Case Diagnoses

HINDALCO - NOVELIS ACQUISITION:

CREATING AN ALUMINIUM GLOBAL GIANT

CASE ANALYSIS I

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Dr. V.J. Sebastian,

Associate Professor,
IMT Ghaziabad, Raj Nagar, 201001.
E-mail: svj401@yahoo.com
The topic of this case is an interesting example for the apparently insatiable
hunger of Indian companies for becoming global giants. This case
demonstrates how desperate the Indian companies are for acquisition of
global players which are sometimes even bigger than their own size. It talks
about the pros and cons of an acquisition, where management is paying not
only for the value of company but also for a dream, which seems to be very
expensive. Although there are many dimensions to the issue at hand, this
analysis emphasizes more on the future challenges and risk factors associated
with the acquisition.
Issue 1: Risk Associated With Hindalco Novelis Acquisition
Although Birlas are very optimistic about this acquisition, there is a serious
risk with this acquisition. Birlas have paid a very high price to acquire a loss
making company. When asked whether Hindalco is paying a higher price,
Birla said, When you are acquiring a world leader you will have to pay a
premium, which is something irrational and not reasonable. Novelis reported
a 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 company
reported net sales of $8.4 billion. If things doesnt work out in Birlas way
than Novelis can create a serious threat for Hindalcos balance sheet and in
the future the losses of Novelis can even eat Hindalcos net worth. It seems
that due to over optimism, the Birlas have overestimated the synergy valuation
and 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 lowManagement & Change, Volume 13, Number 1 (2009)
Management
Change,
Volume 13, Number 2 (2009)
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24 Hindalco-Novelis Acquisition: Creating An.............

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margin downstream products business. The case has shown that while the
acquisition will more than triple Hindalcos revenues, it will also increase
the debt and erode its profitability. The deal will create value only after the
completion of Hindalcos expansion plans, and due to its highly leveraged
position, expansion plans may get affected. Some of the customers of Novelis
are significant to the companys revenues, and that could be adversely affected
by changes in the business or financial condition of these significant
customers or by the loss of their business. (The companys ten largest
customers accounted for approximately 40 per cent of total net sales in
2005, with Rexam Plc and its affiliates representing approximately 12.5 per
cent of companys total net sales in that year). Novelis profitability could be
adversely affected by the inability to pass through metal price increases
due to metal price ceilings in certain of the companys sales contracts.
Adverse changes in currency exchange rates could negatively affect
the financial results and the competitiveness of companys aluminium rolled
products relative to other materials. The Companys agreement not to
compete with Alcan in certain end-use markets may hinder Novelis ability
to take advantage of new business opportunities. The end-use markets for
certain of Novelis products are highly competitive and customers are willing
to accept substitutes for the company products. Though the Hindalco-Novelis
acquisition had many synergies, some analysts raised the issue of valuation
of the deal as Novelis was not a profit-making company and had a debt of
US $ 2.4 billion. They have opined that the acquisition deal was over-valued
as the valuation was done on Novelis financials for the year 2005 and not
on 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 as
international markets prompted aluminium companies to undertake huge
expansion plans. Huge quantity of aluminium will come into the market in
the coming years. All the three major companies Nalco, Hindalco and
Vedanta Group have drawn up plans to increase capacities. As given in the
case, at the end of January 2007, investment in hand in the alumina and
aluminium products sector amounted to Rs.59,81800 million and are spread
across 35 projects. Most of the major projects, amounting to over 60 per
cent of the aggregate investment in value terms, are under implementation.
If all the projects are successfully implemented, aluminium smelting capacity
will increase from 11.8 lakh tonnes to 18 lakh tonnes. Of this, about five
lakh tonnes each will come on stream in 2009 and 2010. Hindalco has
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Rakesh Gupta & Aman Srivastava 25

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undertaken aggressive plans to increase its capacities through capacity

expansion as well as by setting up greenfield plants. It increased its capacity
at Hirakud plant by 35,000 tonnes to one lakh tonne. When Hindalco
completes all its project, smelting capacity will increase by about 10 lakh
tonnes. Along with smelting capacities, the companies are expanding alumina
capacities and setting up captive power plants. Domestic alumina capacity
is set to increase by 9.5 million tonnes when all the outstanding projects are
completed. Large alumina capacities will not only feed captive aluminium
smelters, but also leave surplus alumina to be exported to lucrative markets
like China.
Given the above scenario, the profitability of Hindalco is likely to be
under cloud for some time to come and the company could suffer a fate not
different from Tata Motors/Tata Steel post their costly acquisition of foreign
companies, undertaken at the peak of the economic boom. Of course Hindalco
could hope for better luck with sign of economic recovery in the offing.
CASE ANALYSIS II
Dr. Sonu Goyal
Professor
Business Strategy and Entrepreneurship
International Management Institute
B-10, Qutab Institutional Area
New Delhi 110016
E-mail: sonugoyal@imi.edu
The case, Hindalco - Novelis Acquisition: Creating An Aluminium Global
Giant discusses at length the $6 billion worth acquisition of Canadas Novelis
by the Aditya Birla Group owned Hindalco Industries in the year 2007. The
case closely examines the issues that emerge in an acquisition move and
highlights the strategic rationale for such acquisitions. It also discusses the
financial implications for the acquiring company.
Mergers and acquisitions (M&A) have long played an important role in
the inorganic growth of firms. Acquisition means that company X buys
company Y and thereby acquires control over it. When one company takes
over another and clearly establishes itself as the new owner by absorbing
its operations, the purchase is called an acquisition. There are normally
several determinants which influence firms choice to go in for an acquisition.
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26 Hindalco-Novelis Acquisition: Creating An.............

