A structure change in aluminum sector thanks to cuts of unauthorized capacity
We were in Europe the week before, with Chalco's president Mr. Ao Hong, generalfinance manager Ms. Gao, Shandong branch CFO Mr. Shen and fund managerMs. Zhu. According to management, China has stopped the construction ofunauthorized projects and shutdown 4.16mt illegal operating capacity, whichwould result to a balance market instead of substantial surplus expected earlier.
In addition, there is another 2mt capacity which is likely to be identified asunauthorized capacity per Mr. Ao, although we will wait for government's finaldecision. China government had talked about no new capacity approval for awhile, but only this time mgmt indeed expects a structure change, thanks tocentral government's determination on illegal capacity elimination, air quality,together with local government's obedience.
Heating season production cut; and capacity relocation will happen eventually
According to management's knowledge, production cuts in 2+26 cities duringheating season would impact output of 1.3mt carbon anodes , 3.05mt alumina,and 1.28mt aluminum. However, impact on Chalco will be relatively limited, withestimated output impact of 0.7mt for alumina for 4 months, very minor anode andaluminum capacity in those areas. Practically, Mr. Ao believes smelters in thoseregions will have to move as capacity restriction during heating season in Beijingsurrounding areas will not be an one off event, and moreover, it is quite timeconsuming （c.3months） and cash consuming （RMB500/t+） to restart smelters. ForChalco itself, it took them more than 5 months to relocate 300kt capacity fromLiaoning to Baotou, Inner Mongolia, not much advantage compared to its newcapacity construction period of 6 months to 1 year.
Chalco to further improve its cash cost position in the industry cost curve
Chalco's aluminum production cost was about RMB1000/t higher than Chinaindustry average in 2015, and was generally in line with industry average in 2016thanks to strict cost control measures. In 1H17, Chalco was within 45 percentileof the cost curve, and mgmt aims to move up to 40 percentile by 2017 and headinto 30 percentile in next 2-3 years, as a result of its improving labor efficiency,advanced new projects in coal and bauxite abundant area such as Inner Mongolia,Guangxi, Shanxi and Guizhou, and better energy efficiency over the time.Moreover, government's strong focus on environment and intention to collectpower surcharges will also improve Chalco's relatively cost competitiveness as awell behaved smelter.
Globally, Chalco is the only one with most integrated supply chain, frombauxite, carbon anode, aluminium and aluminium semis （Al semis in the parentgroup for now）。 Chalco's plan is to have reasonable control over the upstream,optimize mid-stream operations, and achieve leap-forward development of thedownstream. Chalco is discussing bauxite mining project in Guinea with localgovernment, planning to make it a bauxite supply base for the company. They arealso trying to improve the product mix by lifting chemical alumina and aluminiumalloys sales instead of primary metals, with total capacity sitting at 5mt foraluminium and 17mt for alumina, respectively. President Ao Hong expects thatsimilar to steel industry, M&As will happen in aluminium too, with detailed timeand target suggested by SASAC.
Debt plan and potentially dividend
Chalco's currently has around RMB110b debt, with about 40% of the obligationbeing long-term and 60% short-term. General finance manger indicates that theyare trying to have a more comfortable structure with 60% long term. They expectRMB50b debt to mature on year basis, with average interest rate of 5%. Totalliability to asset ratio is around 72% currently, and the Company aims to lowerit to 70% by this year and hopefully 65% by 2019. Mgmt is also thinking aboutdividend once they cover the previous losses.
Valuation and risks
We use 2.2x 2017E PB - Chalco’s +1 standard deviation from average since itslisting in 2001. We believe the multiple is fair as Chalco’s ROE is improving frombreak-even last year to 12%+ in 2018 （a record high post 2007 super cycle）。 Risksinclude lower aluminum and alumina prices and lack of implementation of China'saluminum supply-side reforms.