Description

Novelis trades at 5x medium term free cash flow and is a potential takeover candidate. Expiration of onerous contracts and recently regained timely filing status should allow the company to focus on driving improvement and growth in the underlying business.

Novelis, spun-off from Alcan in early 2005, is the world’s leading aluminum rolled products producer. Operations are geographically dispersed between North America, Europe, South America and Asia with 75% of production concentrated in North America and Europe. NVL converts scrap and primary aluminum into aluminum sheet, plate and foil. The primary end markets include beverage/food can, construction and general industrial, foil products and transportation (automotive market).

Worldwide aluminum demand growth varies by end market. The automotive sector has experienced increasing demand as aluminum continues to penetrate the automotive market. The can sheet business has been growing steadily with increased appeal in the US and continued aluminum penetration into the can business internationally. The remaining end markets, with possibly the exception of construction (which NVL has somewhat limited exposure to), are characterized by steady demand. NVL typically earns a fixed conversion margin per pound which insulates the business from fluctuating primary aluminum prices.

Can Sheet Business

Beverage can sheet is a very specialized business; in North America there are only three suppliers (Novelis, Alcoa, and Wise) with a combined total of five rolling mills. These three rollers sell can sheet to four beverage can manufacturers (Ball, Rexam, Crown Cork, and Metal Container Corp, the Anheuser-Busch can business).

For the past ten years demand in the industry has declined 0-1% per year but has recently started to grow and is expected to continue to grow 1-2% per year as a result of new energy drinks and an overall perception by designers that aluminum has become a “sexier” packaging. Capacity in the industry is very tight and the only player that has the ability to meaningfully increase capacity is Novelis (NVL could shift capacity away from other business lines; competitors are limited in their ability to shift due to the lower quality of their rolling assets). New capacity is unlikely, as the scale of an economically viable can rolling facility would be such a large % of existing capacity (20%+) that the extra facility would destroy industry pricing (thus rendering the new plant uneconomic for many years).

Typically, the industry charges a fixed conversion margin over metal prices and earns the conversion margin less the cost to convert. However, at the time that some of NVL’s contracts were signed industry dynamics were less favorable to rollers (and rolling operations were integrated with primary aluminum production); as a result, NVL was forced to include metal caps in their contracts. Currently 20% of NVL’s North American can contracts are subject to caps. This declines to 10% at the end of 2006 and all of the cap contracts should expire by the end of 2008 (the remaining 10% is mostly Anheuser-Busch, whom NVL is now suing to renegotiate the contract possibly allowing for an even earlier resolution). As primary aluminum prices soared throughout 2006 NVL realized huge losses in their North American can business as they were unable to pass through metal prices above $0.85 per pound on the capped contracts.

Financials

To understand the true earnings potential of the business we adjust the reported numbers in the following way:

regional income – this is the same as ebitda before corporate expenses

plus: cap impact – this is both the loss on the cap contracts as well as the foregone profit (it is important to remember that NVL doesn’t lose money when aluminum rises above $0.85 per pound, they lose money when aluminum goes above $0.85 per pound + conversion profit/pound)

less: metal timing benefit – basically the benefit realized as a result of holding aluminum inventories during rising aluminum prices

less: cash settled derivatives –  gains/losses (cash settled gains/losses included in regional income)

less: minority interest

One might also adjust these numbers for increased energy and transportation costs as these are items that NVL should be able to recover in new contract negotiations as contracts come up for renewal.

Nine Months Ended September 30^th, 2006 Regional Income

  464mm reported regional income

+350mm cap impact (loss + foregone profit)

-   44mm metal timing impact

- 191mm cash settled derivatives

-     2mm minority interest

   577mm adjusted regional income

-   45mm corporate expense (normalized company target)

-  200mm depreciation (includes JV depreciation)

-  130mm interest expense (~$2.4bn of debt)

   202mm pre-tax income

-   71mm taxes (35%)

   131mm after tax income

+ 200mm depreciation (includes JV depreciation)

-  143mm capex (incl. jv capex), this is significantly higher than maint. capex  ~ $80mm

    188mm free cash flow

      74mm shares

$2.54 free cash flow per share (9 months)

$3.40 free cash flow per share (annualized) – business has little seasonality

 <  8x free cash flow

Adding back energy and transportation cost increases, the benefit of de-bottlenecking and further conversion margin price increases could add another $0.50 - $1.00 of free cash flow per share.

In addition, NVL management is projecting organic regional income growth of 3-5% for the next 5 years and is targeting a minimum of $400mm of annual free cash flow generation in the medium term (2010-2011), or $5.40 per share.

Other Opportunities

Input shift to scrap – Currently two thirds of the inputs are primary aluminum and one third scrap. Management has stated that they want to shift more of the inputs to scrap, which should allow NVL to capture the scrap spread on a larger portion of their production (scrap sells at a discount to primary even after factoring in lower efficiencies).

Further working capital improvement – Even with all of the negative events since the spin, NVL has still been able to repay ~500mm of debt, largely through working capital reductions. Management has stated that while the bulk of working capital improvements have already been implemented there are still certain inventory opportunities, most importantly a reduction in metal inventories as current contracts roll off (current contracts require NVL to hold large inventories) and with the implementation of new IT inventory management systems.

Restructuring/divesture of European foil business – NVL has stated that they are exploring a possible divesture or some sort of restructuring for the European foil business. This business has significant assets and over 2,000 employees but is currently breakeven on a cash basis and negative on a reported basis.

Potential sale of Brazilian smelter – NVL recently explored the sale of its Brazilian smelter, but has decided not to sell for the time being. The smelter acts as a natural hedge to the beverage can caps as it benefits from rising aluminum prices.

LBO opportunity – Prior to Novelis’s spin-off in 2005, Alcan was in late stage negotiations with numerous private equity firms to sell the business for an enterprise value that based on today’s capital structure would imply a $36 share price (the business has grown over the last two years, and would presumably be worth more).

CEO, CFO replacement – Earlier in the year the board fired the CEO and CFO. They have since hired a new CFO and will announce a new CEO shortly.

Catalyst