October 2009 ICRA Rating Feature Rating Methodology for Domestic Primary Aluminium Producers Aluminium is a versatile non-ferrous metal with wide applications, especially in the electrical, construction, packaging, transport, and consumer durable segments. The industry is dominated by a few large players, given the high capital intensity in the business. Like many other base metals, the aluminium industry exhibits cyclical characteristics, which causes wide swings in the profitability and cash flows of individual producers, increasing their business risks. Such volatility poses a challenge to the rating process since predicting the issuer s future cash flow patterns, an integral part of analysing credit protection levels, may get unduly influenced by the position of the industry on its cyclical trajectory at the time of the rating exercise. This may in turn impart some instability to the rating along the cyclical path. However, ICRA s rating framework focuses on the issuer s fundamental credit quality and seeks to evaluate its credit risk profile across cycles. Determinants of issuer s competitive position: The extent of impact of the industry cycle on a primary aluminium producer varies in accordance with its cost structure, which in turn is determined by the extent of integration in metal production, technology used, and cost of raw material and power. Market position derived from scale of operation and productmarket diversification, financial health and management depth are also key success factors in the primary aluminium industry. Each of these factors is briefly explained below: Cost position: As is the case with any company operating in a commodity environment, cost efficiency of a primary aluminium producer is a key rating factor. Since all producers are necessarily price-takers, profitability of individual players depend upon their respective positions on the industry cost curve, which is largely determined by their costs of raw materials and power and the extent of vertical integration. Aluminium metal is produced by smelting alumina, which again is produced by digesting bauxite in the refinery. With bauxite having an unfavourable weight to bulk ratio, internationally refineries are increasingly being located near the mines to reduce transportation costs (around 6 tonnes of bauxite are required to produce 1 tonne of aluminium). The quality of ore and type of mining operations are also important determinants of an aluminium producer s overall raw material costs. For instance, the bauxite available in the Orissa region is rich in alumina content and is amenable to digestion at lower temperature and pressure, keeping processing cost at low levels. Smelting on the other hand being an energy-intensive operation and the cost of disruption because of power failure being high, ICRA believes that the quality and cost of
power of an aluminium producer are other important drivers of its cost efficiency. Globally, therefore, the location of a smelter is increasingly being dictated by the availability of assured and cheap power. There is significant vertical integration (refers to the value chain up to the production of aluminium metal/ingots) even within the primary aluminium industry. A higher degree of integration of operations imparts self-sufficiency and an ability to control operations, which, in turn, leads to a better cost structure. Aluminum being a globally traded commodity, ICRA believes that a primary producer needs to be globally cost competitive for it to remain profitable throughout the cycle. This has become even more important with the progressive reduction of import duties, largely eliminating the level of protection the domestic industry enjoyed against the threats of import. Additionally, with a number of large smelting projects being at various stages of completion, India s aluminium capacity is likely to increase significantly in the medium to long term, while the demand is likely to grow at a more even pace, which is likely to force producers to focus on the export markets to ensure high operating rates of their capacities. ICRA therefore benchmarks the company s cash cost of production against its global peers. In ICRA s opinion, cash cost determines an entity s staying power in business because if price falls below this level, it starts losing cash. Scale of operation and product market diversity: An aluminium producer is better insulated from cyclical volatility when it has a large scale of operations and a diversified product mix. While size in itself cannot determine a player s competitive advantage, it confers upon a company an ability to control costs through greater bargaining power with raw material suppliers and customers, enter into long-term supply contracts with large customers, access funds from the market at better rates besides the economies of scale which accrues from size. Forward integration by primary players into downstream businesses protects them against the volatility risks associated with commodity metal prices to an extent. Although downstream businesses also suffer during periods of stress, such businesses display relatively lower cyclicality compared to pure primary metal businesses. Besides, since different downstream products find applications in different industries, forward integration into more value added products enables a company to lower its dependence on any particular user industry or customer. Since the late 1990s, the stronger domestic primary aluminium producers acquired downstream semi-fabrication units to increase the scale of their value-added activities, broaden their product and customer base and reduce volatility in earnings, which is viewed positively by ICRA. New project risks: India currently has an installed aluminium capacity of over one million tonne, which is likely to increase sharply in the medium to long term. All domestic producers have chalked out ambitious growth plants, given the abundance of good quality bauxite ore in the country. ICRA therefore evaluates the various risks associated with large projects including completion risk, funding risk, technology risk and offtake risk, and examines the impact of the same on the entity to ascertain its overall credit risk profile. Primary aluminium is highly capital intensive, specific investment requirement for an aluminium complex being almost three times the requirement for a steel plant. An integrated complex with an alumina refinery and captive power facilities could increase such ICRA Rating Services Page 2 of 5
