Metals rally — Building on a weak base
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.
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.
