Profile
The biggest trait of the aluminium industry, being a commodity, is the cyclicality of the industry, wherein there are periodic ups and downs. That said, when compared with cement and steel, aluminium is a value-add commodity. It is a highly capital intensive sector (Rs 200 bn required for a 1 million tonne greenfield capacity expansion). Cost efficiency plays a critical role in the survival of a company in the sector for which, control over inputs (say raw material) is of utmost importance. Fortunately, the advantage of having the 5th largest bauxite reserves in the world coupled with cheap and abundant labour helps the Indian companies to retain the distinction of being the lowest cost producers in the world.

Globally, the industry is less fragmented when compared with steel and cement.

On basis of scale of operations and level of integration, aluminium producers can be categorized into the following two types:

1.      Integrated producers/Primary producers: Integrated producers have presence right from the mining of bauxite (raw material) to producing aluminium ingots (finished product). Some companies may even go a step further and have downstream manufacturing facilities such as manufacturing of semi-fabricated products (foils). Primary producers could either be a company that is just into mining of bauxite and alumina production or pure aluminium ingot manufacturing. For companies, which have restricted themselves from venturing into the downstream segment, the user industries are basically the secondary producers.

2.      Secondary producers: For this segment of producers, which are involved in the production of semi-fabricated products, the raw material is acquired from primary producers, which is in the form of aluminium ingots and billets. The user industries for this segment would be the packaging industry (foils), auto ancillary (wheels), to name a few.

Aluminium products can be classified under three categories. Rolled products find applications in automobiles, consumer durable, construction and engineering sectors. Extrusions include bars, pipes and tubes that find usage in the electrical and the transportation sectors. Finally, foils are used in the packaging sector, which are high-value products and have higher margins.

Now let us proceed with the various parameters indicated in the flowchart above:

Revenues

Revenues = Volumes * Realisations

Let’s look at the volumes side first.

Volumes
Growth prospects of the aluminium industry are a function of economic growth. In the Indian context , economic slowdown does influence the demand for aluminium, as its user industries like infrastructure, transportation, consumer durables and housing get affected. It must be noted that the consumption pattern of aluminium in India is tilted largely in favour of power and electricity (over 1/3rd of total consumption), as against the world consumption pattern, wherein transportation, especially airlines, have a major role to play. Whenever there is an economic slowdown, demand is affected in these sectors that in turn impact aluminium sales.

The key application of aluminium across sectors is in products like power transformers, railways, auto industry (components and body building), housing (furnishing), packaging (competition is from tin and plastic) and consumer durable sector (body parts). Investors could gauge potential for aluminium demand based on the aforesaid user industries.

Other user industries
The industry is also looking at increasing volume sales by presenting itself to the steel-user industries as a good substitute option on the basis of its qualities of strength and lesser weight. This could be a potential opportunity for aluminum, as user industries like auto, could switch to aluminium. Globally, this is a growing trend in the developed economies.

Competition
On the domestic front, protection from competition is in the form of tariffs, which makes the landed cost of aluminium into the country comparatively expensive vis-à-vis the domestic produce. Investors have to keep in mind that when customs duty falls, threat of imports increases unless domestic producers are competitive.

Realisations
Some factors, which determine the realisations for the company, are:

·         London Metal Exchange (LME): Unlike steel and cement, pricing for aluminium is determined at a global exchange called LME. This serves as a benchmark. Prices are determined depending upon the demand-supply mismatch, which in turn is dependent on the economic cycle . When aluminium prices start firming, in order to cash in on the rise in price, manufactures increase the capacity utilisation, which ultimately distorts the demand-supply picture and prices start to weaken. If demand fails to match production, the consequent rise in inventory impacts prices and vice-versa. Domestic prices closely track international price movements. However, the volatility on the domestic front is reduced to a certain extent owing to factors like import tariff protection and the absence of fragmentation in the domestic aluminium industry (Two players control 70% of the domestic market).

