Did you know that the stock price of Hindalco, the aluminium major from the Aditya Birla stable, is up 47% in the last one month? For a company of the size, scale and complexity of Hindalco, such a rapid price appreciation in one month is not only infrequent but also indicative of some big structural changes happening in the company.
Data Source: NSE
Of course, intuitively all metal companies have been doing extremely well. This includes companies in the steel, aluminium, copper and even zinc space. There are three triggers. Firstly, the demand from China has been reviving rapidly and is likely to hold global demand in the next on year. Secondly, even the most conservative projections are pegging India’s GDP recovery in FY22 at 12-14%. That means a lot of aluminium demand is likely to be coming by. Lastly, the combination of growth and demand has kept LME prices of aluminium robust. While all these were factors in the performance of Hindalco, there is a more company specific factor in the form of a brand-new capital allocation framework that Hindalco has adopted. Let us look at this unique framework in greater detail.
What do we understand by capital allocation framework?
What do we really understand by capital allocation framework? Globally, most of the large Fortune 500 companies have been following this capital allocation framework for a fairly long time. When does this framework become actually relevant? When a company starts generating more cash flow than it requires in the normal course of business, it creates a problem of plenty. Now problems of plenty may look like a good problem to have but actually they are not. That is because, unless the company comes up with a solid and fool-proof plan to productively use this cash, its valuations could be in trouble.
Remember what the legendary Warren Buffet said about capital allocation frameworks, “They help to generate long-term value because shareholders and institutional investors now have a clarity on how the cash will be utilized in order to enhance shareholder value”. Just to cite an example, in a capital allocation framework, the company clearly lays out how much of its excess cash flows will be allocated to capital outlays, how much to debt reduction, how much to shareholder rewards and how much to treasury operations.
Hindalco needs a capital allocation framework and here is how it looks
Hindalco proposes to generate $1.2 billion of cashflows each year over the next five years resulting in total cash flow generation of $6 billion in aggregate, after normal working capital and maintenance capex requirements. The question is how does it deploy this cash? The challenge is how much to deploy for growth capex, how much for debt reduction and how much to give back to shareholders as dividends or as buyback of shares.
We will come back to the actual graphic representation of the capital allocation framework later to summarize our understanding. Out of the $6 billion (Rs.37,000 crore) cash flow surplus that Hindalco will generate in the next 5 years, half of that or nearly Rs.18,500 crore will be reserved for capital spending to spur growth. Then there is debt reduction. Nearly Rs.11,000 crore or 30% will be reserved for debt reduction.
This will result in Hindalco’s debt pile of $11.14 billion reducing to $9.43 billion by Jun-21. In short, the debt reduction is going to be front-ended. That would reduce net debt/EBITDA ratio from 3.8X to 2.6X. Why are capital expenditure allocation and debt reduction allocation so important? Clearly, that is how companies create long term value for shareholders. You never create value by paying out dividends because that is just a depletion of investor wealth.
The reason this framework is important is that the shareholders now have a degree of clarity that going ahead the company will focus more on value creation through investing in the core businesses and by debt reduction. As the image below shows, distribution of surplus to shareholders is much less important.
Chart Source: Hindalco Investor Presentation
That is why the capital allocation framework generates value as it gives a clear time table and pathway as to how the billions generated by Hindalco including Novelis will be productively utilized by the company.
Finally, does the capital allocation framework really add value. There is not much of data in the Indian context, but in the US, it has been observed that companies with a clear-cut capital allocation policy have tended to outperform other companies by a margin. That is, perhaps, a good starting point.