Outlook beyond Q3 remains cloudy; maintain Sell
* Recent strength in alumina prices is driven by production disruption at the Alunorte alumina refinery in Brazil. Norsk Hydro has announced that the Alunorte refinery shall achieve full production in Q4CY20, which will put alumina prices under pressure.
* The aluminum market is likely to remain in surplus in 2020 in China (1-1.3mt) and in Rest of World (2-3.4mt). This will keep aluminum prices under check. Recent run up in stock is on account of the disruption in Alunorte.
* Q1 earnings beat our estimate due to higher-than-expected alumina sales vs. our assumption of higher aluminum sales. Rs4.5bn negative change in inventory is the largest in the last 30 quarters, which should reverse in the coming quarters.
* Nalco is trading at 4.9x our FY22 EV/EBITDA estimate. It has planned capex in excess of Rs300bn in various projects, the benefit of which is unlikely to be seen before FY23. We make minor adjustment to our estimates, maintain Sell with a TP of Rs30 (up from Rs29).
Alumorte disruption appears priced in: The run up in the last three months was driven by two minor disruptions at Brazilian operations of Norsk Hydro. First, a disruption in power supplies to its paragominas bauxite mines for three weeks, followed by a 30-day bauxite supply disruption at its Alunorte refinery that will impact production of alumina in H2CY20. This led to panic buying in the Chinese market, and Alumina prices reacted strongly. However, we believe this event is now already priced in, unless there are further disruptions in the alumina market in China or elsewhere.
Volume growth continues to elude Nalco: The company reported positive aluminum EBIT after a gap of four quarters. However, this is assuming transfer of alumina at cost to the aluminium division. If alumina is transferred to the aluminium division at market, then the aluminium division should continue to report losses. In addition, we do not expect significant volume growth in production/sales volumes till FY23, which leaves metal prices as the only lever of profitability for the company.
Outlook and valuation: Alumina prices currently are guided by 1) supply disruption at Alunorte (already priced in) and 2) possible closure of smelters as China announces winter production cuts. This should lead to increasing surplus in the alumina market on a month-onmonth basis unless Chinese demand for imported alumina continues to remain robust. The stock trades at 4.9x our FY22 EV/EBITDA estimate. Reduced cash of Rs4.4/2.9 in FY21/22 offers little comfort as we expect a nominal Rs1 DPS going forward. Maintain Sell. Key risk is any significant hike in alumina prices.
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