Hindalco-Novelis: Just the novelty the latter needed

Four years have passed since Hindalco, the leading Indian aluminium producer, acquired the global aluminium processor Novelis. Given Hindalco's capacity to produce alumina and aluminium metal at low cost, the acquisition seemed a good fit. It was neatly complemented by Novelis' using aluminium metal to make products catering to beverages, producer automobiles and consumer durable sectors.

HOW HAS THE MOVE TURNED OUT SO FAR?

Not too badly, considering that Novelis had come with a debt of about $3.5 billion and there was little overlap between Hindalco and Novelis in terms of product mix. Hindalco was producing the low-end stuff and Novelis had to process them into value-added products. Hindalco also had to manage new products and a much larger scale of operations because Novelis consumes roughly 5-6 times the amount of aluminium produced by Hindalco. Novelis was also locked into risky long-term contracts with key customers. The contracts left Novelis footing the bill for higher aluminium prices when they soared, thus pushing it into losses.

Hindalco's first challenge was to tide over Novelis' sizable portfolio of problem contracts which had locked it into fixed selling prices for many years. The second was to minimize possible losses by hedging against rising raw material costs. Novelis became a drag on Hindalco's bottom-line. It was the latter's net profits that came to the rescue of Novalis in FY08 when both revenue and volumes dropped off the shelf. 2009 was a bit better in spite of an 8 per cent drop in volumes because, thanks to stimulus spending by governments around the world, realisations saw a mild-recovery. Hindalco, whose consolidated debt spiked by four fold to Rs 32,000 crore following the acquisition, had to tide over the contractual obligations and ensure its hedges minimized losses.

But bad things also pass, and the sizable loss-making long-term contracts expired in December 2009. Gradually, things improved. The consolidated operational cash flows have risen from Rs 5,400 crore in FY08 (first full year of acquisition) to Rs 6, 200 crore in FY11. Improving performance at Novelis also led to a debt-rejig within the consolidated entity. Novelis raised $4.8 billion of which $1.7 billion was returned to the parent entity, Hindalco, freeing it up to raise fresh leverage for its domestic expansion. In addition, Novelis is also undertaking an over 30 per cent increase in overall processing capacity over the next five years. Among the more physical benefits of acquiring Novelis is that of a UK plant used to produce beverage cans being moved to India. The Hindalco domestic operations are likely to be the major growth drivers over the next few years.

DOMESTIC CHALLENGES

Hindalco's consolidated debt has dropped from Rs 32,350 crore in FY08 to Rs 27,700 crore in FY11. Expansions are underway to increase alumina and aluminium metal production capacity by four and three fold, respectively. With these additions, Hindalco hopes to boost consolidated margins given the integrated Indian operations. The additions also provide Novelis an effective hedge against raw material price rise. Being among the world's lowest cost producers of alumina and aluminium metal (by virtue of captive mines and power) Hindalco is well-placed to emerge as a fully-integrated bauxite to aluminium producing entity. Challenges facing the company on this front include land acquisition, adding coal mining capacity (new mines) and avoiding cost and time over-runs which could dent profits.

INVESTOR POSITION

Investors who bought into the Hindalco stock at its peak of Rs 200 in early-January 2008 now find its value themselves down by over 30 per cent. Buying into the stock within a few days of the Novelis-acquisition announcement would not have been the most profitable endeavour, given that the stock hasn't gained from that level. The BSE Sensex has posted 15 per cent absolute returns in the same period. Investors who did have the stomach for risk in October 2008 to buy the stock at Rs 40 find themselves with a more than three-fold gain.

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