Metal Stocks - Best buys !!

The metals sector has been facing a tough time, partly due to the correction in global commodities prices and also because of certain domestic developments like the ongoing CBI probe into the mining industry in Karnataka.

Many frontline metal stocks like JSW Steel, Tata Steel, Sesa Goa, Hindalco and Sterlite, to name just a few, have seen a severe contraction in prices. What has further compounded the problem is the ongoing crisis in the Euro Zone and the fear that China's metal demand may slow.

It is tough to say which metals segment — copper, steel or aluminium — would take a greater hit than the others or whether the producers catering to domestic demand would be spared from demand recession compared to companies like Tata Steel which has a significant presence in European markets.

But for long term investors, it would be tempting to know whether the current meltdown in metal stocks make them hot investments, even in the likelihood of further price correction in these shares. All the five metal stocks mentioned earlier have suffered serious erosion in value and three of them have seen their Price to Earnings (PE) ratio come down to single digits.

The extent of carnage the sector has suffered could be judged by taking a look at today's NSE closing prices compared to their year's high (given in brackets):

Sesa Goa - Rs 204.25 (Rs 383.65); Jindal Steel and Power – Rs 480 ( Rs 755.50); Tata Steel - Rs 420.70 ( Rs 737); Hindalco - Rs 126.10 (Rs 252.85) and Sterlite - Rs 113.35 (Rs 195.95).

But what is intriguing is that while the stocks of metal companies has seen a correction, it is not as if all metal prices have corrected. For instance, the steel prices have not gone down so much compared to the share price of steel stocks. Given the problem in mining in India, it is possible that domestic steel prices may remain firm, benefiting steel producers.

In an interview to Business Line, Mr Bhavesh Chauhan (Senior Research Analyst  — Metals & Mining), Angel Broking, Mumbai, shares his views on the metal sector's performance and what it holds for them in future. Excerpts:           

Metal stocks have taken a hammering. Do you consider them worthy of investment at current prices or is some more pain due?

The last 6-8 months have been bad for metal companies due to escalating debt crisis in Europe and stocks have been battered. As long as the situation in Europe remains grim, metal demand would remain weak and sentiment will keep metal prices lower. Monetary tightening in China has also played its part, although there hasn't been any huge decline in China's appetite for resources so far.

Different metal stocks (Sterlite (copper), Hindalco (aluminium), JSW Steel, Tata Steel and Sesa Goa) have suffered. Do you see any particular company recovering in the short term? Are all metal stocks in the same league?

Metal being a global commodity, all the stocks would be in the same league, although broadly we classify the companies as ferrous and non-ferrous and then we could have the classification in terms of steel makers and miners as well. Again, recovery of any stock would depend on how Europe shapes out. Also, there are concerns on US going into double dip too. So that factor has to be seen closely.

The reasons for the downslide in shares — controversy in the Karnataka mining sector and slowdown in Europe — are different. Do you think it would take some time for these negative factors to disappear?

 For Karnataka mining, it is more of a regional thing and it affects companies operating in Karnataka. I believe the Karnataka issue could be sorted out in 6-9 months. European slowdown is a big concern actually and how long it will take for these factors to disappear is a challenging question.

The economic slowdown has led to demand contraction resulting in fall in metal prices. But any economic recovery would see demand for metals picking up. So, do you feel the fall in prices is temporary or will it continue for a while?

Any recovery in Europe should see base metal prices recovering, although the way the scenario is today, it is difficult to give a time frame. At least in the near-term I do not expect any recovery in base metal prices.

Which are the sectors that would benefit due to metal prices falling — autos, housing, electrical goods, capital goods. Do they have any upside potential because of this?

Companies in capital goods and infrastructure will benefit if prices fall. However, steel prices have not fallen so far. Steel is the commodity which is used mainly as a raw material in machinery and construction. We do not expect any significant fall in steel prices anyway as prices of raw material remain high and are expected to remain firm due to supply concerns.

Though metal prices have fallen, the woes in Europe and US may not lead to pick-up in demand for products. How will Indian companies benefit?

Base metal prices have fallen. So, a little benefit will flow to some companies. However, steel remains the most widely used commodity.

How will the rise in dollar value and fall in rupee value affect the Indian metal cos? Hasn't the fall in rupee value neutralised any benefit of fall in commodity prices?

