Norsk Hydro's road to recovery

For the past many years, aluminium has been an exception amongst base metals, thanks to material capacity cuts (in 2013-14) and sustained growth in demand (+4% p.a. since 2013). Hence, exceptional and lasting gains for giants like Norsk Hydro, +148% during 2013-17 vs. negligible metals sector returns (+6.5%), were well-deserved. Interestingly, aluminium (players) started faring reasonably well, much before the sector’s euphoric recovery began in early 2016.

A litany of issues

Just when all seemed hunky-dory, 2018 wreaked havoc for global aluminium markets, starting with Norsk being accused of major environmental negligence at Alunorte – resulting in suspension of 50% of capacity, followed by the US sanctions against Rusal. Simultaneously, lingering global trade and growth worries compelled the aluminium biggies (i.e. Norsk, Rusal and Alcoa) to moderate their demand projections. Norsk’s situation worsened in March 2019, when it reported a group-wide cyber-attack – resulting in a NOK300-350m financial impact in Q1 19 and another NOK200-250m impact guided for Q2 19. As a consequence of these events, the Norwegian giant lost >45% from its peak market value, and its Q4 18 and Q1 19 operating margins plummeted to negligible levels (average 1.4%).

Still outperforming over five years

Despite the sell-off, Norsk remains a 5-year outperformer, which can be attributed to:

• Negligible Chinese sales exposure (1.4%) vs. >35% for diversified miners; remember, China’s economic vulnerability still remains a contentious issue;
  
• Even after the NOK12bn mega acquisition of JV partner  SAPA, Norsk ended 2018 with comfortable gearing of 8.8% vs. c.22% for peers;
  
• Undisputed dominance across the value chain, with compelling demand prospects – especially in extrusion;
  
• Avoidance of exorbitant M&A at the commodity cycle peak; moreover, the group has done well to extract value from acquired businesses – thereby avoiding hefty impairments during (sustained) market turbulence.
  

Some relief for now

Fortunately, in the first half of 2019, the issues began retreating. The US withdrew sanctions against Rusal in late January, which was followed by the Brazilian court dismissing civil and criminal lawsuit proceedings against Norsk in May. Given that there was no ‘major’ calamity associated with Alunorte, unlike the disasters at Vale, it always seemed that Norsk would walk away blemish-free, sooner or later. Management from the outset had a clear stance that there was no negligence on its part. Moreover, the Norwegian State – given a 34.3% stake in Norsk, might have played an important, though not a swift, role in helping to find an amicable solution.

Followed by better times ahead

Even though aluminium prices remain subdued at $1,750/t (a 20-month low) as the sudden disappearance of supply-side issues has been offset by growth worries, gradual improvements should stem from reverting to normal operations at Alunorte – management targets to reach 75-85% capacity utilisation in the next two months. Moreover, with optimal internal sourcing of alumina, Norsk can refocus on its efficiency programmes which were missed by a massive margin in 2018.

While Norsk has no material Chinese exposure, developments in the country are of high importance. Remember, China’s unrelenting focus on a clean environment should prevent any major restart of its polluting alumina capacities, thereby averting a scenario of complete collapse in prices – which should be supportive for Bauxite & Alumina’s cash flows. Moreover, the increasing Chinese emphasis on EVs – resulting in higher per capita usage of aluminium to reduce weight and increase efficiency – should be an added impetus. According to some estimates, EV-driven aluminium demand can increase by as much as ten times to c.10mt (16% of 2018 production) by 2030. Interestingly, with formidable control of key battery materials already secured, attainment of EV supremacy could be China’s response to US (trade) tantrums.

Aluminium’s EV gains

 
Source – Investor Presentation Q1 19 results

Despite some hiccups …

A dominant European sales exposure (c.57%) – where the region’s recovery momentum is being questioned, and a meaningful US sales exposure (c.20%) – where there are accelerated efforts by Mr Trump to reduce import dependence, implies that Norsk needs to revisit its geographic balance. Moreover, management’s admission that even the 2019 efficiency programme targets won’t be achieved and a strategic review of Rolled Products being undertaken hint that restoration of healthy profitability might still take some quarters. This may well be a Litmus test for the new CEO – Hilde Merete Aasheim. Hence, investors should shelve any expectation(s) of instant gratification.

… it’s a must-have asset

At present, Norsk is trading at a major discount on both fundamentals and relative valuation metrics (ex. P/E), with the highest upside on NAV (+104%) and P/Book (+100%) measures. The group is undoubtedly an apt long-term play for investors seeking exposure to a green business model – both from an input (i.e. energy consumption) and output (i.e. EVs) perspective, with the added cushion of a credible sovereign cover, and, hence, is substantially more than a cyclical ride at rock-bottom prices.