Hindalco Industries (Novelis) (Outperformer) - Favorable scrap spread boosts earnings

Novelis Q1FY19 result highlights- On a firm footing

• Novelis, a 100% subsidiary of Hindalco, reported better than expected operating performance with adjusted EBITDA of US$332m (IDFCe: US$310m), up 14.9% yoy and 4.1% qoq with EBITDA/t of US$417, up 13.1% yoy and 5.1% qoq. The results could have been better than this but was affected adversely due to loss of 20kt sales volume (10kt in North America due to auto customer unplanned shutdown and another 10kt in Brazil due to 10-day truck strike) in Q1FY19 which will bounce back in Q2FY19. The consistent operating performance highlights the stability of the conversion business, allaying fears of negative effect on financials amid geo political and trade uncertainty.
• Adjusted EBITDA was up primarily due to higher volume (up 2% yoy to 797kt) and favourable scrap spread (aluminium-scrap price) as Novelis uses scrap to produce 55-60% of aluminium products. The management informs that the favourable spread may not be sustainable and expect some softness in spread going forward which can hit EBITDA/t by ~US$20.
• Net debt remained at US$3.6bn with net debt/EBITDA of 2.9x.

Key positives: favourable scrap spread, EBITDA/t of US$417; S&P Credit rating upgrade to BB- from B+

Impact on financials: Will review post Hindalco’s result

Valuation & view: Reiterate outperformer with TP of Rs346

Novelis’s FY19 earnings is expected to be driven by 3% yoy higher volume, improved product mix, favourable scrap spread and end of negative beverage can pricing. This along with the improved financial performance of Aleris (Novelis has signed a definitive agreement to acquire it in July 2018) bodes well for the stock. We remain confident of management’s guidance of Aleris achieving EBITDA of US$360m in the first year of operation after Novelis completes the acquisition. The acquisition is expected to be completed by 1HFY20E. With Aleris acquisition, HNDL’s ~65% of EBITDA will be based on conversion margin which is growing and more stable in nature. Being in the lowest quartile of the world aluminium cost curve, HNDL’s Indian aluminium operation can withstand any downfall in aluminium prices. We value the India operations at 6.5x FY20E EV/EBITDA and Novelis at 7.0x FY20E EV/EBITDA and arrive at a TP of Rs346. Reiterate Outperformer.