Regaining shine

SPECIAL REPORT

Metal stocks, after losing heavily in the free fall, bounced back in the last few trading sessions but look like attractive buys.

After a dramatic decline in prices in the market meltdown since May 11, metal stocks staged a remarkable comeback in the past two trading sessions.

BSE Metals index gained 15 per cent in last two days to settle at 7500. But even after the sharp rise, it is still down by 31 per cent "� the biggest loser among the sectoral indices. 
 

WEALTH CRASH Market capitalisation of metal stocks (Rs crore)
	May 10, '06	Jun 16, '06	% chg
Hind Zinc	41963.68	22302.70	-46.85
Sterlite	13116.10	7652.64	-41.65
Essar Steel	3262.50	1992.30	-38.93
Hindalco	27723.28	18080.40	-34.78
Nalco	20826.96	14106.82	-32.27
Jindal steel	6376.70	4318.30	-32.28
Tata Steel	36932.11	25545.84	-30.83
Jindal Stainless	1582.10	1132.95	-28.39
Sail	38739.40	28951.30	-25.27
Total	190522.82	124083.25	-34.87

Experts say this is because valuations of metal stocks ran far ahead of their fundamentals. For example, while LME zinc and copper prices more than doubled in the past one year, the stock prices of Hindustan Zinc and Sterlite Industries nearly quadrupled and tripled, respectively, during the same period.

Since metal stocks ran up to unjustifiable heights, they were bound to see correction.

Besides, adding fuel to the fire were fears of rising interest costs, which triggered a selloff by global hedge funds who borrowed due to cheap money available and invested in the commodities market.
 

BOOMING COMMODITIES % gain in LME prices
	Yesterday's price ($/tonne)	CY2005	YTD-CY2006 *
Zinc	3103	57.80	62.30
Copper	7130	46.30	57.10
Aluminium	2567	24.60	13.00

Since May 10, the prices of three major metals "� aluminium, copper and zinc "� have all slumped 20-24 per cent. Consequently, most domestic metal stocks plunged in the higher range of 30-40 per cent in the same period.

Now, metal stocks have come to more attractive levels, feel analysts. Manish Kanchan, CEO of Ambit Capital, says, "There has been a secular bull run for commodities. I am bullish on metals for the next three-five years, as demand for metals in Asia is unlikely to come down."

Zinc
Despite the stunning show last year and a further 60 per cent rise in year-to-date after touching its all-time high of $3990 a tonne recently , the outlook for zinc prices is still bright.

Analysts say demand for zinc will keep prices firm. While there is good demand driven by the automobile sector and the construction/ infrastructure activities in China and other Asian countries, which account for about 50 per cent of total global zinc consumption, inventory levels are declining.

Deficit for zinc is, thus, expected to continue for at least two years. Says Si Kannan, commodity analyst at Sharekhan, "I am most bullish on zinc among the non-ferrous metals space; any weakness in the metal offers good opportunity to buy."

Hindustan Zinc: The largest and integrated domestic zinc producer Hindustan Zinc, a Vedanta group company, has undoubtedly become the biggest beneficiary of spike in zinc prices which reflected in its financial performance in FY06.

Its sales shot up 76 per cent and profits almost doubled. Not surprisingly, its share price also shot up by 10 times in a year till May 10. In the market correction, the company was hit the hardest, and it became the biggest loser. However, analysts have a positive view about the company.

Says Karthi Keyan, vice-president (research), Strategic Capital, "I see some value in the company at the current levels. It is expected to witness improved profitability led by robust volume growth, thanks to recently expanded capacity."

The company enhanced its capacity by 42 per cent to 4 lakh tonne and plans to raise it further by a similar rate by 2008. It is also expected to save substantially on its energy costs through its 154-MW captive power plant. The stock trades at 8.4 times its FY07E.

Copper
Copper has been the second best performer after zinc last year and also till date.

