Hindalco: Slippery metal

Post-Novelis, cutting costs is key to Hindalco's operating profit margins

The acquisition of Atlanta-based Novelis has catapulted Hindalco to the global aluminium industry, but the Street is worried: When will the synergies between the two players actually materialise?

Novelis has certain long-term contracts with its key customers till 2010, which has resulted in its inability to pass the rise in aluminium prices on to them. As a result, its EBITDA was merely $399 million on net sales of $7.37 billion in the first nine months of calendar 2006.

Hindalco is expected to have spare aluminium capacity for meeting Novelis' needs only by 2012, once it scales up its output to 1.5 million tonne.

Also, to finance the acquisition, at an enterprise value of $6 billion which is about 8 times its trailing EBITDA, Hindalco will use $450 million of its cash reserves, while its SPV will raise debt to the tune of $2.8 billion. Hindalco's cash flows are viewed as sufficient to meet the interest payments for its enhanced debt levels.

Analysts, however, point out that in a scenario where the consolidated entity is not able to reduce costs over the next few quarters, it could knock down Hindalco's operating profit margins to 8-9 per cent levels, from 21.8 per cent in the first nine months of FY07. These concerns took their toll on the Hindalco stock, which on Monday got a hammered of 14 per cent to plunge to Rs 149.45.

Analysts foresee Hindalco's consolidated EV/EBITDA at about 8.8 times in FY08 and 6.8 times in FY09. Before the buyout, its EV/EBITDA for the trailing 12 months ended December 2006 was about 7 times.

So the price it has paid for Novelis is expensive from the short-term perspective. However, in the medium term, the acquisition is expected to help Hindalco get a ready foothold in the higher-margin segment of the global aluminium industry, given that Novelis produces an estimated 19 per cent of the world's flat rolled aluminium products with marquee customers. If aluminium prices were to fall in the medium term, it would help Novelis improve its operating margins "� though it will hurt Hindalco's domestic business.

Nevertheless, lower aluminium prices will be good for the merged entity simply because Novelis is the larger of the two. Because of the long-term contracts, analysts expect the acquisition to be earnings-accretive only from FY10.

Without the impact of the Novelis takeover, Hindalco trades at about 8 times estimated FY08 earnings and 6 times FY09 earnings, and is likely to remain an under-performer in the short term.