The Hindu Business Line : Hindalco: Hold

Hindalco is expected to stage a comeback of sorts in 2003-04 after an indifferent previous year. But risks relating to international price stability remain, says Krishnan Thiagarajan.

SHAREHOLDERS of Hindalco Industries (Hindalco) may hold the stock at the current market price. The stock trades at a price-earnings multiple (PEM) of 11.4 times its 2002-03 per share earnings (before extraordinary items). The PEM may seem to be high for a commodity stock, but in the case of Hindalco, these valuation levels may be justified.

After all, since the completion of the scheme of amalgamation of Indo Gulf Corporation's copper division in February 2003, Hindalco has emerged as a non-ferrous metals powerhouse. Besides, given the strong volume growth anticipated for the rest of the year on brownfield expansion of aluminium and copper capacities, sound fundamentals and encouraging domestic market growth, shareholders can retain the stock for near-term upside potential.

However, shareholders should be geared to "pare exposures" if there is a decline in the overall market in the near term. At the same time, fresh exposures in the stock may be avoided as the scope for capital appreciation from these levels may be limited relative to downside risks. From an investment entry standpoint, both the PEM and price/book value (at 1.4 times) remain fairly stiff.

On the road to recovery

The year 2002-03 proved to be an indifferent year for Hindalco. On the sales front, the sluggish aluminium prices at the London Metal Exchange due to weak global economic environment put pressure on the topline. Whereas, on the production front, the disruption in power supply affected the production at the aluminium smelter in September, which stabilised only in the fourth quarter.

In addition, the higher operating costs on account of increased power costs and attack by insurgents on bauxite mines contributed to a squeeze in operating profit margins (OPM) in the third quarter. Despite a reasonably strong fourth quarter for the aluminium division, the OPM declined for the full year.

Factors aiding a bounceback

Driven by a combination of factors, Hindalco is poised to stage a comeback in 2003-04. These are:

Brownfield expansion: Hindalco has undertaken brownfield expansion of both its aluminium and copper capacities. The brownfield expansion of aluminium ingot capacities was completed in 2003-04 first quarter. This completion takes Hindalco's production capacity to 3.45 lakh tonnes from 3.1 lakh tonnes in the fourth quarter of the previous year. It is expected to continue contributing to the financials in the coming quarters.

This expansion, at a capital cost of Rs 1,800 crore, 40 per cent lower compared to a greenfield project, will lower its cash cost of production by another $50 per tonne. In any case, Hindalco is one of the lowest cost producers of aluminium in the world. Through de-bottlenecking, it proposes to enhances the aluminium metal capacity further to 3.6 lakh tonnes by end-2003-04.

The enhancement of the copper production capacities, which is currently under trial runs, is slated to go onstream in 2003-04 second quarter. Its existing smelting capacities are to be raised to 2.5 lakh tonnes from 1.5 lakh tonnes currently. Here again, Hindalco is aiming to be in the investment mode, in the process of finalising another expansion to copper capacities.

Margin recovery: Though the realisations in both aluminium and copper are expected to be flat, the drivers for margin growth will be strong volume growth and cost-efficiencies. If the domestic demand remains strong, the realisations from value-added aluminium products such as rolled products, extrusions and foils may marginally offset the pressure on prices for aluminium ingots.

The volume growth, in both aluminium and copper will be driven by stable production and expanded brownfield capacities. In aluminium, it has already been evident in the production growth in the first quarter of 2003-04 and fourth quarter of last year. In copper, the first quarter performance was affected due to bi-annual shutdown of smelter for maintenance.

Second, cost-efficiencies from its ongoing cost-reduction exercises and lower production costs on expansion are likely to drive up margins. The OPMs of the aluminium division, which fell to 33 per cent and 31 per cent in the second and third quarters of last year recovered to 38 per cent in the first quarter of this year and are likely to stabilise or be on the upcurve in the coming quarters. In copper, the low-cost expansions, leading to lower production cost per tonne and the acquisition of mines (for copper concentrate availability), will help margins (which are considerably lower than aluminium) in the medium term.

The downside risks

International prices: The international aluminium prices have improved in the latest quarter on account of commodity fund play. However, domestic prices have remained under pressure on account of competition and low demand. The margin outlook will depend to some extent on international prices remaining stable and the value-added aluminium products profile.

The copper fundamentals are improving, with recovery of prices in the latest quarter. But sustained rise in these prices will hinge on the Asian demand for exports and recovery in demand in the domestic market from its end-user segments — jelly filled telephone cables and power sector.

Any weakening in the aluminium/copper pricing environment (which generally move in tandem) will be a blow to the topline of Hindalco which has remained flat over the past 18 months.

Low TC/RC rates: Spot treatment charges/refining charges (TC/RC) rates collapsed by nearly 30 per cent in the latest quarter. The company claims that it has already entered into TC /RC contracts for copper concentrates (the basic input for copper cathodes) for a good part of the year at higher rates under long-term contracts. And is insulated from these lows for the year. Currently, negotiating on TC/RC rates are on for the calendar year 2004.

If they do not recover, the contracts are likely to be struck at levels which are lower than the TC/RC average for calendar year 2003.This is bound to have an impact on the operating profits of the copper division of Hindalco towards the end of this full financial year.

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