However, FY19 outlook is intact and higher Al prices offer opportunity to hedge FY19 sales at higher rates
We believe HNDL may not fully gain from the recent sharp rally in aluminum prices as it has hedged around 56% of its FY18 volumes, 13% below spot Al LME. Hedging gains related to Fx hedges would likely offset Al hedge losses and cushion the impact on FY18E EBITDA. While hedges may limit Al price leverage in FY18, we stay positive as (i) FY19 outlook remains intact; (ii) higher Al prices offer opportunity to hedge FY19 sales at higher prices. Maintain Buy.
Almost 56% of Al volumes hedged at lower prices: As per FY17 annual report, HNDL has hedged 979 kt of Al volume (78% of FY 18E volume) at $1796/ton, 13% below spot (6% below our FY18 Al estimate). Of this around 72% of hedges would mature in FY18E. HNDL’s stated strategy has been to hedge around 30-40% of its Al volumes, but proportion of hedged volumes in FY18 appears higher. Separately, HNDL’s standalone entity has hedged $1.38 bn (notional value) of Fx at 72.03 Rs /$ (spot 64.1 Rs /$), of which 68% would mature in FY18. Losses on Al Hedges may be offset by Fx hedge gains: Assuming Al LME est. of $1913/ton in FY18 (our base case), hedging loss in FY18 related to Al could be around Rs 5.4 bn (at base case Fx of 65 Rs /$). We estimate corresponding gains on Fx hedges could be around Rs 6.6 bn. Assuming 50% of the Fx hedges pertains to Al, hit to Al Ebitda could be $25/ton.
Al price leverage could be limited in FY18E: Al LME has surprised positively, with spot Al LME rallying 8% since June to $2060/ton, ahead of our base case estimate of $1913/ton in FY18. While HNDL may meet our estimates, large outstanding Al hedges limits scope for potential Ebitda upgrades in FY18 despite the Al price rally. We see scope for earnings upgrades in FY19, if spot aluminum prices sustain. We assume AL LME of Rs $1935/ton in FY19E. Chinese Al production falls in July, likely reflecting supply cuts: Strong rally in Al prices has been led by news flow around smelter cuts and expectation of output cuts in winters. As per IAI data, annualised Chinese Al output in July is down 11% on m-o-m (4mn tons) likely reflecting impact of non compliant capacity cuts.
HNDL is trading at 6.5x FY18E Ebitda. Our PT of Rs 261 is based on SOTP valuation. We value India operations at 6x FY1e Ebitda and Novelis at 7x FY18e Ebitda (Sept 18e). Risks: lower Al prices; higher coal costs; lower margins at Novelis.