With the rupee depreciating, it helps companies selling metals as imports become expensive and hence domestic producers can raise prices. As far as importers of commodities are concerned, so far the falling rupee has offset falling commodity prices as you rightly say.

Have the frontline metal stocks become investment worthy after price correction? What are your picks and why?

We do feel that front-line metal stocks are now worth investing as we believe markets are discounting on the near term global macro issues (primarily Euro zone crisis). The current price levels do not discount the expansion plans by companies over the next 2-3 years. We like companies with captive resources and big expansion plans. With captive resources, these companies would generate higher return on capital employed at even current metal prices. Though we like Hindustan Zinc, SAIL, Sterlite amongst others, Tata Steel and Hindalco are our top picks –Tata Steel with a target price Rs 614 and Hindalco with a target price of Rs 196.

We like Tata Steel for its buoyant business outlook, driven by higher sales volume on completion of its 2.9 mt brown field expansion in Jamshedpur. The company's raw material projects are expected to be commissioned by 4Q FY2012 with lower off take initially; the full benefit is expected to accrue in FY2013E. Additionally, restructuring initiatives at Tata Steel Europe are likely to benefit the company going forward. We believe Hindalco is well placed to benefit from its aluminium expansion plans (capacity increasing by nearly two-three folds in the next two-four years). Most of its new capacities will be backed by captive mines leading to robust margins. Further, we expect steady EBITDA of $1 billion annually from Novelis.   

Steel prices have not fallen much but steel stocks have suffered. Because of the mining issue, steel prices may remain firm. Does that make steel stocks attractive for investment?

Steel prices have not fallen because prices of iron ore and coking coal across the globe are still firm. The mining problem is only India-specific and does not have any impact on the steel prices, which are globally determined. We believe steel stocks are attractive given that their margins have shrunk drastically over the last 9 months or so. We like steel stocks as coking coal prices are expected to fall, interest rates in India should fall sooner than later, capex cycle should pick up in the next six months. The stock prices have discounted all the negatives, leaving some of the stocks highly undervalued. 

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Hindalco - Buy

Hindalco Industries Ltd., a Aditya Birla group company, is the largest aluminum producer in India and one of the world's largest aluminium rolling companies. It is also one of the biggest producers of primary aluminium in Asia.

The company has captive bauxite mines, that source around 70 per cent of its requirements for its 1.5 mtpa (million tonne per annum) alumina refinery, and its 0.54 mtpa smelting capacity.

The company also produces copper and its copper smelting capacity is the largest in Asia. Hindalco's products include standard and speciality grade aluminas and hydrates, aluminium ingots, billets, wire rods, flat rolled products, extrusions, foil, alloy wheels copper cathodes, continuous cast copper rods along with other by-products, including gold, silver and DAP (Di Ammonium Phosphate) fertilisers. On a consolidated basis, Hindalco is a global player operating through its global subsidiary Novelis (global leader in aluminium rolled products and aluminum beverage can recycling) which has 32 plants in 11 countries.

Hindalco has been performing well since the last four quarters on standalone as well as on consolidated basis. It has reported good growth in net sales and profits in the last 4 quarters as a result of better price realisation and rising demand in domestic markets. Also, on a consolidated basis, Novelis recently witnessed a turnaround and has significantly contributed to the rapid growth of Hindalco in FY11.

Novelis continues to enjoy pricing power in the developed markets due to recovery in demand and has been able to increase product prices continuously this year. However, the rise in sales realisation has not been fully converted in net profit mainly because of higher coal (a key raw material) prices. A slight dampener to the company's copper business was planned shutdown of 3 weeks in one of its smelters. With the buoyant demand from domestic and global market, we can expect the growth to continue in coming quarters as well.

Hindalco is the industry leader with a strong global and domestic presence in aluminum and copper segments and is one of the world's largest aluminium rolling companies. To strengthen its position further, the company is planning to enhance its refining capacity from 1.7 million tons at present to 6.15 million tons by 2015.

The demand for aluminium and copper is expected to grow rapidly in the coming years. Hindalco is the largest player in the above segments and with its expansion plans it is likely to benefit the most from the rise in demand for aluminum and copper.

After touching a 52 week high of 250 the stock has been falling. Has good support around 160 levels, where we can buy for a target of 240 holding of 3-4 months. Scrip has been languishing and has in fact gave -ve returns during the last 6 months.

