Citi Group: Indian Aluminium Sector

Valuation Our target price is based on 9x FY09E earnings. We use P/E because stocks such as Hindalco are largely driven by commodity price trends, which translate into earnings momentum. The stock has been trading in a P/E band of 7x and 9x over the past four years. It tends to move towards the upper end of the band when international aluminium prices move up. We use a 9x 12-month forward P/E multiple to value the stock, giving a target price of Rs240. The multiple appears justified given the substantial upgrade to our 2008-10E international aluminium price forecasts based on the deficits we expect due to strong demand growth and supply curtailments. Our target multiple continues to be at a discount to Nalco ‘ s target P/E multiple of 10x, based on the sluggish outlook for Hindalco ‘ s copper division in FY09-10E.

Risks We rate Hindalco Medium Risk based on our quantitative risk-rating system, which tracks 260-day historical share price volatility. Possible downside risks to our target price are: 1) commodity prices (aluminum and alumina) or copper TC/RCs coming in weaker than our forecasts; 2) appreciation of the rupee versus the US $ more than we forecast; 3) reduction in import duties; 4) lower utilization levels than we expect.

National Aluminium Company description Nalco has a smelter capacity of 345,000 tpa in eastern India . This will be expanded to 460,000 tpa by end-2008. It has enough deposits of bauxite to meet more than 50 years’ requirements of its expanded alumina capacity (2.1m tpa from 1.58m tpa by end-2008). Good quality bauxite, open cast mines and low bauxite transport costs make Nalco one of the lowest-cost producers of alumina in the world. The company sells its surplus alumina in international markets, and is India ’s largest alumina exporter. In the power- intensive business of producing aluminum, Nalco’s 960MW thermal power capacity meets all of its in-house requirements at 33% of the grid cost, and some surplus power is sold to the state grid. Low costs for power, alumina and labor make Nalco one of the lowest-cost aluminum producers in the world. Nalco plans to increase alumina capacity to 3m tpa and aluminium to 575,000 tpa by 2012. They will have adequate bauxite, coal and power to meet their enhanced requirement. The capex for this phase is expected to be Rs41bn. In addition they have longer term plans for greenfield capacities in Orissa, Andhra Pradesh , Indonesia , Iran and South Africa .

Investment strategy We rate Nalco Buy/Medium Risk (1M) given our buoyant aluminium and alumina outlook over the next three years. Our global analyst, Alan Heap, expects a deficit in 2008, moving into deeper deficits in 2009-10. The main drivers of the deficit are continued robust demand growth (8%/yr) and supply curtailments induced by high power costs and shortages. Our global pricing forecasts were hiked substantially to US$3,600/t for FY09 and US$4,500/t in FY10. However, in the short term we expect some weakness following a reversal of recent dramatic inflow of investment funds. Nalco’s share price has generally moved in line with international aluminum prices, and based on the trends we forecast, we expect the stock to show strong upside even from current levels.

Valuation We use P/E to value Nalco because it is driven largely by commodity price trends, which translate into earnings momentum. In the past six years, the stock has traded in a P/E range of 7-9x. In the past year the P/E band has moved up to a range of 9-11x. In the past few months an uptrend in international aluminium prices has led to Nalco largely trading at the top end of this range, i.e. between 10-11x. Our target price of Rs546 is based on a 12- month forward P/E of 10x. While this continues to be at the mid-point of Nalco ‘ s one-year trading range of 9x to 11x, it is higher than the 9x we used
earlier. This appears justified due to: 1) The deficits that we expect in the aluminium markets during 2008-2010 based on the continued robust demand growth and supply curtailments; 2) Its position among the lowest-cost producers of alumina and in the lowest cost quartile for aluminum globally. Its P/E multiple is at a discount to the average P/E of 14x for 08-09 for global aluminium stocks due to Nalco ‘ s relatively smaller size, lower liquidity and low free float of 13%. Over the past six years Nalco’s EV/EBITDA has ranged between 3x and 5x. Over the past one year, the range has been between 4.5- 6x. Based on our target price of Rs546, Nalco’s EV/EBITDA (12-m forward) works out to 5.5x, near the top end of its trading range, and justified given our robust aluminium outlook.