investment requirements further substantially. Capital cost competitiveness is therefore an important determinant of business returns of producers. However, these additional investments have to be balanced against potential gains in cost structure. For instance, power costs typically accounts for over one third of smelting costs. Therefore, in a country like India where power purchased from external sources could be costly, a lack of a captive facility could significantly depress project returns. Similarly an alumina refinery too can enhance a project s economic feasibility significantly, since India s major competitive advantage lies in its large bauxite reserves, the benefits of which can be fully harnessed if an aluminium project includes a refinery facility as well. In addition, alumina itself being an internationally traded commodity with significantly less fixed capital intensity, a producer like National Aluminium Company Limited (Nalco) with surplus alumina capacity enjoys superior returns on capital employed, which is viewed positively. Financial strength: The financial strength of an aluminium producer is an important rating consideration. While assessing the financial position of an aluminium producer, ICRA reviews the Accounting Policies followed by the company, Notes to Accounts, and Auditors Comments that are part of the Annual Report. Any deviation from the Generally Accepted Accounting Practices is noted and the financial statements of the issuer are adjusted to reflect the impact of such deviations and also to compare more meaningfully against peers in the industry. Apart from balance sheet strengths which determine a player s ability to withstand a deep down cycle, ICRA also evaluates the profitability and cash generating ability of the business as well as other sources of financial flexibility available to an entity to evaluate its overall financial risk profile. Profitability: Profitability of a primary producer is primarily a function of its cost structure and product mix. However, aluminium being a cyclical industry, profitability varies significantly along the cycle. Additionally, for integrated producers having captive bauxite mines, a significant proportion of overall costs representing bauxite and power costs tend to be fixed, which accentuates the impact of cyclicality on margins. Nevertheless, producers having cost structures better than the industry median level can generally be expected to remain profitable across cycles. Leverage and cash flows: As with companies in other commodity industries exhibiting cyclical price trends, a low financial leverage is viewed as a credit quality positive for primary aluminium players. Besides protecting the cash flows of players by imposing a lower debt service burden, especially during periods of cyclical stress, a low gearing also imparts greater financial flexibility to primary metal producers to access funds from institutional sources. Besides capital structure, ICRA pays special attention to coverage indicators including interest coverage, operating profit and net cash accruals relative to total debt while evaluating the financial health of an aluminium company. ICRA is particularly concerned with a company s capability to honour its contractual obligations under stress conditions. The more robust a company s performance is likely to be under a range of reasonable projections; the better it is from a credit evaluation perspective. ICRA also critically looks at other sources of financial flexibility available to an issuer, which could be in the form of, ICRA Rating Services Page 3 of 5
among others, availability of a portfolio of liquid financial assets, strategic importance of the entity to the group to which it belongs along with the financial strength of group entities. Foreign currency related risks: The manufacturing costs of a domestic aluminium producer are incurred primarily in the domestic currency while selling prices are, even if the company sells its produce within the country, linked to the exchange rate, being typically benchmarked against the landed cost of imports. The foreign currency risk can also arise from unhedged liabilities, especially for companies with liabilities denominated in a non US$ currency. The ICRA analysis also focuses on the hedging policy of the issuer concerned in the context of the tenure and nature of its contracts with clients (short term/long term, fixed price/variable price). Tenure mismatches, and risks relating to interest rates and refinancing: Large dependence on short-term borrowings to fund long-term investments can expose an issuer to significant re-financing risks, especially during periods of tight liquidity. The existence of adequate buffers of liquid assets/bank lines to meet short-term obligations is viewed positively. Similarly, the extent to which an issuer could be impacted by movements in interest rates is also evaluated. Contingent liabilities/off-balance sheet exposures: In this case, the likelihood of devolvement of contingent liabilities/off-balance sheet exposures and the financial implications of the same are evaluated. Management strength: Management quality is one of the most important factors that ICRA evaluates in assigning ratings, but is an intangible and difficult to quantify. For primary aluminium players, ICRA looks at management strategies with respect to the company s cost position and product portfolio. ICRA also evaluates how the management responds to the cyclical behaviour of the industry, i.e. strategies followed to mitigate the risks arising out of such cyclicality. Generally speaking, a record of conservative financial philosophy provides an extra level of comfort for the rating. Some of the other points assessed are: - Experience of the promoter/management in the line of business concerned - Commitment of the promoter/management to the line of business concerned - The issuer s policies on leveraging, interest risks and currency risks - The issuer s plans on new projects, acquisitions, expansion, etc. - Strength of the other companies belonging to the same group as the issuer - The ability and willingness of the group to support the issuer through measures such as capital infusion, if required Conclusion ICRA s approach to rating primary aluminium producers incorporates both qualitative and quantitative factors, some of which are used to assess other commodity sectors which display cyclicality. While the former includes, among others, an assessment of cash flow generation under normal and stress scenarios, cost competitiveness and financial strength, the latter includes market position, management strategies for managing cyclical downturns and an overall approach towards investment and growth. ICRA Rating Services Page 4 of 5
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