Metals India Buy into strong volume growth:: Kotak Sec

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Metals
India
Buy into strong volume growth. Indian metal stocks offer favorable risk-reward ratio
even after assuming subdued commodity prices. Returns, in our view, will led by shift in
focus over the next 12 months on FY2013E financials and have catalysts in the form of
(1) strong capacity expansion, especially towards end-FY2012E and FY2013E, and
(2) profitable growth courtesy captive ownership of raw materials. Sterlite, Hindalco and
Tata Steel offer the maximum upside on FY2013E financials. Our strategy team recently
went overweight on the sector in its model portfolio.





Indian metal stocks appear attractive after correction/underperformance
Indian metal stocks have underperformed the broader markets over the past 12 months with the
exception of JSW Steel (strong volume growth) and Hindalco (Novelis turnaround). We believe that
several factors contributed to the underperformance (1) production indiscipline at the early stage
of recovery in the steel segment; (2) most of the capacity expansion geared towards end of
FY2012E or early FY2013E.

However, after correction and underperformance, valuations look relatively inexpensive, especially
against the backdrop of 15-30% EBITDA CAGR and 10-35% earnings CAGR over FY2011-13E.
Most of the stocks in our coverage universe trade at 5-6X FY2012E EBITDA and have an added
catalyst in the form of strong volume growth in FY2013E. We are comfortable with our current
earnings forecasts; Exhibit 3 gives details of our FY2011-13E metal price assumptions and
compares the same with spot prices and last five-year averages. We believe we have sufficient
buffer in our forecasts. Note that we have subdued outlook on commodity prices on account of
high inventory (non-ferrous) and excess capacity (steel).

Strong profitable growth ahead
We forecast volume growth of 20-30% from FY2012-13E for the India business of the metals
sector. More important, volume growth will be profitable since most of the capacity expansion has
raw material integration. For example, Hindalco will increase aluminium capacity by 2.3X, alumina
capacity by 2X and Novelis’ capacity by 10% by FY2013E. Hindalco also has bauxite and coal
blocks in place for greenfield expansion. Tata Steel is also increasing its India capacity by 40% to
10 mtpa. The company has iron ore self sufficiency for the expansion, while it is working towards
increasing its coking coal capacity. Sterlite’s aluminium capacity expansion may be impacted after
the Central Government rejected its bauxite mine application and has growth from the power
segment. JSW Steel will also expand capacity by 40% in FY2012E, though it lacks captive raw
material resources.

Highest upside for Tata Steel, Hindalco and Sterlite on FY2013E financials
We believe that Street’s attention over the next 12 months will shift to FY2013E financials.
Companies—that have capacity expansion lined or will receive full benefit of volume growth in
FY2013E—will benefit the most. Among our coverage universe, Hindalco and Tata Steel stand to
benefit the most. Sterlite will also benefit from expansion in the power business, JSPL in power
and sponge iron and JSW Steel. Applying a standard methodology on valuations, fair value for
Hindalco increases to Rs275 (28% upside from CMP), Sterlite to Rs230 (31% upside from CMP)
and Tata Steel to Rs775 (24% upside from CMP). JSW Steel, JSPL and Sesa are expensive even
after assuming reasonable capacity expansion. Nalco has stopped reacting to aluminium price
movements and trades at a very high 7.8X FY2013E EBITDA.