Chalco downsizes amid low aluminum prices and disappointing 1Q earnings

In the first quarter, Chalco posted a loss of CNY 2.2 billion, or roughly $350 million, even though companywide sales increased 3% relative to the same period last year. Before its earnings update, in light of prevailing low aluminum prices, Chalco announced that it intends to shutter 800 thousand metric tons per year of refining capacity and 600 thousand metric tons per year of smelting capacity. Although taking roughly 5% of its refining capacity and 15% of its high-cost smelting capacity off line will allow Chalco to produce aluminum more efficiently, this significant scale reduction signals the possibility of additional curtailments in the future as the high-cost producer makes an effort to rationalize its production volume.

After being bailed out by parent Chinalco, which purchased Chalco's loss-making aluminum fabrication businesses last year, Chalco returned to profitability in 2013. However, the company now appears to have been left to its own devices in crafting a turnaround strategy. For this reason, we anticipate that more curtailments are likely to come as management strives to move down the industry cost curve.

In light of Chalco's sizable capacity reductions, we have materially reduced our expectations for the company's alumina and aluminum shipment volume over our explicit forecast period. The impact of this adjustment is partially offset by the fact that the closure of high-cost facilities will result in modestly higher profitability for both reporting segments. Additionally, however, we increased our near-term forecasts for the company's bauxite procurement costs due to the reporting of a higher-than-expected figure in the recently issued 20-F filing. These adjustments led us to decrease our fair value estimates to $11 per ADR from $12 and to HKD 3.50 from HKD 3.60 for shares domiciled in Hong Kong. Because the company's competitive positioning has not improved, we retain our no-moat rating.