Re-rating could be around the corner

Updated: Feb 19 2013, 01:37am hrs
Utkal and Mahan projects are ready for commissioning; aluminium prices have possibly bottmed out

Hindalco Industries remains among our top picks in India and we remain overweight with a price target of R160, implying 50% upside potential. In our view, the current stock price of Hindaclo is only pricing in Novelis (downstream subsidiary, 100% owned) and a part of the current India business in FY14e and not even Novelis in FY15e. With project commissioning on the way and India aluminium recovery (as production stabilises), we expect the sharp discount to our fair value estimate to narrow.

Admittedly, reported earnings for the standalone business would be under pressure given higher capital costs as projects start flowing through the P&L (profit& loss account), however, cash earnings should pick up as the projects deliver positive Ebitda.

Our December 2013 price target of R160 is based on our FY14e sum-of-the-parts (SOTP) valuation. We remain Overweight given the inexpensive valuations at 0.55x (times) P/B (price-to-book value) and continued strong downstream earnings at Novelis.

Expect re-rating on non LME drivers: Hindalco has corrected 17% from recent highs driven mostly by a beta sell-off seen in India over the last one month. In our view, the stock is attractively priced and offers investors decent risk-reward at current levels. Novelis (100%-owned downstream subsidiary) remains on a strong footing (the Q3 earnings miss was mostly driven by one-time issues) and volume growth should start as the new projects get ramped up (with the Pinda facility in Brazil among the big ones). The much-delayed greenfield projects in India (Utkal alumina refinery, Mahan and Aditya Aluminum smelters) are ready for commissioning and we expect both Utkal and Mahan projects to get commissioned by June 2013.

The India aluminum business which saw Ebit (earnings before interest and taxes) margins drop to 8% from over 20% levels should see margins recover as production stabilises at both smelters (Hirakud and Renukoot). Project Blue Fox (the downstream project in India) should also aid incrementally from the current levels. LME aluminum prices have likely bottomed out.

The key pushback we are facing from investors is on three fronts. (i) The likely sharp increase in reported interest and depreciation as the projects get commissioned and flow through the P&L instead of being capitalised. (ii) The possibility of bauxite mining getting delayed which would sharply increase alumina and aluminum cost of production, and (iii) Large net debt at the consolidated level (FY13e exit should be near R400 bn).

In our view, the key issue is ramp up of bauxite mining at the Utkal mine and once that is achieved the other issues become less relevant. Captive bauxite mining would allow Hindalco to produce alumina at <$250 per tonne on steady state and aluminum <$1,900 per tonne even on bought out coal. We expect Utkal and Mahan to be commissioned over the next three-four months. In our view, while the capital costs (interest and depreciation) would increase, Ebitda generation should also start increasing from new projects.

Novelis update: Pinda commissioned in Dec-12, expects 60KT for FY14e. The Brazil capacity expansion (capacity addition of 220KT) should aid earnings growth. The volume ramp up guidance (50-60kt in FY14), is conservative and could be higher if market demand growth surprises on the upside.

The company highlighted that demand remains solid and the operating performance should improve from the current levels.

The company believes the can market in North America has become very competitive. There is pricing pressure in Asia. As the Oswego auto facility comes on stream over the next 18-20 months, the company expects overall Ebitda/ tonne to benefit. While the company does see some moderation in Ebitda/t, overall it should be much above Q3 levels. We are enthused by the companys comments that over the next 24-36 months as (i) the scrap usage rises, and (ii) the auto segment sales increase, $400 per tonne adjusted Ebitda/t is possible.

JP Morgan