Risks We rate Nalco as Medium Risk according to our quantitative risk-rating system, which tracks 260-day historical share price volatility. Possible downside risks to our target price are: 1) Weaker-than-expected aluminum and alumina prices; 2) Delays in expansion plans and lower utilization levels; 3) rupee appreciates more than we forecast against the USD; 4) Cut in import duty.

Sterlite Industries ( India ) Company description Sterlite is a non-ferrous metals major with a presence in aluminium, zinc and copper. It is a custom copper smelter (capacity 400,000 tpa) with treatment and refining charges (TC/RCs) driving profit. Sterlite is in the lowest-cost quartile of worldwide copper smelting operations. Its aluminium revenues and profits come from its 51% ownership of Bharat Aluminium Co (Balco), with smelter capacity of 355,000 tpa. It has access to 810MW power, the most important cost component in aluminium manufacturing. Sterlite’s zinc and lead revenues come from its 64.9% holding in Hindustan Zinc Ltd (HZL), an integrated zinc producer with a 60% domestic share. It is among the lowest- cost producers in the world largely due to the low cost of mining ore at the Rampura Agucha mine, which meets 90% of its requirement. Zinc capacity rose 63% to 669,000 tpa in the past five months in two phases, both ahead of schedule, taking total zinc-lead capacity to 755,000 tpa. HZL has announced further capex of Rs36bn (US$900m) that will hike zinc capacity by 210,000 tpa and lead capacity by 100,000 tpa taking the total to 1.07m tpa by 2010 together with mining and captive power capacities. Sterlite hopes to complete buying out the minority government stake in HZL (29.5%) and Balco (49%).

Investment strategy We rate Sterlite shares Buy/Low Risk (1L). Zinc (Hindustan Zinc) is the biggest contributor to Sterlite’s EBITDA (60% of total) and should continue to benefit from strong volume growth in FY09. The aluminium business should benefit from the energy crisis. We have substantially raised our international aluminium forecasts to US$3,600/t in FY09 and US$4,500/t in FY10. This is on the back of a deficit in aluminium in 2008-10 based on robust demand growth and supply curtailments induced by high power costs and shortages. We expect limited volume growth for Bharat Aluminium but expect EBITDA to grow 67% in FY09E and 28% in FY10E. Sterlite’s shareholding in Balco should increase soon and reach 100%. Copper has a difficult outlook due to subdued TC/RC margins expected in FY09-10 vs. FY07-08. We expect Sterlite’s attributable net income to rise 52% YoY in FY09E due to higher profits in zinc and aluminium and completion of the minority stake acquisition of Hindustan Zinc (29.5%) and Balco (49%) over the next few months. Sterlite has been allocated coal mines for Balco, driving cost savings in the long term. Commissioning the first phase of the power project being set up by its 100% power subsidiary from Sep 2009 onwards is on track.

Valuation We value Sterlite on a 12-month forward P/E to which we add the value of its power business. We use a target P/E multiple of 10x which is at the mid-point of the trading range of 7-13x over the past one year. The P/E multiple is at a premium to the 8.5x multiple we have applied to Hindustan Zinc reflecting the substantially greater liquidity that Sterlite enjoys relative to Hindustan Zinc, strong outlook for the aluminium business, and the greater level of attributable earnings for Sterlite’s investors when Sterlite completes acquisition of the balance minority government stakes in Balco and Hindustan Zinc. Based on 10x 12-month forward P/E, we get a price of Rs984/share for Sterlite. To this we add the value of the power business (at 2x book value of the equity investment) to arrive at our target price of Rs1,053. At our target price, the stock would trade at an adjusted EV/EBITDA of 7.5x.

Risks Risk factors that could prevent the shares from reaching our target price are: 1) Delays in acquiring minority stakes in Hindustan Zinc and Balco; 2) Weaker- than-expected commodity prices or TC/RC margins; 3) Lower capacity utilization than we assume; 4) Substantial dependence on the Rampura Agucha mines in case of zinc; 5) Trends in exchange rates; and 6) Cut in import duty.

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