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Hunan Nonferrous Metals Corporation Limited ( 2626.HK ) ---- Large financial risk, waiting for industry recovery

Wednesday, September 3, 2008

5363

Hunan Nonferrous Metals Corporation Limited(2626)

Recommendation on 3 September 2008
Target Price	$1.510

Weekly Special - 9618 JD.com

Summary

Hunan Nonferrous Metals Corporation Limited (HNMC or Company) interim report shows, the Companys first six months revenue and net profit respectively dropped 22% and 75%, which are greatly dragged by non-ferrous metal smelting incomes sharp decline.

In term of the Companys specified major products, its non-ferrous metal products mainly are Lead and Zinc, while owing to global market tends to form oversupply pattern, meanwhile plus with unfavorable export policy and domestic smelting capacity expansion, the prices for zinc and lead are continuously suppressed. It is estimated that in the coming two years, tungsten and cemented carbides will have good performance, while still insufficient to backup the Companys overall profitability. In addition, the Companys business structure is greatly relying on smelting, therefore the gross profit is comparatively low, and the operational risk is relatively high.

Nevertheless, current stock price already over-reflects the negative factors of the Company, so we still give 12-month target price at HK$ 1.51, and “Buy” rating.

Sharp interim performance decline

HNMC 2008 interim report shows, the first six months revenue and net profit respectively dropped 22% and 75%, which were greatly dragged by non-ferrous metal smelting incomes sharp decline (Figure 1) and rapid rising interest payments.

However, within the sector of non-ferrous metal smelting, owing to continuously prices drop, zinc products sales and profit both sharply declined ( Table 1), which was the main cause dragging the Companys performance and stock prices recently. The interim report shows, overall gross profit for the sector dropped 41.7%, down to RMB 391 million, while the gross margin dropped to 8% from 9% in 2007.

In term of zinc products, we think that Chinas macro-economic situation is unusual in 2008, which may greatly impact the domestic and overseas market trend. At the same time, economic prospects in home and abroad are still unpredictable. It is estimated that price fluctuation in second half will be greater, which may increase difficulty to the operation for the Company latterly.

Company advantages

With apparent favorable production scale, and as one of Chinas largest non-ferrous metal integrated manufacturers (except from copper and aluminum), the Companys cemented carbides, zinc and antimony productions are ranked as the first largest one nationwide, while its lead production is also ranked into the second largest in China.

On aspect of technical and brand image, the Company has powerful capacity on lead and zinc smelting, while also has strong equipment strength on the production of mining, nonferrous metal smelting and cemented carbides, with products quality leading the domestic level. Among these products, Zinc is an important non-ferrous metal raw material, and its consumption is second only to that of copper and aluminum.

In term of industrial chain, the Company owns a comprehensive integrated industrial structure, with business covering from upstream mineral resource prospecting, exploration, to midstream processing, smelting, and the downstream refining and deep processing. Strong and complete industrial chain is the base for HNMC to achieve sustained profitability and operational risk reduction.

Meanwhile, the Company is a subsidiary of a large-scaled state-owned enterprise group in Hunan, and also a resources and strategic company; therefore it enjoys a high degree government support. It is planning to take HNMC as major part to process external integration and merger.

On aspect of the Company development planning, resources control will be highlighted. By multiple means to enhance resource self-sufficiency rate, therefore provide powerful support for the Companys stable production and cost control. At the same time, through many cooperative ways to deepen the industrial and value chains; while in term of scientific research, the Company will put greater attention and give more support. All of these will provide impetus for the Companys sustained development.

Overall industrial environment impact on the Company

Currently non-ferrous metal prices are in downturn period, which is influenced by global growth rate slow down. The Companys main products like Lead and Zinc, their prices may further be suppressed; meanwhile, global market trends to form supply surplus, couple with unfavorable export policy and domestic smelting capacity expansion. It is estimated that in the coming two years, tungsten and cemented carbides will have good performance, but still insufficient to backup the Companys overall profitability.

Terminal prices continuous drop drove domestic manufacturers trying to stabilize the prices through jointly production reduction, while performance was unsatisfying. Furthermore, the electricity price rise at the end of June increased the Companys production cost. In medium-term, electricity price rise and products price decline trend will continue.

Valuation

Since the successful listing in Hong Kong in 2006, the Companys ROE has sharply dropped. It was partially caused by operation deterioration, while it also reflected that the Companys overlarge financial leverage, with low capital utilization rate. But it is worth noting that this financial structure may significantly improve valuation, in case of the Companys profitability recovering, while once the economic prospect is clarified, it will rapidly improve the Companys performance and stock prices level.

In term of valuation, owing to the Companys first half net profit dropped 75% than a year earlier, and fluctuated sharply comparing with previous figures, therefore we adopt P/B method. In view of the Companys recent troubled factors will continue, we conservatively give 0.8 X P/B in 2008, namely 12-month target price at HK$ 1.51 (estimated Renminbi 12-month appreciation is 6%), with 19.8% premium than current price. Then we give “Buy” rating.

Financial Date

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