The flagship A.V. Birla group company, Hindalco Industries Ltd. (HIL), has faced another challenging year. The slowdown, which started in FY01 seems to have intensified in FY02, which is reflected in turnover and bottomline growth of the company. Growth in FY01 was largely through better realisations. However, in FY02, with a global and domestic economic downturn, both demand and realisations took a hit, which impacted the business.
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The slowdown, much of which began in 4QFY01, seems to have taken a toll on the first quarter performance of HIL. The company, ever since, has been improving its YoY quarterly sales performance. Having said that, full year sales have been driven by 4QFY02 performance. As was the case with the subsidiary -- Indal -- turnover growth has been generated by higher volumes, as realisations declined in FY02. Productions figures were higher by 3.8% - 34.9% for saleable products, except extrusions (-12.6%) and alloy wheels (-0.7%). The marginally higher inventories indicate that much of the production did materialise into sales. HIL has come ahead of our full year sales growth expectation of 1%.
Volume led growth mentioned earlier largely fructified in the last quarter of FY02. Over three years -- FY02 - FY04 -- HIL plans to augment smelting (aluminium) capacity by 100,000 metric tonnes per annum (MTPA). As per schedule, the 9th potline with 33,000 MTPA of capacity was commissioned during FY02. The entire rise in aluminium production of 9,846 MT has materialised from the new potline. Having said that, at the start of FY02, the company anticipated additional output of 15,000 MT, which seems to suggest an estimated delay of 2 months from production target date. The potline seems to have operated for an estimated 4 months, commencing commercial production in December '01, as compared to expectations of October '01.
Operating above rated capacity in refining and smelting prior to the expansion, the new potline has offered some breathing space to the company. However, there is no indication of additional alumina capacity to support the higher aluminium production. But a sweetening process seems to have facilitated the entire 18,024 MT increase in alumina production, which is commendable considering the high existing operating rates. This performance seems to explain the stretched process parameters of the company. Realisations, and to that extent margins, have been protected by greater presence in downstream, high value products.
With a drop in margins, operating profits for the concerned periods took a hit, as expenditure grew at a faster clip compared to sales. Operating costs have increased due to higher volume sales, which also indicates that unit cost has not fallen commensurately with realisations, leading to pressure on margins. Peer group companies have reported a similar trend. Prices of caustic soda, a key input for alumina production, doubled during fiscal '02. Increase in coal prices at start of FY02 led to higher energy costs. Also, the company entered into a fresh wage agreement at start of 2002, which impacted 4QFY02 expenses. The agreement is valid upto December '04 and entails an estimated 30% hike in wages.
That said, high operating rates, efficiency improvement initiatives, downstream presence and better product mix helped ameliorate some of the pressure on margins. In FY02, the company undertook Project Rocket - 2K, a profit improvement exercise, emphasising on higher operating efficiency and cost reduction. The initiative was expected to yield savings of Rs 400 m - 500 m over two years. HIL continues to drive the initiative, but entire savings are now likely to materialise by FY04. In the current fiscal, the company begun implementation of an ERP system likely to be completed over the next 2-3 years with an estimated cost of Rs 240 m. The IT system is likely to streamline business processes, especially supply chain and customer relations, which could yield additional savings by lowering cycle times.
Interest costs have declined in all quarters of FY02. This could be due to reducing interest rates over the past 12 months. Also, the company has capitalised some of the interest in FY02, which to some extent has added to the depreciation. Investment of surplus funds in FY01 has led to higher other income. Also, with investment in debt funds and declining interest rates, the company yielded capital gains, which were offset against carryforward losses to reduce tax liability. Adjusting for other income, pre-tax profits would drop by 6.4%, which indicates that quality of earnings have weakened. A lower effective tax rate by 520 basis points, which could be due to removal of corporate tax surcharge in FY02, has also helped lift post tax profits.
The Rs 18 bn brownfield expansion at Renukoot is targeted to be completed by FY04. The exercise will expand capacity by approximately 50%, removing production constraints. Also, with an expected global & domestic economic turnaround, realisations are likely to improve. Financials in FY03 and especially FY04, assuming global economic growth gains momentum, could get a double kicker from higher volumes and better realisations. The company seems well poised to gain from an upturn in business. Also, over a twelve month period commencing February '02, a share repurchase programme through the open market route is being conducted by the company. Shares will be repurchased at a maximum price of Rs 825 with aggregate outlay not exceeding Rs 4.3 bn. Extrapolating from percentage holding of non-promoters, HIL seems to have repurchased at estimated 20,500 shares. The lower equity will lift per share earnings going forward.
At Rs 740, the scrip is trading on a multiple of 8x FY02 earnings. The higher valuations accorded to the company, compared to its peers, is due to the greater focus on downstream products. Alumina and alumina chemicals contribute an estimated 20% and 25% of Nalco and Indal sales. The entire alumina production is consumed internally at HIL. This does not expose company revenues to volatility in alumina prices, which were down an estimated 50% in FY02. Ability of the company to increase revenue share of downstream, value added products is likely to further insulate earnings from commodity cycles, which could favourably impact valuations.
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