13-Hindalco - Novelis Acquisition - Creating an Aluminium Global Giant -1

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Management & Change, Volume 13, Number 2 (2009)

HINDALCO - NOVELIS ACQUISITION:CREATING AN ALUMINIUM GLOBAL GIANT

CASE ANALYSIS I

Dr. V.J. Sebastian,Associate Professor,IMT Ghaziabad, Raj Nagar, 201001.E-mail: [email protected]

The topic of this case is an interesting example for the apparently insatiablehunger of Indian companies for becoming global giants. This casedemonstrates how desperate the Indian companies are for acquisition ofglobal players which are sometimes even bigger than their own size. It talksabout the pros and cons of an acquisition, where management is paying notonly for the value of company but also for a dream, which seems to be veryexpensive. Although there are many dimensions to the issue at hand, thisanalysis emphasizes more on the future challenges and risk factors associatedwith the acquisition.

Issue 1: Risk Associated With Hindalco Novelis Acquisition

Although Birla’s are very optimistic about this acquisition, there is a seriousrisk with this acquisition. Birla’s have paid a very high price to acquire a lossmaking company. When asked whether Hindalco is paying a higher price,Birla said, “When you are acquiring a world leader you will have to pay apremium”, which is something irrational and not reasonable. Novelis reporteda loss of $102 million, or $1.38 a share, in the third quarter. A year earlier,net income was $10 million, or 14 cents a share. In 2005, the companyreported net sales of $8.4 billion. If things doesn’t work out in Birla’s waythan Novelis can create a serious threat for Hindalco’s balance sheet and inthe future the losses of Novelis can even eat Hindalco’s net worth. It seemsthat due to over optimism, the Birla’s have overestimated the synergy valuationand it may be damaging for the shareholders of Hindalco in long run.

Issue 2: Post Acquisition Financial Challenges of this Acquisition

The acquisition is likely to expose Hindalco to a weaker balance sheet.Besides the company will move from high margin metal business to low-

Management & Change, Volume 13, Number 1 (2009)© 2009 IILM Institute for Higher Education. All Rights Reserved.

Case Diagnoses

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24 Hindalco-Novelis Acquisition: Creating An.............

margin downstream products business. The case has shown that while theacquisition will more than triple Hindalco’s revenues, it will also increasethe debt and erode its profitability. The deal will create value only after thecompletion of Hindalco’s expansion plans, and due to its highly leveragedposition, expansion plans may get affected. Some of the customers of Novelisare significant to the company’s revenues, and that could be adversely affectedby changes in the business or financial condition of these significantcustomers or by the loss of their business. (The company’s ten largestcustomers accounted for approximately 40 per cent of total net sales in2005, with Rexam Plc and its affiliates representing approximately 12.5 percent of company’s total net sales in that year). Novelis profitability could beadversely affected by the inability to pass through metal price increasesdue to metal price ceilings in certain of the company’s sales contracts.

Adverse changes in currency exchange rates could negatively affectthe financial results and the competitiveness of company’s aluminium rolledproducts relative to other materials. The Company’s agreement not tocompete with Alcan in certain end-use markets may hinder Novelis abilityto take advantage of new business opportunities. The end-use markets forcertain of Novelis products are highly competitive and customers are willingto accept substitutes for the company products. Though the Hindalco-Novelisacquisition had many synergies, some analysts raised the issue of valuationof the deal as Novelis was not a profit-making company and had a debt ofUS $ 2.4 billion. They have opined that the acquisition deal was over-valuedas the valuation was done on Novelis’ financials for the year 2005 and noton the financials of 2006 in which the company had reported losses.

Issue 3: Future Outlook

High prices and buoyant demand outlook in the domestic as well asinternational markets prompted aluminium companies to undertake hugeexpansion plans. Huge quantity of aluminium will come into the market inthe coming years. All the three major companies Nalco, Hindalco andVedanta Group have drawn up plans to increase capacities. As given in thecase, at the end of January 2007, investment in hand in the alumina andaluminium products sector amounted to Rs.59,81800 million and are spreadacross 35 projects. Most of the major projects, amounting to over 60 percent of the aggregate investment in value terms, are under implementation.If all the projects are successfully implemented, aluminium smelting capacitywill increase from 11.8 lakh tonnes to 18 lakh tonnes. Of this, about fivelakh tonnes each will come on stream in 2009 and 2010. Hindalco has