·         Player positioning : This factor plays a crucial role in determining the profitability of a company. Since a company can be largely present in the upstream segment or the downstream segment or be an integrated player, the cyclicality of the industry has a varying effect on the performance of the company. For example, a company, which is largely present in the upstream segment , will be prone to volatility. This is because raw material prices increase or decrease depending upon aluminium production. Whereas, a company, which has a significant presence in the downstream segment, margins will be squeezed in a cyclical upturn, as aluminium prices strengthen. The ability to pass on the rise in input costs is relatively less. However, an integrated player is best placed as he has the advantage of captive mining, which will protect its input costs, while its presence in the downstream segment will help it to keep a check on the realisation aspect.

·         Value added products: Realisations are also dependant to a large extent on the product profile of the company. Companies with a larger presence in value added segments (downstream segment) like extrusions, foils and aluminium wheels are able to realise higher value for their products, which assists margin improvement.

·         Competition: Competition is more global in nature for the sector, similar to other sectors. However, since Indian companies are among the lowest cost producers in the world, pressure of imports is negated to that extent. Indian companies are also protected in the domestic markets from international competition, owing to tariffs imposed on aluminium imports. However, with the government committed to bringing down the tariff levels, companies will have to improve cost efficiencies to protect margins.

Expenses
As pointed above, in the face of increasing competition, survival would depend on cost efficiency, more so given the commodity nature of the business. Some of the key expense heads pertain to raw material, power, employees and interest cost.

Since raw material and power constitute over 50% of the total operating expenses, companies with captive facilities have an added advantage. Employee expense is the next big contributor with a share of 12%-15% of the total operating expenses. If the company has presence in mining, employee requirements tend to be on the higher side. Freight is another important cost, which is dependent on the company’s proximity to the raw material source and also to customers. Finally, as aluminium companies are capital-intensive in nature and have significant exposure to debt, managing interest cost is of utmost importance.

Key parameters to be kept in mind while investing in an aluminium company:

·         Cyclicality of the sector: As mentioned above, the industry is cyclical in nature. Nevertheless, identifying the bottom of the cycle is not an easy task. Instead to trying to time the cycle, investors could take a view based on growth prospects of user industries mentioned in this article. Globally, the performance of the airline industry plays a vital role as well. While this is not true on all occasions, capacity expansion could also be a good indicator.

·         Integration advantage: Whether the company is integrated aluminium producer or not is a key factor for consideration. More so, as backward integration has various advantages such as control over mines (raw material) and also captive power facilities that help keep a check on cost efficiency of the company.

·         Operating performance: Margins tend to improve at a faster pace when cycle is on the path to recovery and vice versa. However, players with larger presence into contract sales and value added products are relatively insulated from the aluminium cycle. In this regard, operating profit margins (OPM) is one parameter to consider. OPM is also dependant on various internal parameters such as raw material consumption and power cost per unit and production per employee. All these information are available in the balance sheet for retail investors. However, it must be noted that in the case of production per employee, the numbers could be skewed to the extent of the companies’ presence into mining of raw materials.

·         Valuations: Two important ratios to look at before investing in an aluminium company could be the Price to Earnings (P/E) ratio and the Price to Book Value (P/BV). Since the industry’s performance is linked to economic growth, the P/E multiple of the stock should more or less hover around the country’s GDP growth. However, at the same time, companies with greater exposure to international markets (exports) and/or larger presence in the downstream segment could command a higher valuation. The P/BV ratio can also be used as a parameter for comparison.

To sum it up, large integrated companies with significant economies of scale and high cost efficiencies with presence in international markets and valued added products are the best positioned to capitalize on any increase in demand for the metal.

However, before we go into analyzing ratios, we take a look at the way a bank functions. The primary business of a bank is to accept deposits and give out loans. So in case of a bank, capital (read money) is a raw material as well as the final product . Bank accepts deposits and pays the depositor an interest on those deposits. The bank then uses these deposits to give out loans for which it charges interest from the borrower.

Of the cash reserve, a bank is mandated to maintain a certain percentage of deposits with the Reserve Bank of India (RBI) as CRR (cash reserve ratio) , on which it earns lower interest. Whenever there is a reduction in CRR announced in the monetary policy, the amount available with a bank, to advance as loans, increases. The second part of regulatory requirement is to invest in G-Secs that is a part of its statutory liquidity ratio (SLR). The bank’s revenues are basically derived from the interest it earns from the loans it gives out as well as from the fixed income investments it makes. If credit demand is lower, the bank increases the quantum of investments in G-Sec.