The outlook for the metal remains bullish. Supply disruptions like the ones caused by strike at Group Mexico's largest copper mine, La Caridad, and social unrest near Grasbergled and strong demand for winding wires, telecommunications, power cables and transformers, building construction, air-conditioning and automobiles and infrastructure spending in Asian countries, especially China, are driving growth.

Further, no capacity is coming on stream till 2008, even as total inventories are close to historic lows (less than four weeks buffer stock). Thus, both demand and output are estimated to grow at 5-6 per cent in 2006.

Indian players like Hindalco and Sterlite are mainly judged by the performance of TC/RC (Treatment and Refining charges) margins, as they are mere converters. TC/RC margins, which have almost doubled in the last one year, are expected to remain firm owing to firm copper prices.

Sterlite Industries: The company is a play on all the three key non-ferrous metals. It is one of the two major producers of copper in the country and owns strategic stakes of 65 per cent in Hindustan Zinc and 51 per cent in aluminium producer Balco.

Ajit Dange, analyst at UTI Securities, says, "The primary reason to invest the company is not its low margin copper smelting business, but its investments in these companies. The stock is the best buy, as it is cheaper to buy one share of the company and own half a share of Hindustan Zinc."

At Rs 337, the stock trades at 30.6 times and 33.7 times its FY07 and FY08 estimated earnings, respectively. However, its investment per share in Hindustan Zinc and Balco comes to around Rs 300, which means that the scrip is available at a very cheap price.

The company's expansion of additional 60,000 tpa is expected to operate at full throttle in FY07, which will result into added volumes. The company reported a stupendous performance in FY06 with its net sales and net profits almost doubling.

Aluminium
Even as aluminium prices generally lagged the commodity boom, the metal was hit the hardest as it slumped 27 per cent from its peak levels on the global meltdown.

Going forward, analysts are less bullish on the white metal. Says Kannan, "Increased alumina and aluminium production in China in the coming months is expected to ease the global aluminium prices."

Apart from China, there is also significant demand in North America, the Middle East, Asia (excluding China, the Middle East and Japan), CIS and Eastern Europe.

In the domestic market, demand is largely driven by robust activity in industries like automobiles, construction, power and packaging.

The outlook for alumina "� the major raw material for aluminium production "� is not quite cheerful as the demand-supply imbalance for alumina is expected to shrink from 13,00,000 tonne in 2005 to 4,00,000 tonne in 2006. In the past one month, alumina prices have been cooling down, falling 22 per cent.

Hindalco: The flagship company of the Aditya Birla group derives more than 50 per cent of its turnover and one-fourth of its profits from the copper business. It is amongst the world's top 10 and Asia's fourth largest producer of copper.

It is also the world's 13th largest producer of aluminium. However, value-added products account for a major chunk of its aluminium revenues, a fact that provides some cushion to its margins. The stock trades at 8.3 times and 9.9 times its FY07 and FY08 estimated earnings, respectively.

Analysts say valuations seem to be on the higher side, as the copper business generally deserves a valuation of not more than six times. Moreover, it is a fairly long-term story, as the full benefits of the expansion in aluminium project will kick off only by 2010.

The company has lined up Rs 11,900 crore for increasing its aluminium capacity by 75 per cent to 0.8 million tonne and tripling its alumina capacity to about 3 million tonne by March 2010.

Post-expansion, the company will be fully integrated with captive bauxite mines and power plants. Last fiscal, though its net sales rose 20 per cent, operating profit increased at a lower rate of 15 per cent and margins also declined marginally.

Nalco: The company is a pure aluminium play with a capacity of 0.3 million tonne and 1.57 million tonne of alumina. Since the proportion of alumina sales is higher at 26 per cent, Nalco may be hit more than Hindalco.

The company, however, is relatively stable and almost debt-free. The company is in the process of its second phase of its brownfield expansion for hiking its bauxite, alumina and aluminium capacity to 6.3, 2.1 and 0.5 million tonne respectively.

