Norsk Hydro: Top Aluminum Exposure, Strong Tilt To The Upside

Norsk Hydro (OTCQX:NHYDY) stands out in striking shape amid the energy crisis and demand downturn. Although Hydro added up to Europe’s list of curtailed production capacity, the company continued to benefit from attractively priced value-added products. I believe Hydro’s profitability will take hold going forward, as a result of the company’s strong capacity to leverage secular fundamentals in the aluminum industry thanks to the favorable setup of up- and downstream production mix, and own renewable power generation. I am in for a Buy on Hydro, which is trading at a discount to US peers, and along with dividend track records, gives an attractive opportunity to satisfy long-term investors.

Financials

Hydro reported NOK54.9 billion in revenue in Q3 2022 due to strong double-digit performance in all operating segments. Despite elevated fixed and raw material costs and lower downstream volumes, the company puts NOK 9.7 billion profit on the adjusted EBITDA line, which represents a 34.7% YoY increase, underpinned by favorable alumina prices, positive currency effects, and CO2 compensations.

The above performance resulted in a 59.8% YoY gain in 9mo’22 total revenue, 71% uplift in adjusted EBITDA and a 4.7x surge in net profit for the period, or NOK 11.63 per share compared to NOK 2.46 EPS for the corresponding period of last year.

And again RUSAL

Elevated energy prices and weakening demand are causing serious problems for Europe’s industry, where the region’s aluminum production capacity has already fallen by about 50%. Hydro also added up to that negative number as well, as the primary aluminum production at the Slovalco facility was closed during the third quarter. However, what strengthens the position of Hydro, is that plants in Norway are supplied with own hydroelectric power.

With the European aluminum industry getting weaker, this creates a situation where RUSAL produced aluminum is benefiting by filling the deficit. RUSAL’s revenue from exports to Europe in H1 grew by 44.7% YoY and the share of the European market in the revenue mix for the period was 40% compared to 36% a year earlier. This makes it difficult for the curtailed EU smelters to recover, and it is not surprising that Hydro urged sanctions against Russian aluminum imports. However, it’s not likely such actions to take place, as they will have a great impact on further development of the aluminum industry and would be a strong hit to the EU economy.

RUSAl seems like a bone in the Hydro’s throat, and for another reason. RUSAL positions itself as a manufacturer with a low-carbon footprint, since more than 90% of its aluminum is produced using electricity from renewable sources, the area in which Hydro is pushing and trying to build a competitive position.

Outlook and 2022 forecasts

Looking ahead, the aluminum application has strong drivers. Here is an excerpt from my article on Alcoa (AA):

The growing demand for aluminum will be primarily associated with lightweighting megatrend in the automotive industry in order to increase the fuel efficiency of ICE vehicles, and the range capability of BEVs as much as possible. In the aerospace industry, demand for aluminum alloys should remain strong due to the rapidly growing use of composite materials, supported by passenger traffic and build rates recovery. Overall, the green transition and emission reduction rush will provide for increased demand for aluminum as a result of its endless recyclability, energy saving and waste reduction peculiarity. The green trends could also lead to a reduction in production capacity using coal-fired electricity, which is still the main source of aluminum electrolysis, and force aluminum in short supply.

These trends appear quite favorable for Hydro, as the company operates a strong portfolio of up- and downstream production, recycling, and sources a large part of its electricity needs for primary aluminum production from renewable power, along with its own hydro energy.

Going into Q4 with a softening demand, Hydro announced capacity curtailments in order to optimize power consumption and costs. For the 2022 full year, I assumed a solid 44.7% YoY top-line growth to NOK221.6 billion.

Segment-wise, I expect Bauxite&Alumina (+29.9% YoY), Extrusions (+30.5% YoY), Energy (+35.5% YoY), Metal markets (+48.2% YoY) and Aluminum metal (+58% YoY) segments will remain in strong double digits and deliver NOK 41.8 billion EBITDA on a margin of 18.9%, supported by favorable pricing.

Valuation

Norsk Hydro has a Mcap of NOK 172.4 billion, which translates to an Enterprise Value of NOK 181.4 million if adjusted for NOK 25.9 billion cash position and NOK 28.9 billion IB liabilities. Compared to the sector’s comps, represented by Arconic (ARNC), Constellium (CSTM), Kaiser Aluminum (KALU), Alcoa, and Century Aluminum (CENX), Hydro is quoting at a lower EBITDA multiple.

Hydro is currently trading at forward EV/Sales and EV/EBITDA trading multiples of 0.8x and 4.4x, respectively, which represent a significant discount of more than 40% both to the sector’s median multiples of 1.5x and 7.4x, derived from Seeking Alpha.

Applying my estimates of 2022 Sales and EBITDA to the sector median multiples should yield an enterprise value of NOK 322.5 billion. Deducting interest-bearing debt and pension-related liabilities, the implied Equity Value should be NOK 313.5 billion, which corresponds to NOK 153 or USD 15.3 per share. I give Hydro a Buy rating, as the valuation implies a significant upside potential of 85%.

How could it be justified?

Hydro has a strong presence in the upstream and downstream business, which secures the company as a firm bridgehead to benefit even in a challenging market environment. Hydro also has its own renewable power generation and recycling portfolio, which insulates the company to some extent from energy issues experienced by EU smelters, particularly. Additionally, Hydro has a significant portion of its production operations unfolded overseas, which moves the company further away from the toxic EU energy market.

What sets Hydro apart from competition is that the company is able to address successfully the secular growth drivers of aluminum demand in key end-markets indirectly, thanks to a significant portion of value-added casthouse premium products and directly, due to a strong global position in the extrusion solutions market.

Overall, the strong balance sheet and solid position in the aluminum value chain give the company good expertise, flexibility, and confidence during macro downturns, as well as more possibility to leverage the market fluctuations and price volatility. This could be evidenced by Hydro’s sustainable track record of dividend payout for more than a quarter of a century through different economic conditions.

The way up also will be supported by a share buyback program of up to NOK 2 billion.

Risk factors

Further aggravation of energy prices could be a major challenge for Norsk Hydro, and lead to additional curtailments of production operations. Overall, stagnation in the key aluminum end-market (automotive, aerospace, and packaging industries) as a result of continuing recession fears could break demand for aluminum products, hence the company’s profitability.

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