Hindustan Zinc's Q2FY18 results (Underperformer) - Hedging restrict profits in Q4FY18

Q2FY18 result highlights- Higher zinc lead prices boost profits

• Hindustan Zinc (HZ) reported in-line operating results with EBITDA of Rs30.2bn, up 27% qoq, primarily due to ~13% qoq increase in zinc prices and 4% qoq higher refined zinc-lead volume (233kt). The high zinc prices prompt management to hedge a major part of Q4FY18 zinc volume for the first time. HZ hedged 220kt of zinc (165kt in Q4FY18 i.e. ~85% of Q4FY18E volume and 55kt in Q1FY19) at US$3,084/t (CMP of LME Zinc is US$3,100/t) and 30kt of lead at US$2,418/t.
• Higher zinc-lead realisation and volume offset marginally higher CoP (Zinc CoP excluding royalty up 1% qoq to Rs63,288/t). CoP was higher due to lower overall grade of mined metal (8.13% v/s 8.4% in Q1FY18) and higher coal cost. EBITDA margin, at 57%, was up 486bp qoq.
• HZ recorded one-time gain of Rs2.9bn on account of write back of excess district mineral fund liability recorded during Jan-Sep2015 after the court ruled out imposition of any retrospective tax. Excluding one-time gain, PAT, at Rs22.5bn, was up 20% qoq.
• HZ has net cash of ~Rs194bn (Rs46/share) at Q2FY18-end. 

Key Positives: FY18 volume guidance maintained; Guided FY18 refined zinc CoP of US$900-950/t (1H CoP was US$979/t); Interim DPS of Rs2

Key Negatives: Hedging restricts gains due to any upside in zinc prices in Q4FY18E

Impact on financials: None

Valuation & view- Reiterate Underperformer with TP of Rs267

We expect the high zinc prices will prompt producers like Glencore and a few of the China miners to restart mining which will help restoring balance in the world zinc market in CY18E. As a result, zinc prices are expected to remain high during H2FY18E and then will fall in FY19E. We have factored in average LME zinc price of US$3,100/t in H2FY18E and US$2,900/t in FY19E. We believe the stock price factors in average zinc price of US$3,500/t in FY19E (at 7.0x FY19E EV/EBITDA) and as a result does not provide any upside. Global zinc producers are trading at an average of 5.8x 1-year fwd EV/EBITDA (HZ trading at 8.6x FY19E EV/EBITDA). The solace is that the stock is available at a dividend yield of 5% (expect DPS of Rs17 in FY18E). We reiterate Underperformer with a target price of Rs267, valuing HZ at 7.0x FY19E EV/EBITDA.