Event update: Hindalco Industries (Outperformer) - Concerns overrated; remains preferred pick

Hindalco (HNDL) has underperformed the broader market and corrected ~4% in last 3 months. This note addresses the following key investor concerns: (a) Will aluminum prices fall due to rising aluminium inventories and whether aluminium supply in China increases post completion of winter shutdown in March 2018 (b) Will Novelis’ earnings be hit after imposition of tariffs on the aluminum industry by the US.

Rising aluminum inventories at warehouses not a concern: We believe marginal increase in inventories (1.7 weeks of consumption versus 1.5 weeks of consumption in December 2017) at warehouses (LME+ Shanghai exchange) is not a cause of worry for aluminium prices, as Q1 is usually a lean period for world aluminum consumption. Rising inventories should liquidate from Q2, as Q2 and Q3 are seasonally strong quarters. Moreover, Chinese supply reforms continue with its aluminum production having fallen 2.2% yoy in January 2018. We do not expect Chinese smelters to reopen post cuts seen during winter shutdown, as it would be a loss-making proposition at aluminium price of ~US$2,100/t. Moreover, Q2CY18 regional premium (Japan) is expected to settle ~25% higher qoq to US$129/t, indicating tightness in global aluminum market.

Imposition of US tariff on aluminum is unlikely to hurt Novelis’ earnings: HNDL’s 100% subsidiary, Novelis earned ~38% EBITDA (US$456mn) from North American operations in last 4 quarters. The US has imposed a 10% import tariff on primary aluminum and on value-added products for all countries except Canada and Mexico. As Novelis’s US operation uses a mix of scrap and imports primary aluminum from Canada, it will largely be insulated from any tariff hike. Moreover, as Novelis’ rolled products also fall under the import tariff, it would be at a competitive advantage over any imports in the US. We believe a marginal impact could be its inability to pass on the sudden rise in regional premium at the most for a quarter.

Reiterate HNDL as our top pick; target price unchanged at Rs346: We believe the fall in stock price provides a buying opportunity, as ~70% of HNDL’s FY19E EBITDA is insulated from aluminum price fluctuations. With emerging clarity on aluminum hedging volumes and prices in FY19E and its cost of production (CoP) peaking out soon, we expect EBITDA from HNDL’s India operations to increase 29% yoy to Rs78.7bn in FY19E.   We have not factored in any probable acquisition in our estimates. The stock is currently inexpensive at 5.0x FY20E EV/EBITDA. We reiterate our Outperformer rating with a target price of Rs346, valuing India business at 6.5x FY20E EV/EBITDA and Novelis at 7.0x FY20E EV/EBITDA.