Sell Hindalco; target Rs 142: Citigroup

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Sell Hindalco; target Rs 142: Citigroup

Citigroup is bearish on Hindalco Industries and has recommended sell rating on the stock with target price of Rs 142.

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Citigroup is bearish on Hindalco Industries and has recommended sell rating on the stock with target price of Rs 142.

Citigroup report on Hindalco:

Mid-year contracts settle low

According to our global commodity analyst, Alan Heap, copper mid-year contracts are settling at a combined level of around USD 45-50/t and USc4.5-5.0/lb, down from 60/6. Spot TC/RCs are depressed and currently at a three-year low of USD 20/t and 2.2c/lb.

Downward pressure

The downward pressure on TC/RCs is being driven by very tight copper concentrate supply, increasing copper smelter output and China's expanding copper smelter capacity.

Potential impact on Hindalco 

TC/RCs are the key profit determinant for copper smelters such as Hindalco. We have assumed that combined TC/RC margins would be US15c/lb in both FY08 and FY09. While our assumptions remain unchanged, as negotiations are in progress, the current weakness in contract and spot rates could lead to lower TC/RCs than we estimated, particularly in FY09 .

Reiterate Sell (3M)

Based on our global outlook for falling international aluminium and alumina prices and expected weakness in copper TC/RC margins coupled with rising input cost pressure, we expect a 26% fall in FY08E EPS. The steady appreciation of the rupee versus the USD has forced domestic producers to cut domestic aluminium prices thrice (by about 2.5-3% each) in the past couple of months. Sell/Medium Risk with target price at Rs 142.

Investment thesis

We rate Hindalco as Sell/Medium Risk (3M). The key reasons for our Sell rating are: 1) Hindalco has paid a high valuation for Novelis whose profits are not expected to improve substantially over the next couple of years. Hence the profits will not be able to compensate for Hindalco's high interest outgo, resulting in an earnings dilution. 2) We expect a YoY downside in FY08-09 for copper and aluminum. In copper, TC/RC margins averaged US 37c/lb in 1H FY07, largely benefiting from higher copper prices and price participation. But these are already trending down and are expected to average US 15c/lb in FY08 and FY09. For a copper smelter like Hindalco, profits are determined largely by TC/RCs rather than copper prices. For aluminum, we expect average prices to decline 7% YoY in FY08 to USD 2,480/t and remain around that level in FY09.

Valuation

Our target price of Rs 142 is based on: (1) 7x FY08E earnings (Rs 128); and (2) adding the value of Hindalco's investment holding in associate companies and discounting it by 25%. We use P/E because stocks such as Hindalco are largely driven by commodity price tends, which translate into earnings momentum. The stock has largely been moving in line with international aluminum prices since October 2002 and has been trading in a P/E band of 7x and 9x over the last four years. We have de-rated our target multiple from the mid point (8x) to the low end of this trading range. The proposed acquisition of Novelis raises its risk profile, increases gearing and reduces consolidated margins. Based on consensus earnings and our own preliminary analysis, we see no substantial improvement in Novelis' earnings in 2007 and 2008. Additionally we do not see any upside trigger to the stock price based on our outlook of falling international prices in aluminum and substantial declines in copper TC/RCs.

Risks

We rate Hindalco Medium Risk based on our quantitative risk-rating system, which tracks 260-day historical share price volatility. Possible upside risks to our target price include: 1) commodity prices (aluminum and alumina) surpassing our forecasts; 2) copper TC/RC margins exceeding our forecasts; 3) depreciation in the rupee versus our forecast of an appreciating rupee in FY08 and FY09; and 4) Novelis' operational performance surpassing forecasts.