CHALCO (2600.HK) BUY (TP:HK$10.80)

Profit warning for 2009 already well perceived

WHAT HAPPENED

Chalco (2600 HK) released a profit warning for 2009, citing that the recovery in the second half of 2009 may not make up for the net loss in 1H09 which was caused by low run-rate, diminished demand and aluminium price declines.

ANAYLYSIS

·             Recap for the severe loss in 1H09 and breakeven in 3Q09. Chalco made a record net loss of Rmb3.5bn in 1H09. Utilization rate for alumina refining and aluminium smelting were 67% and 83% in 1H09, respectively, better than industry average but below its own historical 90-100%. Also Chinese aluminium price in 1H09 dropped by 31%YoY. Chalco managed to breakeven in 3Q09 due to a 16% sequential increase in aluminium prices and improved run-rate. We expect the recovery in 4Q09 (i.e. further increase in aluminium prices (up 7% sequentially and improved demand and utilization) would narrow the net loss to around Rmb1bn, within the market’s forecast range of Rmb0.3 - 4.1bn in net losses.

·             Looking beyond the poor 2009. We think the market has priced in the poor 2009 earnings and has already shifted the focus to the further upside potential in aluminium prices and the electricity cost for 2010, which are the key swing factors for the earnings of Chalco and its peers.

·             CHALCO’s share prices tracking closely with aluminium prices. Chalco's earnings are highly geared to aluminium price changes and its share prices have moved in locked steps with aluminium prices since 2008. Assuming cost factors are unchanged, every 2% increase in aluminium prices, Chalco’s net income will increase by 14%.

·             Why aluminium prices may go higher. We think 1) the gradual pick-up in restocking demand from the western world, 2) the petering-out in LME’s warehouse inventories and 3) demand resilience in China will bode well for further upside in aluminium prices, in our view.

·             Electricity cost is a wild card. We think further cut in electricity cost in 2010 from 2009 may be unlikely in view of the recent cold weather conditions as well as solid footings in Chinese economy in 2010. For every Rmb0.02/kwh (about 5 %) increase in electricity cost, Chalco’s net income will be squeezed by around 21%, assuming aluminium prices remain unchanged.

·             CHALCO’s capability in electricity cost cutting. Having said that, we think Chalco’s pricing power against power plants with full government backings as well as its own increasing self-sufficiency in power generation should help limit its average electricity cost increase. Chalco’s historical electricity costs had increased at lower rates than coal price increases.

ACTIONS

Chalco is trading at undemanding 1.8x 2010 PBR on Bloomberg earnings consensus, below its industry average of 2.6x PBR and its own historical mid-to-upcycle valuation of 2.0x, we reiterate our BUY on Chalco, and shall soon review our earnings estimates and target price of HK$10.80, which was based on 2.0x FY10F PBR.