Operating margins of domestic aluminium producers are set to touch a decadal high of 30-31% this fiscal¹ owing to healthy prices – stemming from robust demand outlook and limited global capacity additions – and efficient cost structures.

That will crank up the capital expenditure (capex) intensity of producers over the next two fiscals given their focus on increasing both, capacity and share of value-added products. Free cash flows, stronger debt coverage ratios, and healthy cash buffers will drive improvement in credit metrics, a Crisil Ratings study of three domestic primary aluminium producers², which account for the entire domestic capacity of 4.1 million tonne (MT), shows.

Global aluminium demand is expected to rise 6-7% in calendar 2021, helped by the low base of 2020, when output had contracted ~2% to 64 MT following the Covid-19 pandemic.

Industry growth will be driven by global economic recovery and increased spending on construction, infrastructure and electrification. With governments stepping up on green initiatives and sales of electric vehicles increasing, annual global aluminium demand will rise ~3% over calendar 2021-2025. However, global capacity addition is expected to trail at ~1% through 2025 (global capacity of 79 MT in 2020) on environmental concerns and emphasis on reducing emissions.

Limited capacity addition amid the demand pull will improve utilisation rates of aluminium smelters globally to ~85% this year from ~80% in 2020, and support healthy aluminium prices. London Metal Exchange prices for the metal is currently ~ $2,600 per tonne, up 50% on-year, and touching highs last seen in 2011. While the prices may witness some easing, they are seen healthy at $2,100-2,300 per tonne through fiscal 2023, compared with ~$1,800 per tonne last fiscal.

Domestic prices are driven by the landed cost of imports, which will support the realisations of Indian producers. Also, domestic demand is expected to grow 10-12% this fiscal after contracting 13-14% to ~2.1 MT last fiscal. Growth will be propelled by higher demand from the construction, automotive and power sectors.

Improved demand outlook and healthy realisations will benefit domestic aluminium companies, which are among the lowest-cost producers in the world. Their cost competitiveness is driven by highly integrated operations – 70-75% backward integration on average – marked by the presence of captive bauxite resources (key raw material), alumina refineries, and domestic coal linkages that together constitute close to three-fourths of the production cost.

Says Manish Gupta, Senior Director, Crisil Ratings, “Over the past three fiscals, cost-competitiveness has resulted in Indian aluminium exports increasing to more than 50% of annual production. There was a notable step-up last fiscal to offset declining domestic demand, which supported healthy utilisation rates. Overall, low cost of production and higher realisations will lift operating margins by ~500 basis points this fiscal from ~25% seen last fiscal.”

With strong profitability outlook resulting in an annual operating profit of ~Rs 20,000 crore, and current operating rates close to 95%, domestic producers will see increased capex intensity over the next 2-3 years. About Rs 25,000 crore is expected to be incurred over the next two fiscals, compared with Rs 19,500 crore in the past five fiscals.

The capex will augment smelter capacity by ~10%, and improve forward and backward integration. Over 50-55% of the spending will be to increase downstream capacities, expansion of alumina refinery, and commissioning of captive coal mines. While the capex for backward integration will help sustain cost-competitiveness, increase in downstream value-added product capacities will buff up product portfolios.

Says Naveen Vaidyanathan, Associate Director, Crisil Ratings," Domestic producers are looking to increase the share of downstream capacities to more than 35% from ~20% over the medium term. This will burnish realisations and strengthen business profiles. Also, despite surplus aluminium production, India imports ~30% of its consumption, mainly finished products, whereas exports are mainly in the form of semi-finished products fetching lower realisation. Downstream capacity additions will lower exports of semi-finished products and limit finished imports.”

Additionally, downstream capex will lead to higher, and more stable, profitability, which will also drive improvement in credit metrics. Interest coverage ratio will increase to more than 6x over fiscals 2022-2023 from ~4.6x last fiscal, with cash buffer at a healthy ~2x of debt obligations through fiscal 2023.

That said, a sharper-than-expected correction in global aluminium prices, weaker global demand, or lower-than-expected supply tightness would bear watching.

¹ Operating margin is defined as earnings before interest, tax, depreciation and amortisation (Ebitda) margin
² Vedanta Ltd (including Bharat Aluminium Company Ltd), Hindalco Industries Ltd and National Aluminium Company Ltd