Norsk Hydro: A Decent Quarter, Future Looks Brighter
Summary
- Norsk Hydro remains the largest holding in the Basic Materials segment in my portfolio.
- This holding has, unfortunately, taken quite a beating as a result of the coronavirus and has only recently started to recover somewhat.
- I consider the company likely to outperform over the longer run - but due to uncertainty regarding the company dividend and short term, I recommend bullishness with care.
There are a few types of companies that are essentially "immune" from worry for me. Larger, dominating grocers are one of them - hence why I own a significant amount in them across virtually all invested geographies. Utilities that are well-managed and well-capitalized are another.
A third is Norwegian, state-owned companies - or in part state-owned corporations. Most of my larger Norwegian investments fall into this category, as the Norwegian state is a very active shareholder in most of the significant corporations in our neighboring country.
Norsk Hydro (OTCQX:NHYDY) is one. Usually, owning a metal producer such as this is tied to significant cyclicality, market uncertainty, and other factors that usually make it quite the ride in times of chaos. We've seen some of that here - but for me, the involvement and knowing just how Norsk Hydro is structured provides me with the certainty needed to go forward here.
That's why, rather than pause and not invest further in the company, I've continued to slowly trickle down dividends and capital investments into Norsk Hydro at the same pace as with some other very significant NA holdings.
Let's look at 1Q20, the latest quarter that's been released.
Norsk Hydro - How has the company been doing?
I believe that the company's own presentation slide says it all quite well.
(Source: Norsk Hydro 1Q20 Presentation)
In the previous presentation, we focused on some of the headwinds that the company is facing, including the Alunorte curtailment, raw material risks, and so forth. It didn't look pretty, and coronavirus has, in fact, made this even less pretty than it was a few months back.
The core of the quarter can be said to be as follows:
- Significant FX, raw material, and volume tailwinds.
- Exceeding expectations in terms of EBIT.
- Company cost initiatives and Alunorte ramp-up are ahead of the planned timeline.
- 2023 improvement target on track and unchanged despite Corona.
On the negative side, we have:
- Negativity due to commodity pricing, namely aluminum, and alumina.
- Forward expectations uncertain, demand has cratered.
- The company is plugging holes, securing operations, and safeguarding company liquidity to ride the storm.
Company operations stretch the entire word, including Europe, NA, South America, India, and China. The COVID-19 impact has been very different from geography to geography. Most European geographies have suffered proactive measures to guarantee stability, such as shift reductions - these also include NA geographies, excluding Mexico which has seen no impact on operations (same with China and Turkey).
The high impact has been in the UK, Italy, India, and Argentina.
Segment-wise, we see that both Bauxite & Alumina as well as the Energy segment are running normally, albeit at a higher market uncertainty going forward. The Primary metal segment has taken hits from falling demand.
The highest hit in terms of segment has been Extruded solutions, where only 30% of company capacity is running at normal levels, with 15% of capacity being either closed or running at very low levels. Combine this with the high market uncertainty, and we can understand why the segment isn't exactly characterized by outperformance at this time.
Perhaps most importantly at this time, and in contrary to previous communications, the company has frozen the 2019 dividend at this time, with the intention of resolving the dividend at a later stage in 2020. This means that we may be without a dividend for the year - or the company may pay this out at a later date, depending on how the market recovers in 3Q20 and 4Q20. Despite large state ownership and overall company safety, this highlights a continuing problem in European companies where they seem to believe that facing future uncertainty justifies changing, already-established past economical decisions in terms of shareholder returns. I've been exceedingly critical of Swedish and German companies doing the same, and my stance isn't different here. A company with both Hydro's available liquidity and available credit should consider more carefully the impact of not rewarding shareholders unless the company's fundamental safeties are affected - which they are not.
(Source: Norsk Hydro 1Q20 Presentation)
Rather what we see is a mix of companies bowing to either political pressure, societal pressure or simply seeing an opportunity to withhold shareholder returns as it has become somewhat of a norm in Sweden and Norway to, irrespective of actual company fundamentals and long-term outlooks, "later resolve" the dividend question.
