Further correction in aluminium prices mean more downside for Hindalco

Shares of Hindalco, an aluminium producer, have corrected 6 per cent in the last two trading sessions after a sharp fall in the LME aluminium prices. LME aluminium prices have fallen 5 per cent in the last three trading sessions, after rallying strongly in the year till date. Various fundamental and technical indicators suggest that the aluminium prices could correct further, which may not be a positive development for Hindalco.

Aluminum inventories globally continue to remain high unlike other metals such as steel, iron ore and zinc. Against an estimated aluminium demand growth of 6 per cent since the beginning of 2015, aluminium inventory has increased by 14 per cent. Major part of this has come in recent months after prices rose. For instance, 50 per cent of the rise in inventory has happened since February after several smelters in China were shut down earlier restarted after prices rose. According to experts, majority of demand for aluminium was from speculators in China.

"If we use daily transaction volume as an indicator to show how 'speculative' the specific commodity futures market is, we can see clearly that SHFE (Shanghai futures exchange) aluminium has attracted more speculation than other base metals. If the "hot money" retreats from the commodity market, either due to stricter supervision or higher cost from higher brokerage commission and margin requirement, the aluminium price should see more pain than other base metals," said Sumangal Nivetia of Macquire.

Aluminium prices on SHFE are in backwardation, a trend seen when price of the underlying asset is expected to fall. Backwardation means future prices trade at a discount to spot prices. "A large chunk of inventories is held by traders, banks or is locked in financial deals. Any rise in the interest rates will increase the cost of carry and lead to sharp unwinding — a material risk to aluminium prices," said Abhishek Poddar of Kotak Securities. Hindalco's profit growth will depend hugely on aluminium prices as volume growth upside may be limited.

It has no major capacities being added in the near future and the capacity utilisation for its plants is already high (above 85 per cent). At the current market price of INR 91, the stock is valued at 7 times EV/EBIDTA (Enterprise value to earnings before interest depreciation and tax) after factoring in most of the positives from the rise in the aluminium prices. The EV/EBIDTA ratio is commonly used to value metals, mining and cement stocks.

Historically, metal and mining companies — Indian as well as global — have traded in the range of 5-6 times EV/EBIDTA. Expensive valuation and a further correction in aluminium prices would lead to a correction in Hindalco's share price as well.