Time Span	Price	Change	%Change
Today	177.30	-2.05	-1.14
Week	177.45	1.90	1.07
Month	168.25	11.10	6.59
Three Months	220.25	-40.90	-18.56
Six Months	234.65	-55.30	-23.56
One Year	152.70	26.65	17.45

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Metal sector - Outlook

Metals rally — Building on a weak base

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While valuations have run ahead, earnings of metal companies still reflect the commodity meltdown since July 2008. Financials may perk up by the year end, depending on LME prices and the rupee-dollar exchange rate.

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Despite global metal majors cutting back operations, stock overhang continued until early 2009.

S. Hamsini Amritha

Metal stocks have been frontrunners in the market rally this year, with the BSE Metals index , posting a year-to-date gain of 165 per cent. Base metal stocks, led by Sterlite (India) Industries, Hindalco Industries, National Aluminium Company (Nalco) and Hindustan Zinc, more than doubled since January 2009.

With valuations expanding and the commodity rally relying on an uncertain global recovery, investors in the base metals stocks may benefit by taking some money off the table now. Here’s an assessment of what triggered the leadership in base metal stocks and what may decide their outlook.

Driven by valuations

The stock market rally of 2009 has been driven, in larger measure, by investors being willing to pay higher multiples for company earnings. This is reflected clearly by the base metals complex. From a rock bottom price-earnings ratio of 4.07 times in January, the BSE Metals index has seen its PE shoot up to 21 times this October, indicating that the increase in stock prices is not supported by earnings.

However, Indian metal stocks have merely tracked a global re-rating of mining majors. Global peers such as BHP Billiton, Rio Tinto and Vale now trade at PEs of 32, 132 and 10 respectively. In terms of consensus estimates for 2010 earnings, Hindalco (14 times), Sterlite (15 times), Hindustan Zinc (11 times), are at a discount to BHP Billiton or Rio Tinto which are hovering at forward PEs of 19-20.

Uninspiring earnings

While valuations have run ahead, earnings of metal companies still reflect the commodity meltdown since July 2008. After posting impressive profit growth for the first two quarters of FY09, trouble began from the third quarter (see Table 1). Of the lot, Hindustan Zinc saw the worst dent in sales and realisations.

After posting a meagre 9 per cent increase in net sales, net profits of Hindalco plunged by 87 per cent. Nalco also saw its net profits fall by 22 per cent in the last fiscal, while the consolidated business of Sterlite Industries witnessed a profit decline of 24 per cent, though on a standalone basis the company increased its profits by 28 per cent in FY09.

Do note that the first two quarters of 2008-09 reflected the peak of commodity cycle. Hence, it is unlikely that the companies will post a year-on-year increase in sales or net profits in the current quarter.

Financials may begin to look better from the third (December) quarter, when earnings may pick up on a lower base. This again is contingent on base metal prices in the London Metal Exchange (LME) and the rupee-dollar exchange rate.

Demand from China has played an influential role in determining the price and demand prospects for all metals, as it has emerged as the biggest producer and consumer of metals in the last three-four years. The initial leg of the meltdown in metals was attributed to China winding down its purchases post the Olympics, followed by the onset of the global recession from the third quarter of 2008.

Despite global base metal majors quickly cutting back and operating at just above half their production capacity over the next two quarters, stock overhangs continued until early 2009. From April, most of these companies partially resumed their production capacities; though aluminium smelters remained shut.

Renewed buying interest by China since March 2009, particularly in copper, zinc and lead, triggered the sharp recovery in metal prices. However, the thinning spot differential between the LME and the Chinese SHFE since mid-August applied brakes on the rally, suggesting that China may slow down its restocking activity.

Most economists are now agreed that the Chinese economy will expand faster than expected at the beginning of the year, aided by stimulus spending. Indicators such as purchasing manager’s index and industrial output steadily inching up in the last six months, appear favourable for demand.

Nevertheless, Chinese exports remain quite weak, possibly curbing its appetite for base metals in near future. It is also uncertain whether the US, the UK and Japan are capable of offsetting the slippage in Chinese demand. In addition to the above, each metal may also be impacted by certain factors unique to it.