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Issue 1: Strategic Rationale for the Acquisition

An acquisition may pave the way for the acquiring company to gain more
market share, create a more efficient operation out of the combined
companies by closing high-cost plants and eliminating surplus capacity
industry wide. Quite a number of acquisitions are undertaken with the
objective of transforming two or more otherwise high-cost companies into
one lean competitor with average or below-average costs. Acquisition may
also be intended to expand a companys geographic coverage. Industries
which exist in a fragmented state, with local companies dominating local
markets and no company having a significantly visible regional or global
presence tend to undergo consolidation by way of series of acquisitions
undertaken by the regional players over a period of time. Firms thus tend to
undertake acquisition to extend their business into new product categories
or international markets thus widening their geographic reach and broadening
the number of product categories in which they compete. Efficiency theories
view 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 above
and was considered a good strategic move by Hindalco. It allowed the
company to establish it self as an integrated producer with low-cost alumina
and aluminium facilities combined with high-end rolling capabilities and a
global footprint. Hindalco could ship primary aluminium from India to all its
overseas Novelis facilities for making value-added products. Hindalcos
rationale for the acquisition was to increase scale of operation, enter into
high end downstream market and enhance global presence. Aluminium was
considered the metal for the future because of its versatility, strength, low
weight and corrosion resistance characteristic. Novelis was already the
global leader (in terms of volume) in rolled products with annual production
capacity of 2.8 million tonnes and a market share of 19 per cent. It had
presence in 11 countries and provided sheets and foils to automotive and
transportation, beverage and food packaging, construction and industrial,
and printing markets. Acquiring Novelis also provided Hindalco ready access
to its existing customers such as General Motors Corp. and Coca-Cola Co.
Hindalcos acquisition of Novelis was thus strongly driven by its desire
to increase firms market share and thereby market power. Hindalcos
position as one of the lowest cost producers of primary aluminium in the
world could now be leveraged to become a globally strong player. The
Novelis acquisition gave Hindalco immediate scale and a global footprint.
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In a horizontal merger, acquiring a competitor, provides immediate access

to greater share of the market. Potential economies-of-scale or synergies
that are achieved through an acquisition fall into the efficiency theory models.
If synergy occurs, the value of the combined firm exceeds the sum of the
value of the individual firms brought together by the mergers. This theory
makes the assumption that economies-of-scale do exist in the industry and
that prior to M&A, the firms operate at a level of activity that falls short of
achieving the potential for economies-of-scale.
The acquisition of Novelis was a landmark transaction for Hindalco
and Aditya Birla Group. It was in line with its long term strategies of expanding
its global presence across its various businesses and was consistent with its
vision of taking India to the world. The combination of Hindalco and Novelis
established a global integrated aluminium producer with low-cost alumina
and aluminium production facilities combined with high-end aluminium rolled
product capabilities. The complementary expertise of both the companies
was expected to create and provide a strong platform for sustainable growth
and ongoing success. There were significant geographical market and product
synergies. Novelis was the global leader in aluminum rolled products and
aluminum 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 highgrowth Indian market for rolled products.
This acquisition gave Hindalco access, not only to higher-end products
but also to superior technology. This was in line with Hindalcos plans to
triple aluminium output to 1.5 million metric tonne by 2012 to become one of
the worlds five largest producers from the position of worlds 13th-largest
aluminium maker till 2007. Novelis had a very strong technology for
value added products and its latest technology Novelis Fusion was a
unique one. It would have taken a minimum 8-10 years for Hindalco to build
similar facilities, if Hindalco took organic growth route. Thus Novelis
acquisition helped Hindalco gain quick access to new technologies without
having made the efforts towards time-consuming R&D. Hindalco expected
to 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 that
incurred a loss of $170 million for the nine months ended 30 September
2006. 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. Noveliss
valuation 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 undertaken
between 1972 and 1983, 61 per cent were failures, 23 per cent were
successes and 16 per cent unknown. (An acquisition was deemed successful
if it earned its cost of equity capital or better on funds invested in the
acquisition programme. In other words, income after taxes as a percentage
of equity invested in the acquisition had to exceed the acquirers opportunity
cost of equity.) If the successes and failures are probed further by looking
at the rates by type of acquisition, a company acquiring another company in
a related business has a greater chance of success than one acquiring a
company in an unrelated business. With the statistics suggesting high failure
rates of mergers and acquisitions, the question remains: why merge or
acquire?
There are a number of reasons that have been cited for the failure of
acquisitions. Poor management and unfortunate circumstances (bad luck)
are two such reasons. However, the most likely is that acquirers pay too
much. Companies overpay for a variety of reasons. One reason is that
acquirers are overoptimistic in their assumptions. Assumptions, such as rapid
growth continuing indefinitely, a market rebounding from a cyclical slump or
a company turning around, can sometimes lead acquirers to overpay. A
second possible reason is an over-estimation of the synergies that the merged
company will experience. One potential problem in merging firms with existing
organizations has been the question of how to combine and coordinate the
good parts of the organizations and eliminate what is not required. The third
possible 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 the
price beyond the limits of reasonable valuations. The hubris hypothesis is an
explanation of why mergers may happen even if the current market value
of the target firm reflects its true economic value. Hubris or ego-driven
decision making is a factor contributing to the so-called winners curse.
In an auction environment where there are many bidders, there is likely to
be a wide range of bids for a target company. The winning bid is often
substantially in excess of the expected value of the target company, given
1