Should Norsk Hydro not resolve this at a later stage during the year to shareholder satisfaction - i.e. at least the initially proposed dividend - I will, of course, downgrade the company.
That being said, it's important to note that some of the headwinds the company sees are very much valid. Inventories are up...
(Source: Norsk Hydro 1Q20 Presentation)
...and company revenue drivers overall are down.
(Source: Norsk Hydro 1Q20 Presentation)
The positivity I eluded to in the title comes from among other things raw material prices, which along with everything else is down...
(Source: Norsk Hydro 1Q20 Presentation)
...and overall upstream costs are heavily influenced by favorable raw material and FX developments, guaranteeing the company somewhat of an upside even as we see headwinds more often than not.
In the end, Hydro has been struck by factors which the company, or in fact no company, could influence. Norsk Hydro cannot be expected to influence COVID-19 or the entire market demand for aluminum or alumina. Investing in this sort of company comes with the expectation that commodity pricing may at times hurt the companies you own. This is part of the cycle, in that sense, while this event was excessive, it's no different than any other downcycle except for the scale of it.
In terms of what the company can influence, Norsk Hydro is doing great things...
(Source: Norsk Hydro 1Q20 Presentation)
The focus for this year's efforts is now the company factors that can be influenced, such as the Alunorte ramp up. As of 1Q20, the production at 97% capacity utilization, with the 9th press filter/s in full operation. 100% capacity utilization is expected by the end of 2020. In Rolled Products, the company is proceeding with procurement initiatives, cost optimizations, and an ongoing strategic review. In Extruded Solutions, the segment is enjoying positive impacts from the 2019 optimization, with more restructuring considered. Cost initiatives are on track here as well, and procurement initiatives are underway. The company is ahead of schedule with all of these.
This brings us to the overall, bird's-eye question, just how is the company doing in the long run? I would argue that the company is positioned for some incredible multiple expansion going forward. From the most low-carbon aluminum production in the world, as well as recycling solutions, bringing innovative products...
(Source: Norsk Hydro 1Q20 Presentation)
...to actually beating 1Q19 results...
(Source: Norsk Hydro 1Q20 Presentation)
...the overall current financial and fundamental picture of Norsk Hydro is looking good. The company had revenues of nearly $38.2B NOK, with more than 4 times the underlying EBIT YoY. Admittedly, this was a poor comparative quarter, but the company nonetheless reported an underlying EPS of 0.55 NOK/share. Every segment apart from Energy reported positive results YoY for 1Q20, and this is something that needs to be taken into consideration when viewing the company both now and in the context of COVID-19. The company's net debt is slightly up, from 15.1B NOK in 2Q19 to 15.2B in 1Q20.
The company is continually BBB-rated from S&P with a stable rating, as well as continuing underlying strong liquidity. There is continued 12.2B NOK in cash and equivalents available, with another ~15B NOK available in a yet undrawn multi-currency revolver maturing in as late as 2025.
The crux here becomes the dividend. The company has previously communicated targeting a 40% EPS payout ratio, with a 1.25 NOK/share floor. The intended meaning of the term "floor" is unmistakable. The decision to at this point authorize the board to resolve the dividend question at a later point puts into question what the company's definition of that term is. Should the company, ultimately, decide to not pay, or to pay even a øre less than 1.25 NOK, this policy no longer holds any water.
This is not a "problem" per se - Norsk Hydro is a qualitative company with strong enough fundamentals that I'd own it even if there wasn't the dividend floor policy in the company's statements. The issue becomes forecasting accuracy - if we can't trust the company to maintain what they previously communicated in unambiguous terms, other investors should probably reconsider the company as an investment if 100% continuous dividend safety is the goal.
So, with that, let's look at the company valuation at this juncture.
Norsk Hydro - What's the valuation?
Of course, looking at current numbers, the valuation is unmistakably excellent and appealing.
(Source: Börsdata, P/S)
The idea that one of the most advanced alumina companies in the world because of COVID-19 holds a long-term valuation of 0.35X in terms of sales is ludicrous and works only in a world affected by COVID-19. Similarly, a price/book value of less than 1X for a company holding the most advanced facilities worldwide - in fact, trading at multi-year P/B lows of 0.64 - once again only makes sense in a world affected by this virus.