In FY06, its net sales, operating profit and net profit increased between 18 per cent and 25 per cent. The stock trades at 6.8 times and 7.8 times for FY07E and FY08E, respectively, which makes it cheaper than Hindalco "� yet not a screaming buy.

In the event of any price change of aluminium and zinc prices, change in EPS of Nalco and Hindustan zinc is more than Hindalco. 
 

SENSITIVITY ANALYSIS Metal prices and impact on earnings
Scenario 1 - Most likely Our Price Assumption
	2007	2008	2009
Aluminium Price	2400.0	2200.0	2100.0
Zinc Price	2800.0	2400.0	2100.0
EPS estimates
Hindalco Industries	19.2	16.8	15.1
Nalco	31.9	28.3	26.3
Hindustan Zinc Ltd	52.5	56.5	55.3
Scenario 2 - Pessimistic MINUS USD 200
Aluminium Price	2200.0	2000.0	1900.0
Zinc Price	2600.0	2200.0	1900.0
EPS estimates
Hindalco Industries	16.1	13.1	11.9
Nalco	27.3	23.7	21.7
Hindustan Zinc Ltd	48.5	51.4	49.5
Scenario 3 - Optimistic PLUS USD 200
Aluminium Price	2600.0	2400.0	2300.0
Zinc Price	3000.0	2600.0	2300.0
EPS estimates
Hindalco Industries	22.3	19.0	18.4
Nalco	36.4	33.0	30.9
Hindustan Zinc Ltd	56.5	61.7	61.1
Source: UTI Securities

Steel
Despite soaring raw material costs "� mainly of iron ore (up 71.5 per cent), steel prices declined 28 per cent last fiscal till January 2006, primarily owing to huge inventory build-up worldwide and China turning a net exporter. This led to weak financial performance of Indian steel players as well.

However, steel prices started recovering since February and are up 15 per cent since then. Analysts expect prices to remain firm, but that is largely because of cost push factors.

Iron ore prices are expected to go further up by 15-19 per cent, though prices of coking coal and coke are likely to fall after rising by 20 per cent and 100 per cent, respectively, last fiscal.

Further, demand for steel will continue to be strong primarily led by Asian and BRIC (Brazil, Russia, India and China) countries mainly owing to increased activity in infrastructure, automobile and real estate and housing, but that may be neutralised by increased production in China.

Inventory levels are now at normal levels, as major countries except China like Europe, America and Japan announced production cuts. Overall, steel prices are expected to remain at the current levels.

Tata Steel: The stock trades at a P/E of 5.9 times and EV/EBIDTA of 3 times for FY07E and a P/E of 5.7 for FY08. Analysts feel the company is well positioned to cope with steel price volatility, thanks to its captive ore mines, operational efficiency and focus on value-added and branded products.

This is evident from its financial performance in FY06, a period when despite price pressures, the company managed to record a marginal growth of 4 .5 per cent in net sales and 0.2 per cent in profits.

Further, the contributions from its recent accusations like Natsteel Asia and Millenium Steel should result in better margins. Also, its planned expansion projects are expected to boost volumes.

SAIL: After reporting disappointing results in FY06, wherein its net sales declined 1.7 per cent and operating and net profit tanked 37 per cent and 41 per cent respectively, the prospects of India's largest public sector steel manufacturer, SAIL, looks bright.

The company is expected to benefit not only from improved realisations with steel prices recovering but also with softening of coking coal prices, which it largely imports.

Further, its merger with Indian Iron & Steel Company (which will give additional access to the latter's large iron ore reserves and coking coal mines) and modernisation of its blast furnaces augur well for the steel major. The stock trades at a P/E of 5.3 times and EV/EBIDTA of 4 times for FY07E and a P/E of 5 times for FY08E.

Non-integrated players such as Monnet Ispat (trading at 3 times for FY07E and FY08E) and JSW (trading at 5 times for FY07E and 4 times FY08E) also look attractive at the current levels mainly owing to expected volume growth, say analysts.