Prices slide—recovery to be gradual: The devaluation of yuan and a strong US dollar, weak global demand and large inventories will delay metal price recovery, especially for aluminum and steel despite large losses incurred by many mills. We cut our FY2016-18e commodity price assumptions by 0-9% and TPs (target price) of VEDL to Rs 110 (Rs 140), HZ to Rs 175 (Rs 180), HNDL to Rs 60 (Rs 65), TATA to Rs 175 (Rs 190) and JSTL to Rs 980 (Rs 1,000). We maintain BUY on VEDL and HZ; REDUCE on HNDL and TATA; SELL on NACL. We prefer Vedanta due to its exposure to zinc and low-cost operations. The earnings trajectory of steel stocks will largely depend on expected government measures to restrict imports.
Price recovery can be delayed given multiple global headwinds
At spot aluminum prices (including premiums), about 30% of the aluminum smelters globally are incurring cash losses. Despite these losses, the pricing recovery for aluminum can be delayed due to multiple headwinds, including (i) devaluation of yuan, which can pose higher risks of Chinese aluminum exports as China’s markets remain in surplus despite announced capacity cuts, (ii) a stronger US$ is negative for prices as it lowers smelting costs and delays closures, (iii) weak demand globally can itself alter the demand-supply economics, and (iv) more importantly, the large aluminum inventories tied up in cash-and-carry trades risk fast unwinding due to expected interest rate hikes by Fed over CY2016-17 (See exhibit ).
The global aluminum inventories are largely stored in off-exchange warehouses than in LMESHFE (exchange warehouses). These aluminum inventories are at high levels of 14.9 mn tonne in December 2015 or about 136 days of consumption (for world ex-China). Assuming normal levels of inventory of 60-70 days on consumption (pre-GFC levels), we estimate excess aluminum inventory of about 4-4.5 mn tonne. This compares to expected FY2016e deficit of only 100 kt factoring in announced closures and global demand of +3.8% in CY2016e.
Fundamentals stack up better relatively but risks emanate from weaker demand
Zinc is better-placed compared to aluminium due to (i) lower global inventories and (ii) closure of large mines, especially in the fourth quarter of fiscal year 2015. The global zinc markets were in surplus of 325,000 tonnne in CY2015 led by 3.6% growth in production to 13.7 mn tonne while demand was flat at 13.4 mn tonne. We expect zinc markets to be in deficit of 200,000 tonne in CY2016e due to 4% decline in production led by closures. The major mine cuts are from (i) announced closure of Glencore (0.5 mn tonne) and (ii) closure of Century/Lisheen mines, which account for another ~0.5 mn tonne. The deficit can be at risk in case of weaker-than expected demand in China (+2% in CY2015) and world ex-China (-1%).
Import restrictions to determine earnings trajectory over FY2017-18e
The global steel prices remain under pressure due to China overcapacity and lower raw material prices. While we expect China steel prices to recover given large losses of Chinese steel mills and they will be led by improvement in spreads, steel prices will still be 30% lower compared to FY2015 average due to low raw material prices. We expect the government to impose more safeguarding measure to restrict imports to help the domestic steel industry.
Leverage high and unsustainable at spot prices; we cut Ebitda estimates by 0-9%, target price by 2-21%.
We cut our base metal price assumption for FY2016-18e by 0-9% and China steel price assumption by 0-6%. We also incorporate our KIE energy team’s revised crude price assumption for FY2016-18e and our economist’s revised Fx rate. This results in cut in our Ebitda estimate by 0-9% and target price by 2-21%. The Exhibit on the right summarises changes to our assumptions, estimates.
Earnings trajectory to depend on import restrictions
As per unauthenticated media reports, the government may notify more measures to curtail cheap steel imports, which may include measures such as adoption of a minimum import price (MIP) and restricting the port of import to one. The details of likely structure of these restrictions remain sketchy with many possible scenarios. We believe our estimates for steel stocks, including Tata Steel and JSW Steel, will likely change based on the new measures announced and we await more clarity. Our revised assumption in this note for steel companies only factors in (i) continuation of safeguard duty on HRC for three years (it is currently imposed for only 200 days and can be extended) at the rate of 20% for first year, 15% for second year and 10% for third year, and (ii) builds in gradual recovery in China steel export prices with closure of more loss-making steel mills.
Changes in our estimates
Non-ferrous—we cut our commodity price assumption by 0-9%
* All-in aluminum prices. We cut our all-in aluminum price assumption by 0-6% to US$1,725/ton, US$1,700/ton and US$1,750/ton for FY2016e, FY2017e and FY2018e, respectively.
* Zinc and lead prices. We cut our LME zinc price assumption by 0-8% to US$1,775/tonne, US$1,750/tonne and US$1,800/tonne for FY2016e, FY2017e and FY2018e. We cut our LME lead price assumption by 0-5% to $1,725/tonne, US$1,800/tonne and US$1,850/tonne for FY2016e, FY2017e and FY2018e.
* Crude oil prices. We incorporate KIE energy team’s revised crude price (Brent) assumption of US$49/bbl, US$52/bbl and US$60/bbl for FY2016E, FY2017E and FY2018e from US$52/bbl, US$57/bbl and US$62/bbl. We assume long-term prices of US$65/bbl in our model starting FY2019 (with 2% annual escalation).
Ferrous—we cut our steel price assumption by 0-6%
* Steel. We cut our China export HRC price assumption for FY2016-18e by 0-6% to US$300/ton, US$320/ton and US$330/ton for FY2016e, FY2017e and FY2018e. Steel spreads for Chinese steel companies are at historical lows and majority of companies are incurring losses. We expect closures in CY2016, which can aid prices though lower ironore prices underpin cut in our assumptions.