Copper

Leading the rally in base metals is copper, which finds extensive use in construction, electrical and electronics and capital goods industries. Though visible signs of recovery in the construction sector are evident, the recent rally in prices (Table 2) was mainly driven by Chinese restocking. A recent report published by International Copper Study Group forecasts that world copper mine production will rise by 3.8 per cent in 2009, while usage of the metal will decline by a minimum of 4.3 per cent in 2009, owing to an average decline of 14 per cent in three major markets — the US, the European Union, and Japan.

These three regions represent around 30 per cent of the world total copper usage. This has to be weighed against a 3 per cent growth in China.

In the first half of 2009, world usage is estimated to have decreased by 0.6 per cent compared with the same period of 2008. Slowly rising stock-piles at the LME (256900 tonnes in July to 347150 tonnes now), also suggest that buying activity has been tapering off.

Aluminium

Faced with the problem of mountainous stock piles, aluminium was a laggard in the base metals price rally until recently. Despite an expected 6 per cent decline in world aluminium production to 37.25 million tonnes in 2009, there will still be a heavy surplus as consumption may be lower at 34.63 million tonnes for the year.

Revival in key user industries, such as automobiles/ transportation (which consumes 26 per cent of aluminium), packaging (22 per cent) and construction (22 per cent), are crucial.

Stimulus packages such as the “cash-for-clunkers” in the US and “bangers-for-cash” in Europe have renewed the demand for cars in these countries, but whether this will sustain is open to question.

However, the relatively moderate rise in spot price and reduction in stockpiles at the LME in the recent weeks are positive pointers for the metal’s near-term outlook.

Over the medium term, the shift in preference by car-makers from steel to aluminium as more manufacturers turn to fuel-efficient cars and the relatively good health of consumer companies are positives for the metal.

Zinc and lead

Demand for zinc hinges on the prospects of the galvanisation industry, as it accounts for 50 per cent of demand.

Preliminary data released by International Lead and Zinc Study Group suggests that over the first seven months of 2009, world supply of refined zinc surpassed demand by 0.29 million tonnes. Global demand for zinc fell by 10.8 per cent in this period due to a sharp contraction in Europe, where usage fell by more than half a million tonnes. Even as LME stockpiles are rising, zinc seems to be faced the problem of oversupply, as many smelters across the globe have restarted their idle production capacities taking early cues from the recent rally in spot and forward prices.

However, recovery in infrastructure spending and the construction sector in and outside of China, raises confidence about a faster recovery in steel demand, which may eventually boost the demand for zinc.

Lead has been a latecomer to the metals rally, not gaining much until July, but seeing hefty gains since mid-August on the back of supply disruptions.

The 20 per cent y-o-y increase in automobiles production in China is an encouraging factor for the near-term demand for the metal as lead is the primary input for car batteries. However, long-term demand prospects for the metal are threatened by the agitation raised over lead pollution.

Given the scenario, investors can avoid fresh exposure to metal stocks at this point in time. Apart from the fundamental question of whether global demand will see a meaningful recovery, there is the fact that base metals have been the hottest stocks in the recent rally. With valuations too stretched, they may be quite vulnerable to any stock market correction.

Hindalco Buy on correction for long term

S. Hamsini Amritha

Investors with a long-term perspective can continue to hold the Hindalco (Rs 59) stock even if the company’s near-term earnings performance is lacklustre. Hindalco’s operations have delivered reasonable growth on a standalone basis, but muted profitability and high debt of the Novelis acquisition have brought down valuations in recent times. As a low cost and integrated producer of aluminium, Hindalco could capitalise on Novelis’ value-addition capability and diversified user base in the event of an economic recovery. The tilt towards user sectors such as beverages and infrastructure makes it less vulnerable to demand slowdown than many of its global peers.

At a PE multiple of 7 times its estimated 2008-09 earnings, the stock trades at a discount vis-a-visits Indian and global competitors.

Aluminium: Main revenue generator

Aluminium and copper are Hindalco’s main business streams. On a standalone basis, aluminium contributes 37 per cent to Hindalco’s revenues, but its share in net profits is as high as 80 per cent. Extensive brownfield expansions and low-cost acquisitions implemented over the last five years have put Hindalco on the list of global low-cost aluminium manufacturers. The company concentrates on producing rolled aluminium, ingots, bars and foils. These finished goods are sought after by infrastructure companies, capital goods manufacturers and power transmission and distribution companies.

