NALCO

Investors can consider booking profits in the stock of aluminium producer NALCO. An uncertain outlook for aluminium metal prices, coupled with little visible expansion in aluminium smelter capacity, might leave the company with little scope for earnings growth in a market suffering from an aluminium supply glut and possibly stagnant realisations.



The company trades at Rs 403, which is at 26.3 times trailing 12 month earnings, the higher end of its historic valuation band.

OPERATIONS

The company currently has the capacity to mine over 4.8 million tonnes of bauxite, refine just over 1.6 million tonnes of alumina and smelt just under 5,00,000 tonnes of aluminium metal in addition to 1,200 MW of power (surplus is sold to the national grid).

The company's key operational advantage has been the low conversion cost of bauxite into alumina and its captive power production, both of which helped its aluminium metal operations sail through with a marginal operational profit in 2009-10. This was a period during which very few global aluminium producers escaped red ink.

The company is planning a 30 per cent addition to Brownfield capacity through increases in its mine output and alumina refining capacity, which are expected to come on stream by March 2011.

The company exports roughly a third of its alumina and aluminium production volumes. Alumina realisations are linked to LME aluminium metal prices accounting for anywhere between 13-16 per cent of the latter.

Lower realisations, higher coal prices (disruptions in local supply saw them importing coal) and increasing labour costs over the last two years have seen operating margins slip lower to 29 per cent in 2009-10 with sale of excess power and alumina.

There may be no immediate relief for the company from rising costs of outsourced inputs such as coal and caustic soda.

Net profits are at a third of FY07 levels due to rising costs and deteriorating aluminium metal prices due to excess global smelter capacity, weak demand in developed markets and, as mentioned earlier, rising operating costs.

GLOBAL REALISATIONS

The pricing outlook for aluminium and alumina also does not look too positive, indicating weak realisations for NALCO. First, there is the overcapacity in global aluminium smelter capacity due to weakness in China which accounts for 40 per cent of global capacity.

China's high cost of production, domestic supply glut and various incentives to keep smelters going has led to the country becoming a net exporter of aluminium for the first time in 18 months.

Moves such as the intended shutdown of a million tonnes of smelting capacity (by 2011), provincial freezes on new smelters and rescinding export rebates, may take a two-three year time frame to reflect in prices. West Asia is another region which expects to see major smelting capacity to the tune of over four million tonnes per annum come on stream by 2011.

VISIBILITY

The company's Greenfield expansion plans have remained a cause of concern with poor visibility for intended projects in Orissa and Andhra Pradesh. Other possible initiatives include nuclear energy in addition to mines and smelters in Indonesia.

The finance director had recently indicated the company has cash reserves of Rs 4,400 crore which should serve the company well for mine and refinery expansion. Negligible debt levels make expansion through leverage a possible option.

Indian producers, including Hindalco and Sterlite, have ambitious expansion plans which see their domestic alumina and smelting capacities rise by multi-fold over the next four years. Demand for aluminium has historically tracked GDP figures, however this number is expected to soar to 10-12 per cent over the next few years.

NALCO's operational structure with mines and refinery in close proximity, captive power (excess of which is sold to the power grid) and prudent expansion policies served it well through the recent slump.

However, challenges, including realisations and competition, are likely to bring the stock's current premium under scrutiny.

The government owns 87 per cent of NALCO and recent reports have indicated the possibility of a 10 per cent stake sale or a bonus issue to broad-base the non-promoter holdings.

via BL