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Result in line, guidance lowered for a quarter

Inflation impacts margin adversely

* Novelis reported a strong beat on topline in 2QFY23 but EBITDA was in line with our estimate. Strong performance by Asia division strengthened margin.

* Revenue/EBITDA/APAT came in at USD4,799m/USD502m/ USD238m, down 5.7%/10.5%/14.7% QoQ, respectively. Topline was a sharp 18% above our estimate while EBITDA and APAT were in line with our estimates in 2QFY23.

* Shipments during the quarter stood at 984kt (up 1.7% YoY/2.3% QoQ) and were in line with our estimate of 1,000kt.

* Management highlighted that higher energy and logistics costs are likely to impact the second half adversely, especially 3QFY23 to the tune of USD75- 125/t. Contracts will get reset from 1st Jan, 23 when Novelis will try and cover most of the increased costs and push for higher EBITDA of USD525/t on a normalized basis.

* Revenue/EBITDA/APAT for 1HFY23 stood at USD9,888m/USD 1,063m/USD517m, up 24%/0.2%/5% YoY, respectively. The sharp rise in topline was offset by rising costs leading to a flat EBITDA.

* The lowered guidance comes as a surprise as the management had in the previous quarter itself sounded confident of achieving EBITDA/t of USD525 for FY23. However, we note that these are temporary headwinds and do not dent the structural margin improvement story of Novelis.

* Net debt for the quarter, at USD4.6b, was marginally higher by USD107m QoQ. Leverage remained at a comfortable level of 2.3x.

EBITDA/t guidance for 2HFY23 reduced by USD75-125

* In the 1QFY23 earnings call, the company had raised FY23 EBITDA/t guidance to USD525 from USD500. This implied a guidance of USD505/t for the remaining three quarters in FY23 then.

* However, post-2QFY23 results, the management revised down its 2HFY23 guidance sharply by announcing an additional impact of USD75-125t on margins in 2H due to higher energy/logistics costs.

* The guidance comes despite Novelis being hedged for about 80% of its energy costs for the remaining of FY23 and above 60% for FY24. Management highlighted that the energy costs in Europe have come off substantially and with warmer-than-expected winters, the energy prices could possibly stabilize at that level.

* Management also highlighted that the contracts typically start getting reset from 1QCY23 (viz. 4QFY23) and its endeavor shall be to pass on the incremental cost to the customers and bring back the EBITDA margin to USD525/t. However, it might take a couple of quarters to fully pass on the rising costs.

Valuation and view

* In light of the sudden downward revision to the 2HFY23 guidance, we revised our EBITDA estimate for FY23 to USD486/t from USD535/t. However, we remain optimistic that Novelis is likely to announce an upward revision to its 4QFY23 EBITDA/t guidance at the end of 3Q as it gets more clarity on revision to its contracts for 4QFY23.

* Reduction in FY23 EBITDA/t for Novelis by 9% has led to 7% cut in consolidated EBITDA and 11% cut in consolidated PAT for FY23.

* We, however, note that the sharp drop in LME aluminum prices should lead to a working capital release and as a result of which the net debt should continue to improve. Management highlighted that it expects FCF of more than USD500m at the end of FY23 v/s a negative FCF of UDS90m for 1HFY23, driven by working capital release.

* In addition, Novelis has also lowered its capex spending for FY23E to a range of USD900-1000m v/s previous guidance of USD1.3-1.6b, which should help reduce its debt.

* Leverage continues to remain under control at 2.3x with marginal change in net debt position.

* We note that the stock now fully prices in: a) lower LME aluminum prices, b) a weak Chinese economy, c) recession in Europe, and d) rising inflation reflected in higher input costs and lower premiums.

* Hence, we raise our target multiples for both India and Novelis to reflect the long-term opportunities rather than focus on just one quarter of weak operating results.

* We believe the weakness in the stock post-Novelis result should provide an opportunity to buy as we remain confident about the long-term opportunities of Novelis and its leadership in both beverage can and automotive markets.

* We raise our SoTP-based TP of Hindalco to INR510 from INR480. The stock is trading at 5.8x/5.0x our FY23E/24E EV/EBITDA. On P/B estimates, the stock is available at 1.5x our FY23E. Maintain BUY.

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