Moody's downgrade risk: Additional concern for Hindalco

Ongoing capacity expansion will add to volumes, but risks on declining aluminium premium and coal are a key concern

The Hindalco stock, which hit a low of Rs 118 in early trade on Monday, losing more than a per cent compared to the previous close, bounced back to close at Rs 121.5, a gain of 0.25 per cent. While the correction was due to a knee-jerk reaction to news on risks of a Moody’s downgrade, analysts say sustainability of aluminium prices at high levels is important.

Following some key capacity closures (globally) and curtailments, a sharp rally in aluminium prices since mid-February led to a smart 25 per cent rally in the Hindalco stock. The ongoing expansion at Hindalco aided the stock. Many analysts remain positive on it; they expect good growth in volumes, driven by satisfactory progress at Hindalco’s Utkal project.

But aluminium prices, which had risen $100 a tonne to about $1,740 a tonne on the London Metal Exchange (LME) in a month, are down to $1,680 levels. Girirraj Daga at Nirmal Bang Institutional Equities feels considering the slowdown in China, the upside to aluminium prices remains limited and supplies still exceed demand. Goutam Chakraborty at Emkay Global is concerned about the sustainability of aluminium premia (the excess over the metal’s LME price). The concern of rating agency Moody’s about the debt of Novelis (Hindalco’s international subsidiary) is an added overhang.

While nine of 18 analysts polled by Bloomberg have ‘buy’ ratings and five ‘hold’, consensus target price, at Rs 124.55, means limited upside for the stock.

Moody’s concerns
According to reports, Moody’s has placed the debt of Novelis under review for a possible downgrade. This was because of the company’s subdued operational performance in the recent past. Reportedly, Moody’s had said the review of downgrade was due to contraction in the Ebit (earnings before interest and tax)/interest ratio to 1.7 for the year ended December 2013, and an increasing leverage position, as seen by the debt/Ebitda (earnings before interest, tax, depreciation and amortisation) ratio falling to 6.9 from 5.6 for the financial year ended March 31. This reflects a lower Ebitda level and increased debt due.

The concerns raised by Moody’s can be addressed if aluminium prices and premia improve. The group has, however, said both Novelis and Hindalco are “rock solid companies”, adding there is no question of a default by Novelis.

Aluminium prices: A worry
Analysts at JM Financial say global aluminium markets were oversupplied by 1.57 million tonnes (mt) in 2013. They add about two mt of additional capacity is being ramped up, of which 1.2 mt is scheduled for 2014. They add this will offset any production cut (by other players). Despite the recent run-up in aluminium premia to $450/tonne, they believe any cut in waiting time for physical deliveries, with the implementation of new LME norms across warehouses, could lead to correction in premia from the current record levels. According to analysts at Antique Stock Broking (who peg the premium at $250-300), aluminium inventories on the LME, at 5.4 mt, remain near record highs. Total global inventories are estimated at about 12 mt. Chakraborty at Emkay Global, too, is concerned about the sustainability of premia at these levels.

An increase in interest rates, as the US Fed continues its tapering programme, could make financing deals infeasible, believe analysts at JM Financial. JM’s analysts continue to remain underweight on aluminium majors such as Hindalco.

Capacity expansion: Coal an issue
Alumina and aluminium capacity additions being carried out by Hindalco, especially at Utkal Alumina, are considered positive by analysts. Hindalco’s domestic aluminium annual capacity is being expanded from the current 560,000 tonnes to 1.28 million tonnes by FY16 (through the Mahan and Aditya projects). The company’s alumina project is among production units that have the lowest costs globally. The company started alumina production in December 2013 and analysts at Edelweiss say they have increased their FY15/FY16 volume assumptions to 0.85 mt/1.3 mt from 0.75 mt/1.1 mt earlier. They have also raised their FY16 consolidated Ebitda by two per cent and the target price to Rs 139 from Rs 127.

However, the medium-term profitability depends on coal. In a recent report, analysts at Antique Stock Broking said, “The planned capacity expansion is integrated with respect to alumina by the Utkal refinery (1.5 million tonnes a year) and captive bauxite linkage. However, captive coal availability for the Mahan project is still about 18-24 months away (post the stage-II forest clearance) and uncertainty over the Talabira coal block for the Aditya smelter raises concern on the profitability of these projects.”

Power is an important cost element in the production of aluminium. The analysts added the return ratios for the Mahan and Aditya smelters would be suppressed and the projects would lose value till there was an improvement in aluminium prices and captive coal was available for the projects.