Hindalco: Novelis & increased production from new smelters may not sustain higher profitability

Coal issues to hurt earnings of new aluminium capacities

Hindalco is a stock that has remained popular with foreign investors, though metal prices continue to weaken globally. Over the past year, the stock has risen 40 per cent, compared with the 37 per cent rise in the Sensex. After the company's earnings beat estimates in the second quarter, many analysts have taken a positive stance on the stock, though availability of cheap coal from captive mines continues to be a key overhang for the new aluminium projects (Aditya, Mahan and Utkal). Will the stock continue to deliver in the future?

Analysts have predicted Hindalco’s operating profit would double in three years, as the demand for aluminium body sheet in North America was set to quadruple. Novelis has a 50 per cent market share in this segment. Novelis has invested to change its product mix such that auto sheets account for 20 per cent of its shipments in 2017, against 11-12 per cent in at present. The market is currently assuming higher margins for the company, based on these dynamics.

However, Neelkanth Mishra of Credit Suisse says, “While most believe auto-sheet volumes generate much higher-than-average Ebitda (earnings before interest, tax and depreciation and amortisation), we believe the supply-side response (competitor capacities) is not well understood, and we could see oversupply. But, the market may not get information on FY17 margins for more than a year. Novelis is, thus, unlikely to be a catalyst for now.” There are a couple of other factors that can affect Hindalco’s fortunes in the future.

For starters, premium on physical aluminium has been rising despite falling energy costs. However, as LME prices continue to remain under pressure, physical aluminium could also come under pressure. Also, with demand slowing across the globe, base metals are at risk. Also, Hindalco has been a key beneficiary of cheap domestic coal available to it. But with the company losing its coal mines after the Supreme Court ruling, the benefit of cheap coal is gone as of now. Centrum Broking says Hindalco’s aluminium division reported six per cent higher Ebit (earnings before interest and tax) sequentially, led by higher volumes, better LME prices and strong premiums but this was negated by higher coal costs and shutdown at Hirakud/Aditya smelters.

The brokerage does not expect a break-even at profit before tax level for the new aluminium portfolio (Utkal, Mahan and Aditya) even in FY17 due to high interest and depreciation costs. However, visibility on earnings from a long-term perspective may improve substantially if attractive mining assets are won at the auctions.