FCF generation should be strong; valuations appear cheap; ‘Buy’ maintained with TP of Rs 282
We believe Al LME is bottoming out and may recover as smelter spreads are still thin, alumina prices are stabilising and Chinese downstream demand may improve. Novelis should continue to gain from scrap tailwinds. We believe concerns around re-pricing of auto contracts downwards may be overdone as US Al auto sheet markets are still tight. FCF generation should be strong. At 5.5x FY20e Ebitda, valuations appear cheap. Buy
Al LME range bound YTD
Al LME (flat YTD) has underperformed Cu (+9%) and zinc (15%) YTD CY19. Exchange inventories have been stable. Chinese Al output (annualised) fell 283 kt y-o-y (-2mn tons m-o-m). Lifting of Rusal sanctions, weak Chinese downstream demand, rising Chinese Al exports and falling cost curve (lower alumina cost) have weighed on Al prices.
Prices likely bottoming out
Al smelter spreads have improved from Nov lows, but are still below historic avg. Around 35% of global Al smelters and 50% of Chinese smelters are likely making losses at spot prices. Record high Al exports (500kt) in Jan has been a concern, but this may moderate as Al LME SHFE arbitrage has narrowed in recent weeks and is now below the 3-year average. Potential improvement in downstream demand due to seasonal factors and Chinese stimulus could support better prices. Recent Chinese VAT cut to 13% (from 16%) may however lift smelter margins slightly.
Assessing alumina cost curve for potential downside
Key concern is that likely easing of alumina supply (Alunorte ramp-up) may drag alumina and thus Al prices lower, even if spreads stay thin. Based on cost curve, we think alumina prices may be supported at over $330-350/ton (spot $390/ton) as ~25% of global alumina capacity may be loss-making at these prices. Thus Al LME should be supported at over $1800/ton.
Novelis: Scrap tailwinds; auto headwinds
Q4 YTD average LME scrap spreads are still near Q3 average Spot spreads are a tad lower. Despite auto sector headwinds, Al sheet demand has been resilient due to rising Al sheet intensity. Beverage can markets are also improving. Auto accounts for 20% of Novelis volume. Part of these are due for renewal in 2019. There are concerns around downward re-pricing of contracts, but we think meaningful repricing is unlikely near term as US Al auto sheet markets are still tight. This could be a potential risk medium term.
Mark to market scenario
Stable margin downstream Novelis, Aleris (7x Ebitda) and Cu TCRC business (6x FY20 Ebitda, no debt) account for `189/ share of our SOTP valuation of `282. At spot Al LME and Fx, MTM FY20e Ebitda would be 11% lower vs base case and SOTP valuation would be `235 as per our estimate.
Company description: Hindalco is among the largest producers of aluminum in India with integrated aluminum capacity of 1.2 mn tons, alumina capacity of 3 mn tons. It also has copper smelting assets in India with capacity of 500 kt. Its US subsidiary Novelis is among the leading aluminum flat rolled producers.