Apart from this, a bank also derives revenues in the form of fees that it charges for the various services it provides (like processing fees for loans and forex transations). In developed economies, banks derive nearly 50% of revenues from this stream. This stream of revenues contributes a relatively lower 15% in the Indian context.

Having looked at the profile of the sector in brief, let us consider some key factors that influence a bank’s operations. One of the key parameters used to analyse a bank is the Net Interest Income (NII). NII is essentially the difference between the bank’s interest revenues and its interest expenses . This parameter indicates how effectively the bank conducts its lending and borrowing operations (in short, how to generate more from advances and spend less on deposits).

Interest revenues:

Interest revenues = Interest earned on loans + Interest earned on investments + Interest on deposits with RBI.

Interest on loans:
Since banking operations basically deal with ‘interest’, interest rates (read bank rate) prevailing in the economy have a big role to play. So, in a high interest rate scenario , while banks earn more on loans, it must be noted that it has to pay higher on deposits also. But if interest rates are high, both corporates and retail classes will hesitate to borrow. But when interest rates are low, banks find it difficult to generate revenues from advances. While deposit rates also fall, it has been observed that there is a squeeze on a bank when bank rate is soft. A bank cannot reduce interest rates on deposits significantly, so as to maintain its customer base, because there are other avenues of investments available to them (like mutual funds, equities, public savings scheme).

Since a bank lends to both retail as well as corporate clients, interest revenues on advances also depend upon factors that influence demand for money. Firstly, the business is heavily dependent on the economy. Obviously, government policies (say reforms) cannot be ignored when it comes to economic growth. In times of economic slowdown, corporates tighten their purse strings and curtail spending (especially for new capacities). This means that they will borrow lesser. Companies also become more efficient and so they tend to borrow lesser even for their day-to-day operations (working capital needs). In periods of good economic growth, credit offtake picks up as corporates invest in anticipation of higher demand going forward.

Similarly, growth drivers for the retail segment are more or less similar to the corporate borrowers. However, the elasticity to a fall in interest rate is higher in the retail market as compared to corporates. Income levels and cost of financing also play a vital role. Availability of credit and increased awareness are other key growth stimulants, as demand will not be met if the distribution channel is inadequate.

Interest on Investments and deposits with the RBI

The bank’s interest income from investments depends upon some key factors like government policies (CRR and SLR limits) and credit demand. If a bank had invested in G-Secs in a high interest rate scenario, the book value of the investment would have appreciated significantly when interest rates fall from those high levels or vice versa.

Interest expenses
A bank’s main expense is in the form of interest outgo on deposits and borrowings. This in turn is dependent on the factors that drive cost of deposits. If a bank has high savings and current deposits, cost of deposits will be lower. The propensity of the public to save also plays a crucial role in this process. If the spending power for the populace increases, the need to save reduces and this in turn reduces the quantum of savings.

Key parameters to keep in mind while analysing a banking stock:

However, we would like to touch upon one key aspect. Why price to book value is important while analysing a banking stock rather than P/E? As we had mentioned earlier, cash is the raw material for a bank. The ability to grow in the long-term therefore, depends upon the capital with a bank (i.e. capital adequacy ratio). Capital comes primarily from net worth. This is the reason why price to book value is important. But deduct the net non-performing asset from net worth to get a true feel of the available capital for growth.

The banking sector plays a very vital role in the working of the economy and it is very important that banks fulfill their roles with utmost integrity. Since banks deal with cash, there have been cases of mismanagement and greed in the global markets. And hence, in the final analysis, investors need to check up on the quality of management. This is the last factor but not the least to be brushed aside.

Let’s have a look at the demand drivers for this sector

Order Book

An engineering company can derive revenues from domestic as well as global markets. Usually, there is something-called order book that is declared by most of the companies in its annual report. This is nothing but the quantum of projects that have been won, but are still to be executed. Therefore, order book position indicates the future growth prospects.

Domestic market
The power sector accounts for approximately 60% of total revenues for this sector. Therefore, growth in power capacities is very important for engineering companies. So let’s have a brief look at key fundamental factors that influences power sector performance.

Historically, politics have played a vital role in shaping the power sector as opposed to economics (profitability in easy terms). What a retail investor has to keep in mind is that power capacities will only increase when there is a political will to charge consumers for what they consume. Industrial sector pays higher tariffs while agricultural sector derives power free of cost. This is the root cause for the poor financial health of the SEBs (state electricity boards).

