>Non-ferrous Metals Sector: Soft landing for Chinese economy is also bad for the sector

The Long & Short of it


We remain cautious on global demand recovery and expect the slowdown to prolong in developed countries. We refrain from taking a call on Euroquake/sovereign debt crisis in Europe as it has become more of a political issue than plain economics. However, even if the politicians are able to save the euro currency (which entails major austerity measures for most of the Eurozone members), the case for demand contraction is quite strong in that situation too. The Chinese economy’s hard as well as soft landing would be painful for the entire metals sector barring zinc (which is relatively better placed among other metals), while monetary easing in China is unlikely to result in a pick-up in investment cycle as the investment to GDP (gross domestic product) ratio is already at an alarming level of over 65% and any further rise from here on would certainly lead to a hard landing in China. Our London Metal Exchange (LME) metal price assumptions are around 10-15% lower compared to consensus estimates, but our rupee assumption is 7-9% weaker because of extensive slowdown likely in the Indian economy, leading to 2-6% weaker metal prices in rupee terms compared to street estimates. We are positive on Hindustan Zinc (HZL) due to its attractive valuation, balance sheet strength and steady growth.


■ Soft landing for Chinese economy is also bad for the sector: The Chinese government’s plan to engineer a soft landing for its economy would also lead to investment slowdown in all industries. Construction, real estate, commercial vehicle and capital investments are showing a declining trend, which is likely to continue in the coming quarters. This would result in huge demand slump in all metal categories (China accounts for 35-40% consumption of all metals). 


■ US economy appears to be improving, but still far from its peak: Headline US economic numbers are showing a rising trend, driven largely by the base effect. Economic indicators like automobile sales, housing sales, housing prices and joblessness are still way off from their highs witnessed before 2007 as US new home sales are still at a four-decade low.


■ Whether the euro is alive or dead, metal demand contraction to be evident: LME prices are witnessing sharp volatility on news flow from Europe; but in the case of a deal or no deal to save weaker countries from sovereign debt crisis, demand contraction would be apparent in both the situations. Governments would be forced to go for severe austerity measures, leading to a cut in household and corporate demand.


■ Economic conditions not as bad as 2008, but the ability to fight the crisis is limited:
Although we believe the economic situation is not as dire as the 2008 crisis, the ability to fight the crisis is also limited. Most of the countries have fiscal deficits close to high single-digit with
debt/GDP of over 100%, implying lower ability to further boost their economies.


Metal prices trade below marginal costs for a long period of time: We do not accept the
argument that metal prices are below marginal costs and are thus expected to recover from these levels. Until some capacities go offline on a permanent basis, the threat of supply hitting back the market will keep the prices subdued for a long period of time.


Valuation: We have a Buy rating on HZL as the stock will become more like a bond because of strong cash generation. We also remain relatively positive on zinc prices due to strong demand environment in China and supply concerns. We assign a target price of Rs153 (5.0x FY14E EV/EBITDA) for HZL, which is 25% higher than the CMP. For Hindalco, we assign a Sell rating as new expansion is likely to be value dilutive at current aluminium prices. NALCO has been given a Sell rating due to subdued earnings growth and cash utilisation concerns.


RISH TRADER