Hindalco opts for capital allocation framework to build value

The Dec-20 quarterly results have been favourable for the Hindalco. In addition, global demand for aluminium and copper as well as LME prices have been factors, but there is more to it.

February 26, 2021 10:20 IST | India Infoline News Service
In the recent past, Hindalco stock saw a sharp rise in price. If you just look at the stock price movement over the last one month, Hindalco is up 52%. That is not something that you normally get to see in a stock of the size and international reach of Hindalco. 

Data Source: NSE

The Dec-20 quarterly results have been favourable for the Hindalco. In addition, global demand for aluminium and copper as well as LME prices have been factors, but there is more to it. A lot of this price appreciation in the recent past is to do with the capital allocation framework laid out by Hindalco. What exactly is that and how does it matter.

Understanding capital allocation framework

Globally, the concept of capital allocation framework is quite common among large companies. When a company acquires and generates more cash flow than it requires in the normal course of business, it creates a problem of plenty. The question is how to deploy these excess cash flows in such a way as to enhance shareholder value. It may look like a good problem to have but, as many large companies have realized, it is not.

The legendary Warren Buffett captured the gist of capital allocation framework best, “Capital allocation decisions are critical in generating long-term value. This is especially true for higher quality companies that generate substantial excess capital. This excess capital is the extra cash flows that the core business generates above and beyond its organic growth needs. The effectiveness of how this excess capital, or free cash flow, is deployed can have a significant impact on long-term value creation of the enterprise”.

Why Capital allocation framework at Hindalco

To understand the need for capital allocation framework, let us first look at some of the key financials for Hindalco. Over the next five years, Hindalco expects to generate $1.2 billion of cashflows annually or $6 billion in total, after normal working capital and maintenance capex requirements. Allocation towards growth capex is estimated at $2.5-$3.0 billion over next five years, so the company still has nearly $3.0-3.5 billion of excess cash available. The question is how does it deploy this cash?

One important way to utilize cash flows is to repay debt. As of Dec-20, Hindalco had $11.14 billion of debt, which it proposes to reduce to $9.43 billion by Jun-21. That would effectively reduce the net debt/EBITDA ratio from 3.8X to 2.6X, making its solvency position a lot more comfortable. The eventual target is to touch net debt/EBITDA ratio of 2.5x over the next two years. However, the need of the hour is to put all these ideas into a solid framework and also include shareholder distribution into that. Here is how.

Hindalco’s all-new capital allocation framework for next 5 years

Details of Cash Flows Capital Allocation Framework
Cash flow generation over next 5 years after Working Capital plus Maintenance CAPEX $6.00 billion
Growth Capex over Next Five years $3.00 billion
Net Cash flows Available $3.00 billion
Allocation to Debt Reduction $1.80 billion
Allocation to Shareholder Returns $720 million
Allocation to Treasury $480 million
Data Source: Company Presentations

The capital allocation framework will be valid for next 5 years so there is clarity about the trajectory of how cash flows will be utilized in future. For example, out of the total net cash flow generation of $6 billion, nearly half will go towards capital expenditure. This is normally positive for stock valuations. Secondly, the company pledged to allocate 30% of the cash flow generated towards debt repayment. The graphic below captures how this will impact the net debt / EBITDA ratio.

Chart Source: Hindalco Investor Presentation
The total debt reduction by Hindalco by Jun-21 will be to the tune of $2.9 billion, which will include $2.6 billion debt reduction of Novelis and $0.3 billion Hindalco India. Even shareholders know what they can approximately expect as distribution, either in the form of dividends or buybacks.

Does capital allocation framework really add value?

In the Indian context, there is not much of evidence available on capital allocation frameworks as it is a new concept. However, one can look at the US example. Kevin Fogarty of Du Pont Capital has explained the impact of capital allocation framework with reference to TJX Corporation, a leading globally spread-out retailer in the US. According to Fogarty, the capital allocation framework resulted in the following for TJX Corporation.
  • 6% improvement in 10-year CAGR in revenues
  • 13.4% improvement in 10-year CAGR in EBIT
  • 16.8% improvement in 10-year CAGR in EPS

The net impact of the capital allocation framework was that the EPS grew 27% faster than the EBIT and the EPS grew 60% faster than revenues. Of course, one can argue that this may not be empirically tested in the Indian context. But, if Hindalco can even reap part of the benefits of its proposed 5-year capital allocation framework, which TJX managed, it could be a major value trigger for shareholders.

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