SEBs are financially weak and private sector have been reluctant to invest, as they are apprehensive of receiving money for the quantity of power supplied to the SEBs. Retail investors have to keep in mind that India is power deficient (demand is more than supply). The simple way to gauge growth of a engineering company that is targeting the power sector is to understand what kind of capacity SEBs and private sector players are planning.

It costs Rs 30-35 m to set up one MW of power capacity . If a player is planning to set up a 1,000 MW plant, then the project size could be around Rs 30 bn to Rs 35 bn. This could be assumed roughly as the potential addition to the order book. If public sector power majors are expanding capacity, then it has to be borne in mind that public sector engineering companies benefit the most (as a matter of preference).

Industrial and Infrastructure spending

The industrial sector contributes around 30% of the total revenues of engineering sector. The demand from this segment largely depends on GDP growth, which in turn is a function of the quantum of infrastructure spending and capacity expansion plans of corporate India.

A lot depends on government policies . Formulation of policies favorable to industrial sector can boost the investments and expansion plans for both private and public sector companies. Talking of policies, when government increases participation of foreign companies in infrastructure development, the sector gets a fillip. Demand growth in this sector is fuelled by expenditure in core sectors such as power, railways, infrastructure development, and private sector investments and the speed at which the projects are implemented.

The topline trends of major engineering companies since last five years have shown a high degree of correlation with the IIP (Index of Industrial Production) growth. Thus a fair idea can be taken about the sector looking at the IIP growth. Lets look at the correlation in the graph below.

Exports
While an engineering company from India could tap global markets for contracts, there is a vast difference when it comes to competitors. Players like Bechtel and GE have muscle power and have executed projects on a global scale. This is one of the reasons increasing contribution from international markets is not easy for any company. Retail investors have to tread with caution on this front. Due to intense competition in the international arena, suppliers do not enjoy much bargaining power.

Moreover, in order to win big contracts you need to have big balance sheet size , because only some part of entire contract money is paid up front and rest comes after installation of project. Moreover, in some cases, the engineering company buys stake in the projects during the financial closure.

Key points to be kept in mind before investing…

·         Order book and operating margins:  Order book, as we had said earlier, indicates a company’s standing in a year in terms of future growth in revenues. A consistent rise in order book on a year on year basis (and not quarter on quarter) is also vital. Though order book may be huge for a company, it has to be remembered that operating margins are low in projects. In a downturn, operating margins of an engineering company comes under pressure. If a company acts as an engineering agency (i.e. buys and installs equipment), margins tend to be on the higher side.

·         Balance sheet size:  One should look at the balance sheet size of the company. It will tell you whether company is capable of bagging and executing big contracts. In order to win big contracts and execute them, company needs huge working capital. In this case, past track record of projects executed could be useful (available in the balance sheet).

·         Revenue growth:  Usually, an engineering company derives a large share of revenues in the third and fourth quarter. So, quarter on quarter comparisons is meaningless in this sense.

·         Valuation ratios:  One of the key factors used when it comes to putting a value for an engineering company is market capitalisation to sales. Why the emphasis of assigning a value to revenues and not to earnings? The ability to grow for any engineering company is dependent on the kind of order book, which then translates into revenues. Internationally, the average of 0.4 times to 0.5 times is a benchmark. If price to earnings is used, it has to be remembered that the sector is highly dependent on the economy. So, a P/E in line with the long-term economic growth could be useful.

Apart from what all has been said above, investor needs to look at the past record of the management, its vision and its focus on business. After all it’s the management of the company who is the final decision-maker and the future of the company solely depends on the decisions taken by it.

Logistic strength
While the purchasing ability is a function of economic growth, awareness is a function of the product reach and its usability. It is in this context, that a company’s logistics strength gains importance. But logistics does not only mean a company’s reach in terms of retail outlets, it also means the level of sophistication of this distribution reach. How intelligent is this supply chain, how well geared for the company’s future growth?

For example, Company A products reach 1 m retail outlets, but the reach is largely people intensive using the traditional dealer stockist method. Also, the retail outlets are largely small provision and shop owners. On the other hand, Company B has a retail reach of only 0.5 m retail outlets, but almost 70% of its stockists are electronically networked.

