Hindalco an underperformer: Karvy

Broking house, Karvy Stock Broking has recommended Hindalco Industries an underperformer.

Karvy Stock Broking report on Karur Vysya Bank:

Hindalco has bid to acquire Novelis, an aluminium major based in Atlanta, for USD 6 billion. The acquisition is subject to the approval of 66.7% of Novelis' shareholders accepting the offer. Once it is done, then the remaining shareholders of Novelis will have to give up their shares to Hindalco as per the Canadian stock market regulations.

Background of Novelis:

Novelis has three million ton capacity of value added products and is a leading producer of flat rolled products with a global market share of 19%. The company is globally positioned operating in 11 countries and supplying to prestigious customers like Coca-cola (for beverage cans) and Jaguar (aluminium sheets). Though the acquisition gives Hindalco a global footprint through Novelis' manufacturing plants in different locations, we believe that the acquisition is unlikely to add value in the short to medium term. Novelis is a strategic asset for Hindalco as it has its own bauxite mines and access to low cost coal for generating power in India.

Valuation of the deal:

The deal is valued at EV / EBIDTA of 8x based on CY2005 numbers of Novelis. The valuation can not be done on CY2006 numbers as the company has reported a loss of USD 170 million in the first nine months of CY2006. The EV / EBIDTA multiple of 8x is expensive especially considering that Hindalco, fully integrated profit making company, is quoting at EV / EBIDTA of around 4x. Moreover, even if the consolidated accounts will show doubling of sales, consolidated bottomline is likely to be dragged down by losses of Novelis.

Funding of the deal:

The total valuation of USD 6 billion is divided into two parts – USD 3.6 billion of cash payment and a take over of existing debt of USD 2.4 billion from Novelis. The bulk of the deal will be funded by Hindalco raising fresh debt of USD 2.8 billion. While USD 450 million will be contributed by existing treasury resources of the company, another USD 300 million will come from Essel Mining, which is also an Aditya Birla group company. Apart from funding of the Novelis deal, Hindalco will also need substantial borrowings if it wants to complete all the greenfield and brownfield expansions lined up in India. The expansion projects in India are worth approximately USD 3 billion. We believe that the debt-equity ratio of Hindalco, which is at about 0.5x currently, could balloon up to more than 2:1. This could prove to be very risky if aluminium prices come down from their existing level, which in our opinion is a very likely possibility.

Impact on Hindalco stock:

Hindalco's consolidated earnings will be hit by the cumulative effect of the loss of Novelis, higher interest cost due to the acquisition being funded by debt and lower other income as the treasury will be liquidated. We believe that the acquisition, if it goes through, can bring down Hindalco's FY2008E consolidated EPS by at least 25% to Rs 16.5 from Rs 22. But we are considering the revised EPS only for the purpose of valuation as the same can not be incorporated in our financials pending the actual acquisition. Consequently, we are downgrading our target price on the stock from Rs 165 to Rs 124 (at 7.5x of revised FY2008E EPS of Rs 16.5) and rate the stock as Under Performer.