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Rakesh Gupta & Aman Srivastava 25

undertaken aggressive plans to increase its capacities through capacityexpansion as well as by setting up greenfield plants. It increased its capacityat Hirakud plant by 35,000 tonnes to one lakh tonne. When Hindalcocompletes all its project, smelting capacity will increase by about 10 lakhtonnes. Along with smelting capacities, the companies are expanding aluminacapacities and setting up captive power plants. Domestic alumina capacityis set to increase by 9.5 million tonnes when all the outstanding projects arecompleted. Large alumina capacities will not only feed captive aluminiumsmelters, but also leave surplus alumina to be exported to lucrative marketslike China.

Given the above scenario, the profitability of Hindalco is likely to beunder cloud for some time to come and the company could suffer a fate notdifferent from Tata Motors/Tata Steel post their costly acquisition of foreigncompanies, undertaken at the peak of the economic boom. Of course Hindalcocould hope for better luck with sign of economic recovery in the offing.

CASE ANALYSIS II

Dr. Sonu GoyalProfessorBusiness Strategy and EntrepreneurshipInternational Management InstituteB-10, Qutab Institutional AreaNew Delhi 110016E-mail: [email protected]

The case, ‘Hindalco - Novelis Acquisition: Creating An Aluminium GlobalGiant’ discusses at length the $6 billion worth acquisition of Canada’s Novelisby the Aditya Birla Group owned Hindalco Industries in the year 2007. Thecase closely examines the issues that emerge in an acquisition move andhighlights the strategic rationale for such acquisitions. It also discusses thefinancial implications for the acquiring company.

Mergers and acquisitions (M&A) have long played an important role inthe inorganic growth of firms. Acquisition means that company X buyscompany Y and thereby acquires control over it. When one company takesover another and clearly establishes itself as the new owner by absorbingits operations, the purchase is called an acquisition. There are normallyseveral determinants which influence firm’s choice to go in for an acquisition.

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Issue 1: Strategic Rationale for the Acquisition

An acquisition may pave the way for the acquiring company to gain moremarket share, create a more efficient operation out of the combinedcompanies by closing high-cost plants and eliminating surplus capacityindustry wide. Quite a number of acquisitions are undertaken with theobjective of transforming two or more otherwise high-cost companies intoone lean competitor with average or below-average costs. Acquisition mayalso be intended to expand a company’s geographic coverage. Industrieswhich exist in a fragmented state, with local companies dominating localmarkets and no company having a significantly visible regional or globalpresence tend to undergo consolidation by way of series of acquisitionsundertaken by the regional players over a period of time. Firms thus tend toundertake acquisition to extend their business into new product categoriesor international markets thus widening their geographic reach and broadeningthe number of product categories in which they compete. Efficiency theoriesview the potential of acquisitions in creating possibility of lower unit costs,stronger purchasing power or gain in management efficiencies.

Nolvelis acquisition illustrated many of the reasons mentioned aboveand was considered a good strategic move by Hindalco. It allowed thecompany to establish it self as an integrated producer with low-cost aluminaand aluminium facilities combined with high-end rolling capabilities and aglobal footprint. Hindalco could ship primary aluminium from India to all itsoverseas Novelis facilities for making value-added products. Hindalco’srationale for the acquisition was to increase scale of operation, enter intohigh end downstream market and enhance global presence. Aluminium wasconsidered the metal for the future because of its versatility, strength, lowweight and corrosion resistance characteristic. Novelis was already theglobal leader (in terms of volume) in rolled products with annual productioncapacity of 2.8 million tonnes and a market share of 19 per cent. It hadpresence in 11 countries and provided sheets and foils to automotive andtransportation, beverage and food packaging, construction and industrial,and printing markets. Acquiring Novelis also provided Hindalco ready accessto its existing customers such as General Motors Corp. and Coca-Cola Co.

Hindalco’s acquisition of Novelis was thus strongly driven by its desireto increase firm’s market share and thereby market power. Hindalco’sposition as one of the lowest cost producers of primary aluminium in theworld could now be leveraged to become a globally strong player. TheNovelis acquisition gave Hindalco immediate scale and a global footprint.