While the automobiles industry accounts for about one-fourth of Hindalco’s demand (on a consolidated basis), the improvement in domestic passenger vehicle sales offers some comfort. For the nine months ended December 2008, Hindalco’s net profits (on a standalone basis) from the aluminium segment rose by about 6 per cent and revenues by 10 per cent.

Hindalco acquired Novelis, maker of value-added products such as beverage cans and alloy wheels in May 2007 for $6 billion. Though this changed Hindalco’s business and geographic profile, the deal weakened its balance-sheet as Hindalco was forced to take on Novelis’ debt burden of $2.9 billion.

Novelis Acquisition

Born in early 2005 as a result of spin-off from its parent company Alcan, Novelis has a diversified clientele — Coke, Ford, General Motors, Audi, Lotte, Kodak and Tetra Pak. But in a bid to pump up its business, Novelis entered into fixed price supply contracts with some of its major customers.

Trouble began in 2005 when raw material prices spiralled sharply. Since Novelis was compelled to sell below cost due to contractual obligations it reported losses of $102 million from operations for the nine months ended December 2008. This swelled to $1.82 billion, after the company charged goodwill impairment and losses on derivative contracts.

Despite this, Novelis’ business does offer long-term benefits to Hindalco. Facility to produce value-added products may aid Hindalco’s margins over the long term. The fixed price contractual obligations of Novelis end by January 1, 2010. Moreover, Novelis has embarked on cost savings and had undertaken a production cut. In addition, it is accounting for goodwill impairment which may help Hindalco benefit from the deal

Copper: Yet to shine

Hindalco’s copper business (where demand is mainly from the domestic market) has been facing margin pressures from declining realisations. While the segment’s contribution to revenues is 67 per cent, its high cost structure has limited its share in profits to as low as 20 per cent.

Copper cathodes and rods find use in high end industries such as electrification, housing and construction and infrastructure projects. Apart from US and Europe, Hindalco exports copper to the BRIC nations, which offset decline in demand from US and Europe in 2007-08. But with even the BRICs witnessing a slowdown in 2008, Hindalco’s revenues from copper slipped by 5 per cent for the nine months ended December 2008.

LME prices

Copper prices in the London Metal Exchange corrected sharply, by 62 per cent, between July and December 2008. They have since recovered 44 per cent. Easing warehouse stocks and signs of higher Chinese demand have raised hopes about an early recovery in the copper price cycle.

On the other hand, aluminium prices remain subdued, though they have risen 19 per cent from the February 2009 lows. LME inventories show some improvement in aluminium demand but the recovery is more tentative than for copper.

Financial overview

A strong commodity cycle saw Hindalco deliver sales growth of 24 per cent and operating profit growth of 25 per cent between 2003 and 2007.

In 2007-08, the company saw a manifold growth in consolidated sales from Rs 193 crore to Rs 600 crore (attributable to the acquisition of Novelis), while operating profits rose 50 per cent. But high interest costs from the Novelis acquisition led to a dip in net profits. From a consolidated debt service coverage ratio of 15 times in until 2006-07, it fell to three in 2007-08.

The bridge loan taken for the buyout (due in November 2008) has been fully repaid by the company, through rights issue proceeds amounting to $920 million. For the remaining debt, the company has again borrowed $982 million (at a rate of LIBOR + 80 bps) after liquidating its investments.

The financial year 2007-08 saw a sharp surge in crude oil prices, which had cascading effect on transportation costs and cost of alternative energy sources such as coal. Going forward, Hindalco’s margins are likely to benefit from the substantial correction in crude oil and coal prices.

Other concerns

The major constraint for the aluminium division is the threat of import substitution. With the government recently hiking import duties on the metal, this problem has been addressed adequately. The copper division continues to face raw material supply constraints, resulting in production capacities remaining unutilised.

Moreover, Hindalco faces margin pressures because of depressed treatment and refining charges, which determine conversion margins on copper and this is expected to persist in the near future also.

Source : businessline 12-04-09

OUR VIEW :

The stock is facing resistance at Rs.60 level if it is passed it can go to 75 levels soon.  The drop in volumes is a cause of concern and may depress the price there is a chance it can go down to 50 levels.

Buying range : 45-50

Selling range : Above Rs.60

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