How to play India’s growing demand for aluminium

With an expanding power sector and government spending on infrastructure, India's demand for aluminium is likely to soar. Here, we tip one cheap way to profit.

Cost is everything when it comes to commodities, and India's aluminium producers are among the most competitive in the world. Hindalco Industries (Luxembourg: HINDG) is one of the largest and best-known companies in the sector, with a 2011 turnover of around US$15bn.

It's the largest copper and second-largest aluminium producer in India, with market shares of 51% and 33% respectively. On the aluminium side, it does everything from bauxite mining, to smelting to recycling. Meanwhile, its copper smelter is the world's largest custom smelter at a single location.

The company joined the global topfive aluminium producers in 2007, after buying Novelis Inc a can recycler and aluminium roller - for $6bn. The deal made Hindalco the largest aluminium rolling company in the world. But Novelis acted as a drag on the company until 2009. The debt taken on to fund the deal was one reason, but more importantly, earnings at the unit were depressed by a contractual ceiling on can prices, and exposure to developed markets.

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However, with the expiry of these ceiling contracts in 2009 and cost restructuring, Novelis has emerged as a successful acquisition, with profitability improving. So while sales volumes for Novelis are still below 2008 levels, adjusted EBITDAnearly doubled in 2011.

The future of India's aluminium industry

India has the fifth-largest reserves of bauxite (the raw material from which aluminium is produced) in the world, with deposits of three billion tonnes. Indian aluminium producers are also among the lowest cost in the world, due to their ownership of power plants, the cheap labour force, and their proximity to raw material supplies. Yet India's share of world aluminium capacity is only about 3%.

Meanwhile, consumption of aluminium in India remains at1kgper head, compared to 30kg in the US and Europe, 10kg in Taiwan and 3kg in China. So there is tremendous potential for growth. In the medium term, power sector capacity expansion should spur demand. And in the long run, the Indian government's infrastructure drive should push demand higher.

The metal is increasingly being used as a substitute for others - for example, a need for improved fuel efficiency and pollution reduction is forcing several car makers to replace steel with aluminium. The latter's favourable weight-to-strength ratio and better conductivity helps increase mileage and reduce emissions.

Hindalco has also lined up some aggressive organic growth plans: it will expand its alumina capacity to 4.5m tonnes from current 1.5m, and aluminium capacity to 1.6m tonnes from the current 0.9m, the last phase of which is expected to commence production by 2014. Considering that demand for aluminium is expected to grow at 6-8% per year, this capacity expansion will leave Hindalco well placed to benefit.

The challenges for aluminium

The greatest challenge facing the industry is the continuous increase in raw material prices. Most input costs such as fuel oil, coal tar pitch, and caustic soda have increased along with the freight costs. Alumina costs for non-integrated smelters have gone up and may increase further.

Also, the aluminium industry is of course, highly cyclical, and so depends on the health of the global economy. China accounts for 40% of world aluminium demand, and fears of a slowdown in the country have already led to a decline in aluminium prices.

Hindalco's expansion plans are also facing delays in getting regulatory approvals. As a result the company has to incur extra costs which will squeeze its margins in the short term.

Should Hindalco Industries be a part of your stock portfolio?

As a low-cost producer, Hindalco'sbusiness should be among the more robust in the sector, particularly given that it's the largest producer of aluminium and copper in India. Of course, you have to account for the fact that this is a cyclical industry, and with China's woes and Europe's concerns, cyclical businesses are likely to fall further. However, even now, Hindalco looks cheap while it could get cheaper, long-term investors might consider starting to buy in now.

This article is taken from Equitymaster India's leading independent equity research initiative. Trusted by over a million members all over the world, Equitymaster, with its well-researched, unbiased and honest opinions is the preferred destination for investors interested in investing in India.