Metals - Sector Update - Centrum

Sell producers, Buy miners

We recommend that investors shift their positions in domestic metals &
mining space from producers to miners. There are multiple pain points
for producers ranging from slow demand, margin pressure, stretched
balance sheets and dismal cash flows. However, miners provide an
attractive mix of better pricing & volume growth potential, healthy
margins, strong books and good dividend yields. We observe the trend
of increasing ownership by FII/DIIs in domestic miners vis-à-vis
producers in the past few years and expect this trend to continue.
Valuations remain attractive on domestic miners with huge discounts to
global average which we feel is unjustified. We recommend Coal India,
NMDC and HZL as our top buys. Sell Tata Steel and SAIL.

$ Producers likely to encounter various challenges: Domestic metal
producers face pricing pressure inflicted by slowing domestic demand
and higher supplies globally mitigated (marginally) by weak rupee. We
note that margins for producers shrank by 400-1000bps in the past 3
years, balance sheets got stretched due to large capital spends and
free cash flow remained dismal with low visibility on volumes from new
projects. Rupee depreciation is expected to dent balance sheets
further (forex debt is a major portion of borrowings) and the threat
of oversupply from China adds to the challenges faced by producers.

$ Multiple factors favor miners: Domestic miners have demand-supply in
their favour in the domestic market and apart from better pricing
ahead we see volume growth at an inflection point for large resource
plays due to strong domestic demand and clampdown on illegal mining
supply coupled with slow clearances for new private mines. Robust
margins due to lowest quartile CoP and healthy balance sheets (debt
free and cash rich) with strong free cash flow generation are key long
term positives. Recent thrust of the government in addressing
regulatory and logistical constraints provide confidence on volume
jump in the long run.

$ Institutional ownership increasing in resource plays over producers;
QE tapering could further support the trend: We observe that
institutional ownership is slowly increasing in miners (backed by
higher free floats) but is coming down or is stable in producers for
FIIs/DIIs respectively. However, absolute ownership remains far higher
in producers and with our thesis suggesting continued outperformance
by miners over producers, we firmly believe the ownership trend will
keep shifting towards miners from producers in the domestic metals &
mining space going forward. We also infer that QE3 tapering could
result in subdued metal prices globally, leading to increased shift of
FIIs/DIIs towards resource plays where the impact of QE has been
lower.

$ Valuations – Risk reward in favor of miners: We note that apart from
better financials and healthier books, miners also provide much better
dividend yields and payouts. While domestic producers are trading at
par with global average, miners trade at high discount, which is
unwarranted and expected to narrow down going ahead in our view. We
recommend Buy on Coal India, NMDC and HZL as our top picks in mining
space but advise investors to Sell Tata Steel (downgrade from Hold
earlier) and SAIL. We see upside being capped in Hindalco and JSW
Steel post sharp recent rally and downgrade them to Hold from Buy.
Risks to our call would be higher pricing & volumes (led by better
demand) for producers and logistical bottlenecks to volumes for
miners.



Thanks & Regards,

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