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In a horizontal merger, acquiring a competitor, provides immediate accessto greater share of the market. Potential economies-of-scale or synergiesthat are achieved through an acquisition fall into the efficiency theory models.If synergy occurs, the value of the combined firm exceeds the sum of thevalue of the individual firms brought together by the mergers. This theorymakes the assumption that economies-of-scale do exist in the industry andthat prior to M&A, the firms operate at a level of activity that falls short ofachieving the potential for economies-of-scale.

The acquisition of Novelis was a landmark transaction for Hindalcoand Aditya Birla Group. It was in line with its long term strategies of expandingits global presence across its various businesses and was consistent with itsvision of taking India to the world. The combination of Hindalco and Novelisestablished a global integrated aluminium producer with low-cost aluminaand aluminium production facilities combined with high-end aluminium rolledproduct capabilities. The complementary expertise of both the companieswas expected to create and provide a strong platform for sustainable growthand ongoing success. There were significant geographical market and productsynergies. Novelis was the global leader in aluminum rolled products andaluminum can recycling, with a global market share of about 19 per cent.Hindalco had a 60 per cent share in the currently small but potentially high-growth Indian market for rolled products.

This acquisition gave Hindalco access, not only to higher-end productsbut also to superior technology. This was in line with Hindalco’s plans totriple aluminium output to 1.5 million metric tonne by 2012 to become one ofthe world’s five largest producers from the position of world’s 13th-largestaluminium maker till 2007. Novelis had a very strong technology forvalue added products and its latest technology ‘Novelis Fusion’ was aunique one. It would have taken a minimum 8-10 years for Hindalco to buildsimilar facilities, if Hindalco took organic growth route. Thus Novelisacquisition helped Hindalco gain quick access to new technologies withouthaving made the efforts towards time-consuming R&D. Hindalco expectedto quickly position itself to launch next-wave products and services.

Issue 2: Value Creation

Many believed the company was paying too high a price for a company thatincurred a loss of $170 million for the nine months ended 30 September2006. In its latest guidance, the Novelis management had indicated a loss of$240 million - $285 million for the whole of 2006. Even in 2005, when Novelis

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had made a $90-million net profit, its share prices never crossed $30. Novelis’svaluation became a matter of concern, as to why was Hindalco was paying$44.93 a share for a loss-making company.

In an analysis conducted by McKinsey & Company consultants(Copeland, Koller, and Murrin, 19941) of 116 acquisition programs undertakenbetween 1972 and 1983, 61 per cent were failures, 23 per cent weresuccesses and 16 per cent unknown. (An acquisition was deemed successfulif it earned its cost of equity capital or better on funds invested in theacquisition programme. In other words, income after taxes as a percentageof equity invested in the acquisition had to exceed the acquirer’s opportunitycost of equity.) If the successes and failures are probed further by lookingat the rates by type of acquisition, a company acquiring another company ina related business has a greater chance of success than one acquiring acompany in an unrelated business. With the statistics suggesting high failurerates of mergers and acquisitions, the question remains: why merge oracquire?

There are a number of reasons that have been cited for the failure ofacquisitions. Poor management and unfortunate circumstances (bad luck)are two such reasons. However, the most likely is that acquirers pay toomuch. Companies overpay for a variety of reasons. One reason is thatacquirers are overoptimistic in their assumptions. Assumptions, such as rapidgrowth continuing indefinitely, a market rebounding from a cyclical slump ora company “turning around,” can sometimes lead acquirers to overpay. Asecond possible reason is an over-estimation of the synergies that the mergedcompany will experience. One potential problem in merging firms with existingorganizations has been the question of how to combine and coordinate thegood parts of the organizations and eliminate what is not required. The thirdpossible reason for overpaying is simply that the acquiring company overbids.In the heat of the deal, the acquirer may find it all too easy to bid up theprice beyond the limits of reasonable valuations. The hubris hypothesis is anexplanation of why mergers may happen even if the current market valueof the target firm reflects its true economic value. Hubris or ego-drivendecision making is a factor contributing to the so-called “winner’s curse”.In an auction environment where there are many bidders, there is likely tobe a wide range of bids for a target company. The winning bid is oftensubstantially in excess of the expected value of the target company, given

1 “Valuation: Measuring and Managing the Value of Companies” by TomCopeland; Jack Murrin; Tim Koller; John Wiley & Sons Inc; 1994

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the difficulty all participants have in estimating the actual value of the targetcompany and the competitive nature of the process. The winner is cursed inthe sense that he ends up paying more than the company is worth. A fourthpossible reason is poor post-acquisition integration. Integration can be difficultand during this time, relationships with customers, employees, and supplierscan easily be disrupted during the process, and this disruption may causedamage to the value of the business.

