FREE

Sector update: Metals; Non Ferrous - Time to accumulate

A fall in China Purchasing Managers' Index (PMI) into the contractionary zone in Dec 2018 (49.4 for the first time since Jul 2016) has raised concerns over demand for base metals in China. Consequently, prices of base metals have slumped, especially aluminium, which fell to as low asUS$1,800/t, defying core fundamentals like sustenance of global deficit in CY19, falling inventories and loss-making marginal producers. We expect aluminium prices to recover and average to US$2,000/t in FY20E (CMP: US$1,855/t), in a likely softening trade war scenario between the US and China (by March 2019), further boosted by stimulus from China. We have cut our FY20E EBITDA by 6-9% for non-ferrous companies to factor in relatively lower base metal prices. As a result, we have cut our target prices for stocks (Hindalco’s TP cut to Rs305 from Rs332, while Vedanta’s TP cut to Rs244 from Rs275). However, we believe a fall in Hindalco’s share price (CMP: Rs206) provides an attractive opportunity to accumulate, as it more than factors in weak commodity prices. We reiterate our Outperformer rating on Hindalco and Vedanta and maintain our Underperformer rating on Hindustan Zinc (CMP: Rs273) with a reduced target price of Rs227 (earlier Rs243).

US-China truce and China stimulus expected to overcome slowdown: China manufacturing PMI fell to 49.4 in Dec 2018, implying demand slowdown in China. China saw auto sales fall ~16% yoy in Nov 2018 along with slowdown in construction growth. In a bid to stimulate growth and ease liquidity in the market, China announced 100bps RRR cut in Jan 2019. We believe the Chinese government will provide further stimulus to support the economy. A softening trade war between US and China by March 2019 along with stimulus will aid demand recovery in China 2HFY20E onwards, in our view.

Aluminium: fundamentals intact; prices to recover by 1QFY20E: Nonetheless, aluminium market fundamentals look favourable, despite slow growth in Chinese demand. Alcoa (one of the largest primary aluminium producers in the world) sees China as a balanced market in CY19E, despite ~4% yoy demand growth. Factors we believe that will aid price recovery by Q1FY20E and result in average price of US$2,000/t in FY20E with a positive bias are: 1) Softening trade war between the US and China, accompanied by stimulus from the Chinese government, which would allay fears of further demand slowdown 2) Deficit of ~1.7mt-2.1mt in CY19E versus CY18 deficit of ~2mt in global markets 3) global inventories touching pre-crisis levels seen in CY08 and expected fall in inventory (world ex-China) to 60 days in CY19E from 75-80 days as of CY18-end, and 4) China’s announcement of further capacity cut of 0.8mt in CY19E (~2mt cut in CY18), restricting oversupply. 5) Despite easing cost pressure caused by fall in alumina and coal prices, marginal global producers (according to Alcoa, 40-45% of smelters are cash negative at current prices) operate at losses.

Zinc: CY19E - last year of deficit; prices to soften further: According to International Lead and Zinc Study Group (ILZSG), world demand for refined zinc metal is forecast to rise 1.1% to 13.88mt in CY19E, with 3% rise in supply forecast to 13.81mt in CY19E. ILZSG expects global zinc deficit to reduce from ~322kt in CY18 to ~72kt in CY19-end. Due to low inventory (19-20 days), zinc prices are expected to remain firm at current levels (US$2,550/t) before tapering off to below ~US$2,500/t in 2HCY19.

HNDL provides 30% upside on MTM basis: We factor in current prices (last 15 day average) for base metals (LME aluminium @ US$1,847/t, LME Zinc @ US$2,454/t and LME Lead @ US$1,966/t) and Brent crude price at US$60/bbl while keeping the valuation multiple (1 yr fwd EV/EBITDA) same. In this scenario, our target price works out to Rs272/sh for Hindalco (HNDL), Rs224/sh for Hindustan Zinc (HZ) and Rs200/sh for Vedanta (VEDL). Thus, even after factoring in current weak base metal prices, we see ~30% upside in Hindalco (due to less sensitivity to aluminium prices owing to Novelis).