Valuation: Measuring and Managing the Value of Companies by Tom

Copeland; Jack Murrin; Tim Koller; John Wiley & Sons Inc; 1994
Management & Change, Volume 13, Number 2 (2009)

Rakesh Gupta & Aman Srivastava 29

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

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Tax considerations are also involved in mergers. One example is where

a firm is sold with accumulated tax losses. In some instances, a firm with
tax losses can shelter the positive earnings of another firm with which it is
joined. Consequently, the acquiring firm gains value for its shareholders by
having to pay less taxes than it would have without the acquisition.
The acquisition exposed Hindalco to weaker balance sheet. The
acquisition while more than tripled Hindalcos revenues, increased the debt
and eroded its profitability. Some of the customers of Novelis were significant
to the companys revenues, and that could be adversely affected by changes
in the business (The companys ten largest customers accounted for
approximately 40 per cent of total net sales in 2005, with Rexam Plc and its
affiliates representing approximately 12.5 per cent of companys total net
sales in that year). Novelis profitability was adversely affected by its inability
to pass increasing metal price due to metal price ceilings in certain of the
companys sales contracts. Adverse changes in currency exchange rates
could negatively affect the financial results and the competitiveness of
companys aluminium rolled products relative to other materials. The
Companys agreement not to compete with Alcan in certain end-use markets
could hinder Novelis ability to take advantage of new business opportunities.
The end-use markets for certain of Novelis products were highly competitive
and customers are willing to accept substitutes for the company products.
Though the Hindalco-Novelis acquisition had many synergies, there were
issues regarding valuation of the deal as Novelis was not a profit-making
company and had a debt of $ 2.4 billion. The acquisition deal was overvalued as the valuation was done on Novelis financials for the year 2005
and not on the financials of 2006 in which the company had reported losses.
So the acquisition could be financially challenging for Hindalco and could
test 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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30 Hindalco-Novelis Acquisition: Creating An.............

net loss of $1.8 billion for the October-December 2008 quarter. This was on
account of impairment losses which accounted for a major portion of the
companys losses. The assessment took into account the increased market
cost of capital, the market cost of debt (which was higher than the cost of
Novelis existing debt) and future cash flows discounted in current terms.
The losses had been widening because of decline in volume sales and also
in value terms, as metal prices fell. Globally aluminium prices had declined
by 14.02 per cent on the London Metal Exchange which resulted in lower
realization for both Hindalco and Novelis. Europe and the US markets had
contracted. Housing and automobile sectors had taken a hit. Although Novelis
was better cushioned than many other companies in the same industry as its
beverage can business, which contributed about 50 per cent of its revenue,
continued to do well. Hindalco was selling 30 billion cans of every 50 billion
cans produced in the world in 2009. But its vulnerability to Aluminium cycle
remained. In 2009 the global inventory of Aluminium was continuing to be
very high which was likely to keep the prices subdued for another two to
three years.
Hindalco had leveraged itself hugely which had a direct impact on its
profitability. According to Centre for Monitoring Indian Economy (CMIE),
Hindalcos standalone net profit for 2008-09 was Rs 2,002.79 crore. But
with Novelis and other subsidiaries numbers consolidated with it, net profit
reduced to Rs. 46.74 Crore. Despite Hindalcos attempt at becoming an
integrated aluminium player (from bauxite extraction to aluminium
manufacturing) and worlds largest downstream producer of Aluminium
products (retailing of aluminium products), the financial leverage and
outstanding derivative contracts were continuing to drag the bottom line.
Capital expenditure for Greenfield projects was expected to further increase
the financial leverage. Hindalcos Price to Earning ratio and the Return on
Capital 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

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