Hindalco

Investors with a long-term perspective can continue to hold the Hindalco (Rs 59) stock even if the company’s near-term earnings performance is lacklustre. Hindalco’s operations have delivered reasonable growth on a standalone basis, but muted profitability and high debt of the Novelis acquisition have brought down valuations in recent times. As a low cost and integrated producer of aluminium, Hindalco could capitalise on Novelis’ value-addition capability and diversified user base in the event of an economic recovery. The tilt towards user sectors such as beverages and infrastructure makes it less vulnerable to demand slowdown than many of its global peers.

At a PE multiple of 7 times its estimated 2008-09 earnings, the stock trades at a discount vis-a-vis its Indian and global competitors.
Aluminium: Main revenue generator

Aluminium and copper are Hindalco’s main business streams. On a standalone basis, aluminium contributes 37 per cent to Hindalco’s revenues, but its share in net profits is as high as 80 per cent. Extensive brownfield expansions and low-cost acquisitions implemented over the last five years have put Hindalco on the list of global low-cost aluminium manufacturers. The company concentrates on producing rolled aluminium, ingots, bars and foils. These finished goods are sought after by infrastructure companies, capital goods manufacturers and power transmission and distribution companies.

While the automobiles industry accounts for about one-fourth of Hindalco’s demand (on a consolidated basis), the improvement in domestic passenger vehicle sales offers some comfort. For the nine months ended December 2008, Hindalco’s net profits (on a standalone basis) from the aluminium segment rose by about 6 per cent and revenues by 10 per cent.

Hindalco acquired Novelis, maker of value-added products such as beverage cans and alloy wheels in May 2007 for $6 billion. Though this changed Hindalco’s business and geographic profile, the deal weakened its balance-sheet as Hindalco was forced to take on Novelis’ debt burden of $2.9 billion.
Novelis Acquisition

Born in early 2005 as a result of spin-off from its parent company Alcan, Novelis has a diversified clientele — Coke, Ford, General Motors, Audi, Lotte, Kodak and Tetra Pak. But in a bid to pump up its business, Novelis entered into fixed price supply contracts with some of its major customers.

Trouble began in 2005 when raw material prices spiralled sharply. Since Novelis was compelled to sell below cost due to contractual obligations it reported losses of $102 million from operations for the nine months ended December 2008. This swelled to $1.82 billion, after the company charged goodwill impairment and losses on derivative contracts.

Despite this, Novelis’ business does offer long-term benefits to Hindalco. Facility to produce value-added products may aid Hindalco’s margins over the long term. The fixed price contractual obligations of Novelis end by January 1, 2010. Moreover, Novelis has embarked on cost savings and had undertaken a production cut. In addition, it is accounting for goodwill impairment which may help Hindalco benefit from the deal
Copper: Yet to shine

Hindalco’s copper business (where demand is mainly from the domestic market) has been facing margin pressures from declining realisations. While the segment’s contribution to revenues is 67 per cent, its high cost structure has limited its share in profits to as low as 20 per cent.

Copper cathodes and rods find use in high end industries such as electrification, housing and construction and infrastructure projects. Apart from US and Europe, Hindalco exports copper to the BRIC nations, which offset decline in demand from US and Europe in 2007-08. But with even the BRICs witnessing a slowdown in 2008, Hindalco’s revenues from copper slipped by 5 per cent for the nine months ended December 2008.
LME prices

Copper prices in the London Metal Exchange corrected sharply, by 62 per cent, between July and December 2008. They have since recovered 44 per cent. Easing warehouse stocks and signs of higher Chinese demand have raised hopes about an early recovery in the copper price cycle.

On the other hand, aluminium prices remain subdued, though they have risen 19 per cent from the February 2009 lows. LME inventories show some improvement in aluminium demand but the recovery is more tentative than for copper.
Financial overview

A strong commodity cycle saw Hindalco deliver sales growth of 24 per cent and operating profit growth of 25 per cent between 2003 and 2007.

In 2007-08, the company saw a manifold growth in consolidated sales from Rs 193 crore to Rs 600 crore (attributable to the acquisition of Novelis), while operating profits rose 50 per cent. But high interest costs from the Novelis acquisition led to a dip in net profits. From a consolidated debt service coverage ratio of 15 times in until 2006-07, it fell to three in 2007-08.

The bridge loan taken for the buyout (due in November 2008) has been fully repaid by the company, through rights issue proceeds amounting to $920 million. For the remaining debt, the company has again borrowed $982 million (at a rate of LIBOR + 80 bps) after liquidating its investments.

The financial year 2007-08 saw a sharp surge in crude oil prices, which had cascading effect on transportation costs and cost of alternative energy sources such as coal. Going forward, Hindalco’s margins are likely to benefit from the substantial correction in crude oil and coal prices.
Other concerns

The major constraint for the aluminium division is the threat of import substitution. With the government recently hiking import duties on the metal, this problem has been addressed adequately. The copper division continues to face raw material supply constraints, resulting in production capacities remaining unutilised.

Moreover, Hindalco faces margin pressures because of depressed treatment and refining charges, which determine conversion margins on copper and this is expected to persist in the near future also.