Hindustan Zinc: Favourable risk-reward equation for investors

The stock is attractively priced and there is potential for upside even if the government's plan to sell its stake does not materialise

Hindustan Zinc (HZL) gained 13 per cent to close at Rs 118.75 on Tuesday, as media reports suggested the decks are getting cleared for a stake sale in the company by the government. The government holds 29.5 per cent in HZL and has been mulling ways to divest its stake.

In the past, there have been objections and lack of clarity on whether the government could sell its stake, since HZL was considered a public sector unit (PSU) under an Act. However, the legal hassles have reportedly got cleared because government only holds minority stake (Vedanta group holds 64.92 per cent), and, hence, HZL cannot be considered as a PSU.

If the reports are true, the government in all likelihood will go ahead with the stake sale. It had already accounted for Rs 14,000 crore towards stake sale in Bharat Aluminium Company (Balco) and HZL to meet its Rs 40,000 crore divestment target for FY14. Besides, the government is also under pressure to control the growing current account and fiscal deficits. A K Prabhakar, senior vice-president, equity research, at Anand Rathi, feels looking at the cash requirement by the government, it will try to push for stake sale not only in HZL but in other similar cases.

In the event the government decides to go ahead, experts say it will either have to go for an open auction or sell stake to the Vedanta group.

Analysts believe stake sale to the Anil Agarwal-led Vedanta group could be more lucrative. They also believe the group would be keen to get complete control of HZL (a cash cow for long), something it has clearly stated in the past. HZL is estimated to clock Rs 14,000 crore as revenue during FY14.

Also, as of June 2013, it had cash and investments of Rs 22,365 crore in the books, say analysts (49 per cent of its current market cap). Thus, the Vedanta group in most likelihood might pay a premium to acquire the government's stake. In that case, the minority investors (hold around six per cent stake) will also have to be given an exit option at the price at which Vedanta acquires the government's stake.

In a recent report, Microsec Research notes, "(In January, 2012) Vedanta had valued government's 29.5 per cent stake at Rs 15,493 crore (about Rs 124 a share) in HZL. The company board had also taken shareholders’ approval in August 2012 to sweeten the offer by up to 15 per cent, to about Rs 18,606 crore”. But, since a lot has changed in a year, the gains for investors from a sale to Vedanta would depend on how much it is willing to pay now.

On the other hand, if the government decides to go for open auction, it will have to set a floor price and ask for bids. In that case, the market's appetite for Hindustan Zinc stock will be the key factor for the price, which may be at a discount to the current market price or even higher. At the current price of Rs 108, the government will be able to raise Rs 13,400 crore.

The fundamentals of HZL remain strong. The zinc, lead and silver producing company’s cost of production is among the lowest in the world due to its fully-integrated operations. The increasing silver production (bi-product of lead production) bodes well, as Ebitda margins for silver produced are over 95 per cent. Besides, the company plans to raise mined metal capacity to 1.2 million tonnes per annum (from around one mtpa currently) over the next six years.

It is in the process of shifting to underground mining from open-cast at the Rampura Agucha mines in Rajasthan, which will take five to six years and will continue to use both in the interim. Rampur Agucha’s underground mine and Kayar mine (0.35 mtpa) are likely to start commercial production in FY14.

Overall, while investors would stand to gain if the stake sale to Vedanta happens at a good premium, the downside also looks limited in case status quo is maintained or stake is sold through an auction.

At Rs 108 (PE of 6.6 based on FY13 EPS), the stock is not far from its three-year closing low of Rs 97. And, analysts have a 12 month target price (ranging Rs 132-155), which indicates 22-44 per cent potential upside.