In the above case, even though Company B reaches out only to half the number of retail outlets as compared to A, it is likely to be more efficient and profitable for the company’s growth going forward. For an FMCG company, once a distribution chain is set up, it is the quality of that set up that gives it an edge. Using the same chain, an FMCG company can introduce more products and brands at a faster pace and at a lesser cost, and optimize the channel benefits. In the long run, such a distribution network will be more profitable as it helps the company to keep adding to its product folio at more or less the same fixed cost.

Product folio
MNC companies form almost half of the branded FMCG industry in India. In case of MNC companies, therefore, it is relevant to look at the parent support and commitment to its subsidiary before taking an investment decision. Again, support and commitment alone is not enough. Have a look at the parent’s product profile and what are its plans for its subsidiary in India. If the parent itself is present only in a few categories globally, all its support is of little help owing to the product hindrance.

For all companies, be it domestic or otherwise, a look at the company’s product introduction track record is an eye-opener. How many products has the company introduced in its years of existence, how relevant are they to India’s consumer habits. What are the future plans of the company?

Competitive strengths
FMCG companies’ success is often attributed to their marketing and branding skills. Ability to continuously create successful brands and advertising which gets the message across often spells success for a company. Once a brand is successful, it easier for a company to piggyback on its initial success introduce more products and associate them with the known brand. As they say, ‘nothing succeeds like success’.

As said earlier, the more the number of product offerings, the more each resource is utilised, be it the distribution channel, the marketing or branding strengths. It is in this context, that single or a few product companies are risky. Number one, they have to continuously be wary of competitors coming in and weaning away market share. Therefore, they have to continuously spend higher on advertising and marketing. This is a double whammy for a company under pressure. On one hand, revenues are under pressure and on the other, costs go up and margins are squeezed. Also, due to this, the company is often shy of investing in new products and expanding its distribution network. Bottomline, future growth prospects get stunted.

We talked of MNC companies earlier. One very important thing that an investor should look at is the number of subsidiaries the parent has in the same country. For example, P&G and Glaxo SmithKline, both have a few other subsidiaries, beside the listed entities. If the parent has another subsidiary, especially if it is unlisted, then it is likely that the foreign parent would be inclined to introduce new brands and products through the 100% subsidiary. As such, shareholders of the listed subsidiary will not be able to reap the rewards of the product portfolio expansion.

Investors should be wary of investing in such companies where parent focus and plans are under a cloud.

Key financials and valuation ratios to look at

·         Last 5 years revenue growth (CAGR) and what is the reason for the said growth. If encouraging growth has come about due to continuous new product introductions and growth in market share, it is an encouraging sign.

·         Operating margin trend What sort of margins is the company earning, vis-à-vis its peers. Whether the trend is improving or is there a continuous decline. Find out reasons for both. If it is improving due to efficiencies in supply chain and product focus, it is encouraging. If it is declining continuously due to hike in advertising spends etc., it is a sign of the company facing intense competition. However, if the margin decline is a blip and has come as a result of a new product introduction, it is a good long-term sign.

·         Look at the company’s cash flows and the working capital efficiencies. It will give you an idea of the company’s bargaining power as well as its ability to utilize its resources and supply chain.

·         Look at the return ratios , especially ROCE (return on capital employed) trend. It will give you an idea how effective the company is in optimising its resource strengths. Also, look at the dividend paying track record. A healthy dividend payout, i.e., the ratio of dividends to earnings, is also a good indicator of the company’s willingness to share wealth with small shareholders.

·         It is also important to look at the P/E (price to earnings multiple) and market capitalisation to sales , which the company is trading at vis-à-vis its peers. Growth oriented companies’ will most likely be trading at a premium to peers based on these parameters. If so, then one has to gauge whether that premium is justified. If the premium is unrealistically high then it may not be a good idea to invest at that juncture. After all, valuations have to justify the company’s prospects.

Above all this, look at the past record of the management , its vision and its integrity. For it is the management finally, which is decision maker and therefore the guardian of your interests in the company. So if the management has a track record of being on the sly or slow to react to market conditions, then the biggest distribution channel and the most diversified product folio may not give you your rightful share of the company’s growth and profits.