2016 results: successful cost reduction initiatives but SG&A still highChalco released FY16 annual results with NPAT of RMB402mn. The companyhad previously announced preliminary results, so overall earnings were notsurprise. With aluminium and alumina costs down 17%yoy and 12%yoy in2016, its gross profit margin increased 8ppt yoy. ASP was at a discount tomarket price because the company operates on conservative hedgingcontracts once the metal price is in a comfortable range; in 2017, managementwill still consider a hedge range of RMB13500-14000/t. SG&A was higher thanwe had expected as Chalco needed to take care of non-operating employees.
　　Key takeaways from analyst meeting: well positioned for reformsFor 2017, management indicates a capex budget of RMB15bn, including keyproject ramp-ups in Baotou, Guangxi, Guizhou, Shanxi, and a 30% budget forthe capital market. Thus, the production target of aluminium increases20%+yoy to 3.6mt in 2017. The alumina output target is set at 15mt （3%yoy），including alumina chemicals. Unit costs for 2017 are RMB1,577/t for aluminaand RMB9,000/t+ for aluminium, decreasing roughly 12% and 17%yoyrespectively. Overall power cost for the year is RMB0.285/kwh, with 4Q higherat around RMB0.30/kwh. The company self-supplies around 33% of its power.
　　Out of the remaining direct purchased power, 40-50% is via floating contractprices linked to aluminium price fluctuations with local power suppliers, sayRMB33-35cents/kwh, when the aluminium price is at c.RMB13,500/t.
　　Management believes that strict environmental regulations is a major trendand that execution could exceed expectations. The overall impact of the 26+2cities production limitations on Chalco is c.7mt of alumina capacities in Henanand Shandong, but these plants are relatively inefficient with higher unit costs,thus no significant material impact on profitability.
　　Improving position in cost curve; maintain BuyWe believe that Chalco, as an SOE with a high self-sufficiency rate of rawmaterials relative to other industry peers, will be a major beneficiary ofincreasingly stringent environmental restrictions on the aluminium supplychain. Through continuous efforts in cost reduction, the company was able toimprove its position in the domestic cost curve from the marginal costproducer around the 70th-80th percentile to around the industry average unitcost as of 2016. With decent environmental facilities, and 100% sufficiency inalumina and anodes, the company will become more cost competitive relativeto other private and smaller aluminium players, as the overall industry costcurve is experiencing an upward shift. Our target price of HKD5.4 for Chalco isbased on 1.8x PB, a premium over long-term average, derived from improvingROE and expected performance during the up-cycle. Chalco is trading at 1.2x2017E BVPS. Downside risks include lower alumina and aluminium prices, andworse-than-expected implementation of supply-side reforms.