tracked by the LME are the lowest since December 2011 and orders to draw supplies from inventories, or cancelled warrants account for 26% of the total. About 60% of stockpiled LME zinc may be locked into financing accords and unavailable to consumers. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 3

3 Zinc smelter fees seen rising amid sufficient supply Fees that zinc smelters charge mining companies to refine the metal will probably rise 4.5% this year amid adequate supplies. Smelters including Korean Zinc and producers such as Teck Resources are in annual negotiations at an International Zinc Association industry conference over charges convert semi processed ore into finished metal. The benchmark treatment charge may climb to about $220/t (vs /t last year) based on a zinc price of $2,000/t as per industry estimates. Zinc ore supply is expected to exceed demand by 132,000 tonnes this year, before rising consumption and slowing production growth pushes the market into deficit in The fees to refine semi-processed ore, also known as concentrate, generally climb when supplies of ore increase because miners are competing for limited smelting capacity. World Refined Zinc Supply and Usage tonnes Jan-Dec Sep Oct Nov Dec Jan-Dec Mine Production Metal Production Metal Usage Metal Suplus (Deficit) Source: ILZSG, Kotak Securities - Private Client Research Zinc Metal Suplus/Deficit (KT) Source: ILZSG, Kotak Securities - Private Client Research Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 4

4 World Refined Lead Supply and Usage tonnes Jan-Dec Sep Oct Nov Dec Jan-Dec Mine Production Metal Production Metal Usage Metal Suplus (Deficit) Source: ILZSG, Kotak Securities - Private Client Research Lead Metal Suplus/Deficit (KT) Source: ILZSG, Kotak Securities - Private Client Research Based on Brook Hunt Q data, Nyrstar estimates that new mine projects and expansions will supply the market with approximately 0.9 million tonnes of additional production per annum by the end of 2016 Source: Nyrstar Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 5

5 GLOBAL MACRO China concern overdone - growth to marginally moderate but no significant jitters expected There has been concerns of metals driven by weak PMI data over last two months and reports of credit tightening in shadow markets which could lead to defaults and growth slowdown. Our take is that concerns are overdone. Firstly, China new loan supply for Jan 2014 almost tripled month on month to $218bn which has brought in excess liquidity into the system and its barometer one week Repo has collapsed to less than 3% (vs. 9% levels reached two months back). This along with bailout of trusts by Chinese government in end of Jan 2014 (which were expected to default), indicates that shadow banking concerns are overblown at least for medium term. Also PMI data our affected by fortnight business closure for annual Chinese new year holidays in first half of Feb and we see improvement likely in PMI data in coming months. China 1W Repo Rate - Fallen to low levels China Monthly New Loans ($bn) - Quantum Jump US economy is showing signs of macro improvement Source: MNI - indicators.com The Chicago Business Barometer remained broadly unchanged at 59.8 in February compared with 59.6 in January, as a double-digit gain in Employment offset declines in New Orders, Production and Order Backlogs. The Chicago Report points to firm growth and a continued recovery in the US economy, with the Barometer standing at its highest level since December and remaining around 60 for the fifth consecutive month. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 6

6 Markets have closely followed the Chicago Business Barometer since 1967 due to its ability to capture well US business cycles and predict where GDP is heading. It has flagged recessions and booms well in advance and this remains the case today. The Chicago Business Barometer has been gradually trending higher since the start of 2013, with the recovery gathering pace in the second half when the Barometer rose sharply to 63.3 in the fourth quarter from 54.4 in the third quarter. US GDP data showed it was the strongest second half growth for 10 years and GDP rose 2.4% in the fourth quarter compared with the same period a year earlier, up from 2% in the third quarter. In October, four months ahead of the publication of the GDP advance estimates, the New Orders and Production components of the Chicago Business Barometer expanded at their fastest pace since October 2004 and February 2011 respectively, indicating a significant pick-up in demand. Both indicators have remained around 60 since then, showing business activity has continued to expand firmly, though, at a slower pace. INDUSTRY CHARTS Source: NYRSTAR Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 7

7 LME Zinc Price ($/t) & Inventory (t) MCX Zinc Price (Rs/Kg) LME Lead Price ($/t) & Inventory (t) MCX Lead Price (Rs/Kg) Silver Price (Rs/Kg) USD/INR Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 8

8 Financial assumptions with changes and Valuation - Upgrading to BUY with higher TP of Rs155 HZL - Key Assumptions with changes OLD NEW FY13 FY14e FY15e FY13 FY14e FY15e Production Volume Zinc refined (kt) Lead refined (kt) Silver (t) Sales Volume Zinc refined (kt) Lead refined (kt) Silver (t) Sulphuric acid (kt) 1,204 1,355 1,390 1,204 1,359 1,401 LME Prices Zinc LME (USD/t) 1,967 1,930 1,950 1,967 1,945 2,000 Lead LME (USD/t) 2,120 2,125 2,100 2,120 2,125 2,125 Premium earned over LME Zinc (USD/t) Lead (USD/t) Realisations Zinc (USD/t) Lead (USD/t) Silver (Rs/kg) 56,175 46,625 45,693 56,175 48,310 47,827 Forex Rate (INR/US$) Source: Company, Kotak Securities - Private Client Research Assumption changes for FY14/15 - We at this stage, have been conservative by only marginally improving zinc price estimates and tweaking volume estimates for HZL. Volume changes - We have marginally raised our volume estimate for zinc for FY14 by 2KT and 6KT for FY15 while lead and silver volume estimate for FY15 is raised marginally by 3KT and 5t respectively after sharp cuts made last month. Realization changes - We have raised for zinc realization estimate for FY14 and FY15 by $15/t and $50/t respectively while lead realization estimate for FY15 is raised by $25/t. Silver realization estimate for FY14 and FY15 is raised by Rs1685/t and Rs2134/t respectively. Changes reflect improving industry macro and metal prices at LME and MCX. We have raised our EBITDA estimates for FY14 and FY15 by 3% and 6.2% respectively to Rs bn and Rs bn respectively while EPS estimates for FY14 and FY15 is raised by 2.7% and 4.9% to Rs and Rs respectively. We maintain our valuation methodology but assigning an improved multiple of 4.5x (vs. 4x earlier) FY15 EV/EBITDA and assign a fair value of Rs155/share (vs. Rs141 earlier). At CMP of Rs. 120, stock is trading at an attractive multiple of 6.9x P/E and 2.6x EV/EBITDA on FY15 estimates. We upgrade our recommendation on the stock from ACCUMULATE to BUY with a higher TP of Rs155 (vs. Rs141 earlier), which offers c.30% appreciation from these levels. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 9

9 HZL Valuation - TP based on FY15e earnings EBITDA Multiple Valuation Value (Rs. mn) (x) (Rs. mn) (Rs./Share) Enterprise Value Less: Net Debt (at end of FY15) Target Market Capitalization Target Price 155 Source: Company, Kotak Securities - Private Client Research Risks Any sharp unexpected growth slowdown in China driven by government drive to move away from investment driven economy to consumption driven economy. Ukraine crisis escalating to large scale war which results in unexpected consequences. Kotak Securities - Private Client Research Please see the disclaimer on the last page For Private Circulation 10