Tax considerations are also involved in mergers. One example is wherea firm is sold with accumulated tax losses. In some instances, a firm withtax losses can shelter the positive earnings of another firm with which it isjoined. Consequently, the acquiring firm gains value for its shareholders byhaving to pay less taxes than it would have without the acquisition.

The acquisition exposed Hindalco to weaker balance sheet. Theacquisition while more than tripled Hindalco’s revenues, increased the debtand eroded its profitability. Some of the customers of Novelis were significantto the company’s revenues, and that could be adversely affected by changesin the business (The company’s ten largest customers accounted forapproximately 40 per cent of total net sales in 2005, with Rexam Plc and itsaffiliates representing approximately 12.5 per cent of company’s total netsales in that year). Novelis profitability was adversely affected by its inabilityto pass increasing metal price due to metal price ceilings in certain of thecompany’s sales contracts. Adverse changes in currency exchange ratescould negatively affect the financial results and the competitiveness ofcompany’s aluminium rolled products relative to other materials. TheCompany’s agreement not to compete with Alcan in certain end-use marketscould hinder Novelis ability to take advantage of new business opportunities.The end-use markets for certain of Novelis products were highly competitiveand customers are willing to accept substitutes for the company products.Though the Hindalco-Novelis acquisition had many synergies, there wereissues regarding valuation of the deal as Novelis was not a profit-makingcompany and had a debt of $ 2.4 billion. The acquisition deal was over-valued as the valuation was done on Novelis’ financials for the year 2005and not on the financials of 2006 in which the company had reported losses.So the acquisition could be financially challenging for Hindalco and couldtest its ability to manage this acquisition.

Issue 3: Post Acquisition Performance of Hindalco

Novelis, the US-subsidiary of Indian aluminium giant Hindalco, reported a

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net loss of $1.8 billion for the October-December 2008 quarter. This was onaccount of impairment losses which accounted for a major portion of thecompany’s losses. The assessment took into account the increased marketcost of capital, the market cost of debt (which was higher than the cost ofNovelis’ existing debt) and future cash flows discounted in current terms.The losses had been widening because of decline in volume sales and alsoin value terms, as metal prices fell. Globally aluminium prices had declinedby 14.02 per cent on the London Metal Exchange which resulted in lowerrealization for both Hindalco and Novelis. Europe and the US markets hadcontracted. Housing and automobile sectors had taken a hit. Although Noveliswas better cushioned than many other companies in the same industry as itsbeverage can business, which contributed about 50 per cent of its revenue,continued to do well. Hindalco was selling 30 billion cans of every 50 billioncans produced in the world in 2009. But its vulnerability to Aluminium cycleremained. In 2009 the global inventory of Aluminium was continuing to bevery high which was likely to keep the prices subdued for another two tothree years.

Hindalco had leveraged itself hugely which had a direct impact on itsprofitability. According to Centre for Monitoring Indian Economy (CMIE),Hindalco’s standalone net profit for 2008-09 was Rs 2,002.79 crore. Butwith Novelis and other subsidiaries’ numbers consolidated with it, net profitreduced to Rs. 46.74 Crore. Despite Hindalco’s attempt at becoming anintegrated aluminium player (from bauxite extraction to aluminiummanufacturing) and world’s largest downstream producer of Aluminiumproducts (retailing of aluminium products), the financial leverage andoutstanding derivative contracts were continuing to drag the bottom line.Capital expenditure for Greenfield projects was expected to further increasethe financial leverage. Hindalco’s Price to Earning ratio and the Return onCapital Employed too were faltering.

Vision

Man alone has the power to transform his thoughts into physical reality;man, alone, can dream and make his dream come true.

- Nepoleon Hill

13-Hindalco - Novelis Acquisition - Creating an Aluminium Global Giant -1

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