Capacity investment more than street valuations

Among the most dislocated Asian non-ferrous stocks: Hindalco is the second worst-performing stock in our Asia-Pacific non-ferrous coverage universe on a 12-month basis, down 29%. Consensus has lowered FY14 Ebitda estimates by 10% during this time-frame.

Market concerns are overdone: We believe the Street has concerns over: (i) Hindalco?s $6bn investment in setting up new capacities, which will likely yield a ROCE (return on capital employed) lower than incremental WACC (weighted average cost of capital), and (ii) the shrinking ingot-scrap spread and the risk it poses to Novelis? Ebitda. We believe that while Hindalco?s investments may not be worth what it has paid for them, given the absence of cheap access to coal, they certainly are not worth the ?zero? value the Street appears to be assigning to them. Also, the shrinking ingot-scrap spread will not materially impact Novelis? Ebitda, in our view.

More upside than downside: In our base case scenario, we find investors almost paying nothing for the $4 bn spent on the new capacities. If Novelis? Ebitda grows to $1.3 bn in FY16, even after valuing CWIP (construction work in process) at zero, the stock offers a 24% difference to the current share price. In a worst case scenario, if Novelis? Ebitda does not grow and CWIP is valued at zero, we believe there is a c35% negative difference to the current share price. However, the worst case scenario is fraught with upside risks. In a best case scenario, assuming investors value CWIP at 25% of the amount invested and Novelis? Ebitda reaches $1.3bn in FY16, we see a 66% difference to the current share price. Overall, we see more upside than downside risks.

We lower our FY14-15 Ebitda estimates by 13% and 11%, factoring in lower profitability at the standalone business due to a weak aluminium price outlook. We derive a target price of R120/share and continue to rate Hindalco Overweight. Our target price implies a potential return of c34%.

Lower-than-expected aluminium prices and copper TC/RCs (treatment & refining charges), coupled with delays in project execution at Mahan Aluminium and Utkal Alumina, are the key downside risks.

HSBC