Why Hindalco is a long-term buy

The global economy has been losing momentum since 2018, due to the trade frictions between the US and China and the uncertainties with Brexit. Metal companies, which largely depend on the global economic activity, have been the worst hit. The stock price of Hindalco, a manufacturer of aluminium and copper, has fallen more than 25 per cent from the beginning of 2018.

The recent signing of the phase 1 trade deal between the US and China has failed to address most of the key issues and retained the bulk of the tariffs imposed earlier.

But it has eased up tensions a bit, and with fewer uncertainties around the Brexit deal, sentiments could improve for global trade and investment, over the next one to two years.

While near-term volatility may persist for commodity stocks such as Hindalco, the sharp fall over the past two years provides good opportunity to bet on the stock for the long term.

Hindalco has a diversified presence across geographies, and is well-placed to benefit from a global recovery, when it happens. The Centre’s push for infrastructure spending will also help improve domestic metal demand. The improving operational performance of Novelis, the US-based downstream arm of Hindalco, is also a big positive for the company.

Novelis’ acquisition of Aleris, one of the largest manufacturers of aluminium products in the US, will also help growth.

At a current market price of ₹205, the stock is attractively valued at about 5.8 times its trailing 12-month earnings (enterprise value/earnings), which is lower than the average of 6.06 times that it traded at over the past three years.

Long-term investors with a high appetite for risk can consider buying the stock.

Outlook could improve

Hindalco derives its revenue from its domestic businesses of aluminium and copper, and and its aluminium recycling facility in the US (Novelis). In FY19, while sales of aluminium and copper from the domestic business constituted about 35 per cent of total sales of the company, sales from Novelis accounted for 65 per cent.

The International Monetary Fund (IMF) projects higher growth in 2020 and 2021 for geographies such as Europe, Germany, South America and emerging markets; Hindalco has a presence in most of these locations. Lower growth projections for the US and China in 2020 and 2021 compared with 2019, is a concern, though.

The IMF has also predicted that the prices of non-fuel commodities (including base metals) could increase by 1.7 per cent (y-o-y) and 0.6 per cent in 2020 and 2021, respectively.

On the domestic front, while the IMF’s projections on India’s economic growth are lacklustre at 5.8 per cent and 6.5 per cent, respectively, for 2020 and 2021, they are still better than 2019’s growth estimate of 4.8 per cent.

Also, the Indian government’s initiatives to improve investment in the infrastructure and housing segments, coupled with low interest rates, may support demand for metals going forward.

Novelis, the bright spot

Novelis, a 100 per cent US subsidiary of Hindalco, sold 3.3 million tonnes of output in FY19 and contributed nearly 65 per cent and 55 per cent to the consolidated revenue and operating profits, respectively, of the Hindalco group.

The subsidiary has been posting record operating profits year on year — despite falling LME (London Metal Exchange) prices in the past two years — on the back of favourable market conditions and strong demand.

The company derives its revenue from aluminium flat rolled products — beverage cans (63 per cent of sales), automotive sheets (20 per cent) and speciality products (17 per cent). Novelis is also geographically well-diversified in terms of its revenue mix — North America (35 per cent), Europe (27 per cent), Asia (22 per cent) and South America (16 per cent) in FY19.

The prospects for Novelis appear bright, especially for the beverage can market, where consumer demand for sustainable packaging options (a shift from packaging materials such as glass, steel and PET) continue to grow. While there continue to be some pockets of softness for automotive aluminium sheets in non-US auto markets, the overall demand for aluminium sheets remains quite healthy.

Also, the availability and demand for scrap in the US is expected to get better.

The company’s investment of $36 million to expand and upgrade its current recycling capacity in North America will augur well for growth.

The investment is strategically made, as more auto-makers turn to light-weight aluminium vehicles.

But for now, all eyes are on Novelis’ $2.58-billion cash acquisition of Aleris, an aluminium manufacturer with a global footprint in Europe, the US and China, which the management expects to contribute about $360 million (about ₹2,500 crore) to the firm’s annual operating profit (about 15 per cent of the group’s operating profit in FY19), after the deal closure.

Like Novelis, Aleris, too, is primarily in the downstream aluminium products business. The acquisition will also give Novelis a presence in the construction and aerospace segments.

However, the deal is awaiting approval from the European Commission. For the deal to come through, Novelis have to hive off Aleris’ Duffel facility in Belgium.

It may also have to divest another Aleris plant in Lewisport (US), which has a 200 kilo tonne (kt) auto facility and a 350 kt hot strip mill facility.

Even then, the management expects the acquisition to result in synergies of $150 million per annum.

Dent on financials

Unfavourable market conditions have impacted the operations of Hindalco in the current fiscal. In H1FY2020, its revenues fell 6 per cent y-o-y to ₹59,629 crore.

This was largely on account of a drop in prices and demand for the metals, due to trade tensions.

Thus, the group’s profit after tax (PAT) was impacted, as it slumped 30 per cent to ₹2,037 crore in H1FY20 compared with the previous year. The consolidated net debt-to-EBITDA, too, worsened — 2.83 times at the end of September 2019, versus 2.48 times at the end of FY2019.

The company’s operational performance can remain under pressure in the near term, until there is a revival in global activity.

Key risks to our call include escalating geo-political tensions impacting economic growth and rising imports of cheap metals into India.

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