Sell Nalco: Cost pressure squeezing margins  Motilal Oswal

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Nalco- Cost pressure squeezing margins
 Nalco has invested ~US$900m over the last 3-4 years to increase smelter capacity
from 345ktpa to 460ktpa, captive power capacity from 960MW to 1,200MW, and
alumina capacity from 1.6mtpa to 2.1mtpa. The balance sheet has remained debtfree
with cash surplus of Rs35b-40b.
 The smelter has been fully ramped-up, with estimated production of 435kt in FY11.
Metal production will grow 2-3%, as operating efficiencies improve.
 Alumina capacity expansion is running behind schedule and is now expected to
be completed by April 2011. As the production of alumina ramps up, alumina sales
will grow and drive revenue growth.
 Cost of production has continuously risen. In FY06, cost of production used to be
US$110/ton for alumina and US$1,100/ton for aluminum. Since then, there has
been huge cost inflation due to shortage of coal, rising maintenance cost due to
aging smelter, faster labor cost inflation than productivity improvement and rising
commodity prices. Cost of aluminum production has risen to US$2,070/ton by
3QFY11.
 Fixed cost has risen 52% due to aging of smelter and wage cost inflation during
FY06-FY11. The trend is likely to continue because public sector productivity
improvement usually lags manpower cost increase.
 Power and fuel cost has risen 2.3x in five years, as the captive power plant has
increasingly been sourcing coal through e-auction and imports because coal
linkages have moved down from 100% to 80%.
 Growth will continue to elude Nalco, though the company is working on a number
of expansion projects (Indonesia, Orissa, nuclear power, titanium, etc). However,
there is no visibility of any of these projects. Also, Nalco's intention of getting into
unrelated project (though with the help of JV partner) is also worrisome. The
government may try to extract cash from Nalco by selling equity of other public
sector companies like Hindustan Copper.
 Though Nalco's assets are one of the best in world, with strategic location of
alumina refinery close to captive bauxite mines and the smelter's location close to
coal mines, it is still unable to contain costs. Costs continue to rise on all fronts.
 We have cut our FY11E EPS by 11% to Rs16.1 to factor lower than expected
3QFY11 results and rising coal costs. We have also reduced our assumption of
coal linkage from 90% to 80% for FY12 and FY13. Our EPS estimates are cut
from Rs22.7 to Rs18.1 for FY12 and from Rs24.5 to Rs17.4 for FY13. The stock
Stock performance (1 year) trades at 25.7x FY12E EPS and an EV of 14.1x FY12E EBITDA. Maintain Sell.