The Hindu Business Line : Nalco: Hold

FIRM prices, a favourable demand-supply equation in the medium term and an improved financial profile, offer positive outlook for National Aluminium Company (Nalco).

Investors can retain their holdings in the Nalco stock (Rs 220), which trades at a multiple of about eight times its likely FY-06 earnings.

Though we take a positive view of the company's business prospects, concerns about rising input costs, lower share of value-added products compared to its peer, Hindalco, and modest volume growth underpin our tempered view on the stock.

The earnings growth over the next few quarters is likely to be moderate and driven largely by prices. We expect the volume growth to be almost flat as the company is now operating at near-full capacity.

Also, its second phase of capacity expansion that began this year is likely to go onstream in FY-08. The company is, however, likely to operate in a firm pricing environment in the medium term.

One, fears of Chinese supply acting as an overhang in the aluminium market have receded significantly, following measures to curb exports.

This is likely to see the global aluminium market in a deficit over the next year or two, thereby lending greater visibility to firm prices.

Two, rising shortage of power is likely to push production cost, necessitating firm prices for the metal.

Nalco, being an integrated player, is well-insulated from any rise in price of alumina — the principal raw material for smelting aluminium.

The company sells about 20 per cent of alumina on spot basis. If it manages to increase this proportion over the next few quarters, which is quite likely, it would result in higher realisations.

The risk element stems from the possibility of a rise in coal prices. The Government is considering removal of the core status for the aluminium and paper segments for coal linkages.

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.

The rising power and fuel costs along with buoyant prices for caustic soda have taken a toll on its margins. Revenues for the first half of FY-06 rose 13 per cent, buoyed by higher volumes and better realisations.

Margins have dipped by about 600 basis points on a YoY basis to 46 per cent, largely on account of rise in power costs and higher prices for caustic soda. Nalco's presence in the downstream operations of the value chain is low vis-à-vis its peers.

As realisations on the value-added products are higher on an average, it may be a handicap and deter profitability.

However, with the commissioning of the rolling mill in September, the share of value-added products is likely to improve.

In the light of these factors, remaining invested appears prudent.

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