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Stock Insight: Heavy Metal

Nalco's bottom line is poised to surge in '07 on operational efficiency, buoyant aluminium prices & economies of scale

India's growth story is bringing windfalls for many sectors. Like many other sizzling commodity stories, the aluminium industry in the country is set to hog the limelight with the growing emphasis on infrastructure development and India's growing stature as a global manufacturing hub for automobiles. These, coupled with drivers such as rising aluminium prices and a rebound in alumina, after the recent dip, could boost the fortunes of aluminium producers like National Aluminium Company Ltd (Idirect Code: NATALU).

Nalco - the largest alumina producer and the second largest producer of primary aluminum in the country, next to Hindalco (Idirect Code: HINDAL) - is a fully-integrated company with access to huge reserves of high-quality bauxite and 100 per cent captive power generation facilities. The public sector undertaking enjoys a significant competitive edge over its peers due to low production cost and a high operating margin of over 50 per cent. The company's presence in the entire value chain with operations in mining, refining, smelting and access to high-quality bauxite and captive power plants (CPP) auger well for the long-run. The low cost of production also brings in the flexibility to deal with the vagaries of aluminium prices.

Aluminium production being an energy-intensive industry, power and fuel account for about 40 per cent of operating cost and 17 per cent of the top line. Nalco's use of coal for its power plant and alumina refinery helps the company keep costs low. Due to easy availability, coal prices are unlikely to move up significantly, but the prices of calcined coke - another important cost component - are likely to remain firm due to higher crude oil prices impacting the margins.

As demand for aluminium from the power and construction sectors remain strong, aluminium prices have strengthened by 44 per cent over a period of one year. With the demand for the commodity exceeding supply by a huge margin, players like Nalco could gain significantly with an upturn in the prices as it generates about 70 per cent of its total revenue from this segment.

Nalco, being an alumina surplus producer, exports at least 50 per cent of its production, while the rest feeds its smelting capacity. The company had maintained an export strategy to tie up 70 per cent of its alumina in long-term overseas contracts and offer 30 per cent of its 1.6-million tonne production in international spot markets. However, the company is reversing its marketing strategy of offering higher volumes in the spot market. With international prices of alumina crashing to around $240-250 per tonne due to global overproduction and prices likely to move further down, the company is getting back to long-term contracts concluded at higher levels to tide over the weakening alumina market.

The company is currently operating at 100 per cent capacity level, leaving little scope for volume driven growth. Keeping a future perspective, the company has embarked on a Rs 4,080-crore capacity expansion to be financed through internal accruals and debt. On completion, by 2008, its aluminium smelter capacity will increase by 50 per cent to about 345,000 tonnes, while alumina production capacity will surge from 1.57 million tonnes to 2.1 million tonnes. Bauxite mining capacity of the company too will rise from 4.8 million tonnes to 6.3 million tonnes and power generation capacity from 960 mw to 1,200 mw.

The company is planning a greenfield integrated aluminium complex in Orissa at an investment of Rs 15,000 crore. The company will set up a 1.5-million tonne alumina refinery, a smelter with installed capacity of 2.5-3 lakh tonne and a captive power plant. The company also proposes an integrated alumina refinery and an aluminium smelter in Andhra Pradesh. It has also conducted feasibility studies in Oman, Abu Dhabi and Qatar keeping overseas expansions top on cards. The company is also exploring the possibility of setting up a coal-based power plant and a smelting facility in Indonesia.

For the quarter ended September 30, 2006, the company has posted a net profit after tax of Rs 595 crore up from Rs 283 crore in the corresponding period of 2005. Total income (net of excise) has increased from Rs 1,094.3 crore for the quarter ended September 30, 2005 to Rs 1,543 crore in the July-September quarter of 2006.

The company is expected to show gains in bottom line for FY07 on the back of strong operational efficiency, buoyant aluminium prices and improved economies of scale. The stock has also not retraced even after its fall from the high of Rs 326.05 in early May this year, despite the Sensex staging a smart comeback, leaving sufficient upside for the stock. The stock holds an upside potential of about 20 per cent from current levels over a 3-6 month period.

However, the company has its share of concerns. Rising input costs, lower share of value-added products compared to Hindalco, and modest volume growth are major worries for the company. Any slowdown in the industrial commodities market could be bad news for the company. The resultant price decrease combined with the expanded capacities could impact Nalco's performance adversely.

The earnings growth over the next few quarters is likely to be moderate and driven largely by prices and the volume growth may remain almost flat as the company is now operating at near-full capacity. The government's plan to remove the core status for the aluminium sector for coal may make things difficult for the company. If this happens, the hike in coal prices would put pressure on the input costs. With supply likely to remain tight in the near term, higher import of coal may have a negative impact on margins.

Source: Idirect