Hindalco, Vedanta trading at discount; firm outlook for base metal prices

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Non-ferrous majors such as Vedanta and Hindalco have been in focus after tariff hike talks by the US on aluminum, and consequently, the volatility in global base metal prices. Correction in the markets added to the woes. The share prices of Vedanta and Hindalco have dropped 19-23 per cent from their highs in January. 

However, analysts see this fall as an opportunity because the business outlook for these two companies remains firm, while the current stock valuations are assuming much lower profitability going ahead. Global base metal average realisations may continue to improve or at least remain stable, say analysts. Vedanta and Hindalco will also benefit from capacity expansions, they say. Vedanta, which has a more diversified business profile, will also benefit from higher crude oil prices.

Firm realisations

Despite volatility in base metals this month and prices on the London Metal Exchange (LME) correcting from their February highs, analysts say aluminium and zinc have averaged higher sequentially in the March quarter (Q4). On a year-on-year (y-o-y) basis, prices are significantly higher for all base metals and will drive the performance of these metal producers. 

Soumen Chatterjee, head of research at Guiness Securities, says that after the significant run-up, the correction in base metal prices is healthy and the outlook for 2018 remains firm. In fact, analysts’ estimates suggest steady improvement in prices of base metals till FY20.  

Analysts at Kotak Institutional Equities note that the current market prices of non-ferrous stocks are assuming low returns from aluminium operations, while aluminium has the best demand outlook among base metals and can see structural pricing improvement on lower growth in Chinese supplies and widening ex-China deficit. In order words, the Street is undervaluing the stocks of Hindalco and Vedanta, despite higher earnings potential in their businesses.

Vedanta in a sweet spot

Vedanta, a diversified natural resources player with interests in aluminium, zinc, copper, etc, derives a tenth of its revenues from the oil and gas business. Its per tonne realisation in aluminium, which is seen improving from Rs 135,046 in FY17 to Rs 163,029 in FY18, is expected to rise further to Rs 180,517 in FY20, estimates Kotak Institutional Equities. As the company’s aluminium volumes are also estimated to improve 25 per cent over the next two years, led by expansions, Vedanta’s growth prospects remain strong because aluminium contributes about a fourth to its revenues.

The other important segment is zinc. While Hindustan Zinc (Vedanta’s listed subsidiary) continues to see regular improvement in volumes which are expected to rise 20 per cent over the FY18-20 period, the start of mining by Zinc International (its international operations) will provide further boost. Zinc International volumes are seen growing 2.5 times to 406,744 tonnes over the FY18-20 period. 

While the two major business segments are firing on all cylinders, volumes and realisations in the copper business are also improving. Likewise, Vedanta’s oil and gas segment (represented by Cairn India) is also expected to post stellar gains. Oil production is expected to grow 30 per cent between FY18 and FY20, while Brent crude oil prices are now at $70. Analysts estimate the average oil realisation for Vedanta at $58 a barrel in FY18, versus $49 a barrel in FY17, and at $62 in FY20.

The recent announcement of an interim dividend of Rs 21.20 translates into a yield of over seven per cent. Analysts at Edelweiss Securities say high dividend payout is a manifestation of Vedanta’s prudent capital allocation because its capex cycle is nearly over. This affirms the management’s aim to increase shareholders’ returns, believe analysts. 

Hindalco reaps benefits

Hindalco, which has completed most of its expansions, is now reaping the benefits through higher revenue and profit, while improved free cash flow is helping reduce debt. The company, which has captive coal (used for power generation) and bauxite (key raw material to make aluminium), remains largely insulated from volatility in raw material prices. Hindalco's US subsidiary, Novelis, has also seen significant improvement in performance, and its business outlook is firm despite US tariff restrictions. 

Analysts at JM Financials say Novelis’ earnings will see minimal impact from the 10 per cent tariff imposition on aluminium by the US. The exemption to its key supplier country Canada and significant dependence on recycled raw materials (over 50 per cent) blunt any meaningful adverse impact on Novelis, they add.

The full utilisation of Hindalco’s aluminium capacities in India, a 12 per cent increase in aluminium prices (in dollar terms) over the past 12 months and significant control over its cost of production via higher coal security, augur well for Hindalco’s India earnings. The Street is also expecting Hindalco’s copper business to strengthen further, adding to its profitability further.

A possible risk that investors will need to keep in mind is if the recent events turn out into a full-blown global trade war between the US, China and other countries, as the same could have a bearing on the fortunes of these companies.

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