Upgrading aluminum – Our global analyst, Alan Heap expects an emerging power crunch and shortage of high quality bauxite to cause a shift in the competitive landscape for aluminium, driving aluminium & alumina prices up. New aluminium prices are US$3,600/t (+22%) in FY09 and US$4,500/t in FY10 (+71%).
Electricity constraints – The upward trend in electricity prices and security of supply is a key challenge in countries with major aluminium smelting capacity such as China, South Africa, Brazil, and the USA. Electricity prices are rising at 10%/yr on a production-weighted basis. In China, the electricity supply balance is expected to tighten further and tariff discounts to smelters are being removed.
Bauxite worries – Alumina producers are also affected by rising power costs. However, potentially even more important is reduced availability of high quality bauxite. Most vulnerable are Chinese refineries dependent on imported bauxite mostly from Indonesia. The alumina:aluminium price linkage rate is rising and we have moved our assumed long-term rate from 12.5% to 13.5%.
We recommend buying – Based on the robust outlook we have hiked our earnings significantly and are upgrading: 1) Nalco to a Buy (from Sell) with a target price of Rs546 (10x 12-month forward P/E); 2) Hindalco to a Buy (from Sell) with a target price of Rs240 (9x 12-month forward P/E); 3) Sterlite’s target price to Rs1,053 (10x 12-month forward P/E, and adding the value of its power business).
Risk factors – 1) Weaker prices; 2) Delays in expansions or lower utilization levels; 3) Rupee appreciation above our forecasts; 4) Reduced import duties.
The Shifting Balance of Power An emerging power crunch and a shortage of high quality bauxite should cause a shift in the competitive landscape in the aluminium industry, and drive aluminium prices higher. Aluminium prices should average US$2/lb in 2009, and rise further in 2010. We are also raising our long-term price to US$1.30 in real terms.
Electricity- Rising Prices and Reduced Security Rising electricity prices and security of supply are will present huge industry challenges. Security of electricity supply is a rising challenge in many countries with significant aluminium production: particularly South Africa , China , USA , and Brazil . Indeed as much as 80% of global capacity is located in countries where reserve margins are already below comfort levels or is heading that way.
Power costs are rising at 10%/year on a production weighted basis. In China , electricity costs are more than double the rest of the rest of the industry. The overall electricity market should tighten further, but the government resists increasing general tariffs due to inflationary consequences. Tariff discounts to smelters are being removed, and smelters are likely to be squeezed. Appreciating currencies are also pushing costs higher. This is particularly significant in two major producing countries Australia and China .
The cost of carbon emissions will be an increasingly important source of electricity cost inflation. Smelting capacity is migrating to regions where stranded power exists and 40% of new capacity will be built in the Middle East , Iceland , Russia , Indonesia and Africa . Even in these regions however, improving distribution networks mean stranded power is becoming rarer. Planned capacity increases in China and India may not eventuate.
Alumina – also highly power sensitive The upward pressure on power costs is also pushing alumina production costs higher. However, potentially even more important is likely to be reduced availability of high quality bauxite. Most vulnerable are Chinese refineries dependent on imported tri-hydrate bauxite. The alumina:aluminium price linkage rate is increasing and we have moved our assumed long term rate from 12.5% to 13.5%.
Competitive advantage There will be clear winners and losers among aluminium companies as these scenarios unfold. Winners will be those companies with captive, low-cost hydro power and backward integrated into high quality bauxite. Supply and Demand Balances
Aluminium to Tighten We expect the aluminium market to be in deficit in 2008, moving into deeper deficits in 2009 and 2010. Supply surpluses loom further out, but inventories will remain low relative to history. The main drivers of the deficit are supply curtailments induced by high power costs and shortages, and continued robust demand growth (8%/yr)
This outlook will support prices above US$2/lb for the next five years. However, in the short term some weakness is expected following a reversal of recent dramatic inflow of investment funds. Alumina – bauxite shortage looming Bauxite supply growth is expected to slow. The third party traded market increasing in importance, and access to high quality bauxite will be a key source of competitive advantage. The alumina market has seen some relief from spot rising prices recently, but we expect oversupply until 2010. In subsequent years however a tight market looms.
Hindalco Industries Company description Hindalco is a low-cost integrated aluminum producer (capacity ~500,000 tpa) with access to captive power and bauxite. It operates India ‘s largest copper smelter (capacity 500,000 tpa, 35-40% market share). The aluminum division accounts for 37% of Hindalco ‘ s FY08 net sales and 83% of EBIT. In aluminum, Hindalco has a strong domestic market share with a dominant 60-65% share in sheet products. It plans to triple its alumina and aluminum capacity by 2013. Hindalco owns copper mines in Australia through its 51% subsidiary, Aditya Birla Minerals, which will meet about 10-15% of its requirement when fully ramped up. Hindalco acquired Novelis, which controls about 19% of the world ‘ s aluminium sheet market.
Investment strategy We rate Hindalco Buy/Medium Risk (1M) based on our strong outlook for global aluminium prices over the next three years. Our global analyst, Alan Heap, expects deficits in 2008-10 on the back of continued robust demand growth (8%/yr) and supply curtailments on the back of high power costs and shortages. We have substantially raised our global aluminium price forecasts to US$3,600/t for FY09 and US$4,500/t in FY10 (from US$2,600-2900/t). However, in the short term, we expect some weakness following a reversal of recent dramatic inflow of investment funds. The strong aluminium outlook more than compensates for our sluggish outlook for copper, where we expect copper TC/RCs to trade in a narrow band of US12-15c/lb during FY09-FY10E. Hindalco ‘ s stock price tends to move with international aluminium prices. Given the upward trend in aluminium prices that we have forecasted, we expect Hindalco ‘ s share price to appreciate from current levels.
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