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Nalco: The story continues...

Jan 22, 2005

Performance Summary
India’s leading alumina and aluminium player, Nalco, declared its 3QFY05 results yesterday wherein it continued to report strong numbers, riding on the back of the strength in the aluminium cycle. The company not only reported an impressive topline growth but also registered a splendid growth in its bottomline on the back of significantly improved operating margins.

(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Net Sales 7,115 10,901 53.2% 21,392 28,892 35.1%
Expenditure 3,958 4,980 25.8% 12,393 13,475 8.7%
Operating Profit (EBDITA) 3,157 5,921 87.5% 8,998 15,417 71.3%
EBITDA margin (%) 44.4% 54.3% 42.1% 53.4%
Other income 497 408 -17.9% 1,532 1,413 -7.8%
Interest 225 151 -32.9% 689 496 -28.0%
Depreciation 1,074 1,179 9.8% 3,145 3,444 9.5%
Profit before tax 2,356 4,999 112.2% 6,697 12,890 92.5%
Tax 685 1,939 183.2% 1,971 4,884 147.8%
Profit after Tax/(Loss) 1,671 3,061 83.2% 4,726 8,006 69.4%
Net profit margin (%) 23.5% 28.1% 22.1% 27.7%
No. of Shares (m) 644 644 644 644
Diluted earnings per share* 10.4 19.0 9.8 16.6
Price to earnings ratio (x) 8.7 10.0
(* annualised)

India’s largest alumina player
Nalco is the largest alumina and aluminium producer in the country. The company is amongst the lowest cost producers of the base metal in the world. It has a competitive edge vis-à-vis its peers due to factors like rich bauxite reserves, captive power plants and rail and port operations. The company derives more than 50% of its revenues from exports. Recently, the company received the approval from the Cabinet Committee on Economic Affairs (CCEA) for its Rs 41 bn expansion plan.

Nalco’s expansion plan entails the expansion of its mining capacity from the present level of 4.8 million tonnes to 6.3 million tonnes, the capacity of its refinery at Dhamanjodi from 1.6 m tonnes to 2.1 m tonnes, aluminium capacity from the current 345,000 tonnes to 460,000 tonnes and power generation capacity from 960 MW to 1,200 MW. The company intends to meet this cost of expansion of Rs 40 bn out of internal resources and to an extent from commercial borrowings. This capacity is likely to come on stream only during FY09.

What has driven performance in 3QFY05?
Strong realizations prop up topline: Continuing to benefit from the sustained global demand for the metal and the resultant shortage in the availability of alumina (raw material for aluminium), which has led to a spike in the prices of the latter, Nalco reaped the advantage of strong realizations. This is also evident from the segmental numbers declared by the company. While both its segments - chemicals (including alumina) and aluminium - registered strong YoY sales growth of 93% and 40% respectively during 3QFY05 (including inter-segment sales), the EBIT margins from the former witnessed a sharp increase from 36% to 58% while the margins in the aluminum segment actually fell by 120 basis points! The topline of the company during the December quarter registered a jump of over 53% over the corresponding quarter last year. It must be noted that while the company does not reveal the volume sales numbers, most of the gains in the topline are seemingly a factor of strong realizations.

Riding on strong operating margins: Strong realizations helped the company improve upon its performance at the operating level significantly. Nalco’s margins leapfrogged by 990 basis points during the quarter to over 54%, thanks to strong alumina prices. It must be noted that this is an improvement even when compared to the previous quarter (2QFY05) when Nalco’s margins had slid by 170 basis points. Control over various operating heads like raw materials, power & fuel and staff costs have also aided this performance by the company.

Net profits continue to impress: Nalco continues to ride the aluminium cycle. The effect of strong realisations leading to a significant growth in topline and consequently operating margins has been reflected in the 83% YoY growth in bottomline. The bottomline growth was also aided by a sharp 33% fall in interest expenses. It must be noted that the company is aiming to become a debt-free company in the financial year, thanks to its strong cash flows and absence of any significant capex plans in the current fiscal.

What to expect?
At Rs 165, the stock is trading at a price to earnings multiple of 10 times annualized 9mFY05 earnings. We believe that aluminium, being a cyclical sector, should not be valued on a price-to-earnings (P/E) basis, given the volatility in earnings. During times of cyclical downturns, aluminium companies tend to get severely affected, as the business is capital intensive in nature and has higher fixed cost and vice versa. Hence, a sound and consistent parameter to value the sector would be on the basis of the price-to-book value (P/BV). While P/BV does not factor in the market value of assets, it indicates, theoretically, what the shareholder would receive if the company would ever go into liquidation for a conservative investor.

We have accorded a valuation band of 1.2x - 1.8x book value to Nalco on the basis of its past track record. Considering this parameter and our estimated FY05 book value of about Rs 70 per share, the stock is currently trading at 2.4 times book value, which is richly valued at the current juncture. While the company’s performance has been more or less in line with our estimates for FY05, considering the current strength in the aluminium cycle, we will be upgrading our FY06 estimates. Nonetheless, even after this adjustment, the stock continues to remain a risky proposition purely from the valuation point of view, though near-term momentum could be sustained in the stock owing to strong numbers over the next 2-3 quarters.

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