The long-term prospects for this company promise to be far different when looking at longer-term expectations. Norsk Hydro, in working times, trade somewhere closer to 10-15 P/E, though significant EPS fluctuations have made P/E an all but unusable metric at this point. Still, taking a baseline, 5-y average EPS of 2.2 NOK/share gives us a low-side share price of 33 NOK/share as a 15 P/E target - and the fact is, the company's EPS potential since those averages were calculated is, due to modernization, tech, and ramp-ups, far higher than 2.2 NOK/Share.
It's hard to argue that Norsk Hydro at this stage, with dividend uncertainty and macro the way it is, is worth more than a 13 P/E of 28.6 NOK/share. Make no mistake, however, this BBB-rated Aluminum giant trades far higher and has previously and in good times seen pricing of 60 NOK/share. Since that time, the company has grown book value/share as well as the revenue on a per-share basis.
What's different now is macro and COVID-19.
Using the dividend "floor" of 1.25 NOK/share, which I, at least, consider being tendentially indicative outside of a catastrophe such as this, this gives us a current yield of nearly 5%. My own yield basis is over 3.8%.
The question of whether Norsk Hydro is undervalued is easily answered. It is.
(Source: TIKR.com)
The question, on the other hand, what it should be worth, is quite different and not easily answered. In the short term, there's so much uncertainty that I believe going by assets or book value gives us the best indicator of just how far the company has been undervalued - and sales, as well as book value valuations, speak their clear language here.
In this case, I do choose to use a more normalized EPS of 1.8-2.5 long term, giving us a target of ~30 NOK/share and a potential upside of 14.6%. I choose to use a far lower price target here, including expectations that Norsk Hydro may indeed go against their dividend policy but understand that in this target, there is considerable longer-term uncertainty involved, and I view Norsk Hydro once it's working well and markets have stabilized to be worth considerably more. Giving a price target of 50-60 NOK/share at this time, however, is unrealistic and paints too positive an expectation of this company.
Thesis
I've been harsh towards Norsk Hydro here, despite the overall positive tone of the article title. I want to emphasize that I consider Norsk Hydro very potentially capable of delivering considerable alpha in the long term. The company's efforts for the past few years, however, have been hampered again and again by curtailments, environmental issues, software issues, restructuring issues, and, now, COVID-19. Some of these issues are fully within the company's control, and some are not.
To those seeking immediate dividend safety in metals, I would currently point you to Nucor (NUE) above Norsk Hydro. It's steel, not alumina, but, at the moment, holds a considerably higher safety than this Norwegian investment. Nucor is a Class-1 Basic materials stock, A-1 rated with a nearly 4% yield at only a 0.4% above fair value, with 10% earnings yield and 47 years' worth of dividends, there's no doubt that you'll be getting your money's worth both short- and long-term. It's also why I invested in Nucor.
However, longer term, I want to draw your attention to the capabilities of Norsk Hydro. Forget the dividend floor - in good years, Norsk Hydro has EPS of 4-5 NOK/share. This gives us potential dividends of 1.8-2.5 NOK, with previous Hydro dividends sometimes indeed close to 2 NOK. That would make the current yield 7.8%, for a partially state-owned and one of the world's leading aluminum companies. Here you see my reason for splitting my investment dollars between companies, including Norsk Hydro, when I invest in the Basic Materials sector.
Under that premise, as I consider it likely long term, I see Norsk Hydro as a "BUY" even with this uncertainty.
Thank you for reading.
Stance
Continued undervaluation brings us a 14.6% potential upside in Norsk Hydro, although care and understanding are required with regards to the company's situation.
This article was written by
Wolf Report is a senior analyst and private portfolio manager with over 10 years generating value ideas in European and North American markets.
He is a contributing author for the investing group iREIT on Alpha where in addition to the U.S. market, he covers the markets of Scandinavia, Germany, France, UK, Italy, Spain, Portugal and Eastern Europe in search of reasonably valued stock ideas. Learn more.Analyst’s Disclosure: I am/we are long NUE, NHYDY, NHYKF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.
I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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