Kotak Sec: Buy Sterlite Industries- Solid quarterly performance, delays in execution a concern.

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Sterlite Industries (STLT)
Metals & Mining
Solid quarterly performance, delays in execution a concern. Sterlite reported
3QFY11 EBITDA of Rs19.8 bn (+11.7% yoy), 7% ahead of our estimate. Zinc segment
surprised positively, while other businesses disappointed. The delay in COD of the first
unit of Jharsugda IPP is a concern. The adverse decision by the arbitration panel on
Balco compounds concerns. We revise our metal price assumption and now model
power sale on a merchant basis from Jharsugda IPP—accounting for an increase in our
FY2012E and FY2013E EPS estimates by 6.1%. Maintain BUY on inexpensive valuations

Zinc business powers consolidated performance; other businesses disappoint

Sterlite reported 3QFY11 EBITDA of Rs19.8 bn (11.7% yoy), 7% ahead of our estimate. EBITDA

was helped to the extent of Rs0.6 bn on consolidation of Skorpion mine acquisition for one month.

Performance was powered by zinc business, which grew 9.3% yoy to Rs14.9 bn. Copper business

was impacted by lower production, aluminum by cost increase and power business by steep

decline in realization. Net income of Rs11 bn (+51% yoy) was 15% lower than our estimate on

account of (1) lower-than-expected finance income and (2) higher-than-expected losses in VAL.

Adverse decision by arbitration panel on Balco, negative for Sterlite

The three-member arbitration panel ruled in favor of the Government, implying that it is free to

hold shares as long as it wants and chose a buyer for its 49% stake in Balco. Note that Sterlite had

bought a 51% stake in Balco in 2001 with an option to buy the remaining stake at a price fixed by

an expert panel three years later. Hindustan Zinc, in which the Government owns 29.5%, also has

a similar case. Effectively, the government stake will continue in HZ and Balco. This will lead to an

inefficient capital structure for Sterlite, which has a large portion of cash locked in HZ.

New projects will power FY2012E earnings but execution delays, a concern`

We forecast EBITDA growth of 67% for FY2012E and 19% for FY2013E led by (1) full benefits of

zinc-lead capacity expansion; (2) expansion of silver refinery and (3) strong contribution from the

power business. Revenues from the first unit of the 2,400 MW (4X600 MW) Jharsugda IPP will

start accruing in Apr’ 2011 (a significant delay). COD for the remaining units will likely be done in

FY2012E. Revenue from 1,200 MW (4X300 MW) Balco CPP will also start accruing in FY2012E.

Maintain BUY on attractive valuations

We have raised our FY2012E and FY2013E EPS estimates by 6.1% each. Revision is on account of

(1) the increase in zinc-lead and aluminium price assumption and (2) we now model revenues from

Jharsugda IPP on a merchant power basis versus assuming entire sales to VAL earlier. We maintain

our BUY rating and TP of Rs200 on end-FY2012E financials—more on valuation later.

Value unlocking potential only on resolution of disputes with Government

Our target price of Rs200 is based on conservative assumptions and does not build in any

equity value to VAL project, loans extended by Sterlite to VAL and investments in new

325ktpa aluminum smelter of Balco. In addition to eliminating all investments in VAL, we

assume that Sterlite will provide further funding of Rs67 bn to VAL. This effectively results in

negative equity value of Rs67 bn equating to Rs20/ share of Sterlite. We believe unlocking of

value is possible on resolution of disputes and alleged violation of environment protection

norms. We believe that availability of bauxite mines for Vedanta Aluminium (VAL) can add at

least Rs50/share to our fair value

Key assumptions driving FY2012 and FY2013E forecast and changes to our

estimates

We elaborate on key assumptions and changes to our model for FY2012E and FY2013E

�� Zinc business. We recently raised our zinc price forecast to US$2,300 and US$2,350 for

FY2012E and FY2013E from US$2,150 and US$2,250 earlier. We incorporate these

changes for Sterlite Industries. We model refined zinc-lead sales of 893K tons and 983K

tons in FY2012E and FY2013E respectively. Expansion of Sindeshar Khurd mine and mill is

on track. The company is also on track to exit FY2012E with silver capacity of 500 tons.

We model silver sales of 210 and 358 tons in FY2012E and FY2013E, respectively.

�� Aluminium business. We model aluminium shipments of 267K tons and 269K tons over

the next two years. We have raised our aluminium price forecast for FY2011E and

FY2012E to US$2,210 and US$2,250/ ton from US$2,050 and US$2,150 earlier. Cost of

production in 3QFY11 was at US$1,795/ ton and unlikely to decline in a hurry. We do not

build in any volumes from proposed aluminium smelting capacity expansion at Balco and

VAL. Balco is dependent on Lanjigarh Alumina refinery for alumina feed for its proposed

325 ktpa aluminum smelter. However with the recent stay on refinery expansion, Balco’s

aluminium smelting capacity expansion may no longer be viable. Similar to VAL, Balco

may complete construction of aluminium smelter though it may not start commercial

operations till it is able to source alumina from the Lanjigarh refinery. Balco had outlined

capex of US$840 mn for 325 ktpa aluminium smelter

�� Power business. The power business will drive a large part of EBITDA growth in FY2012E.

We model power EBITDA of Rs33.2 bn; Rs25.8 bn from Jharsugda power plant and Rs7.4

bn from the Balco power plant. We expect growth in the power businesses in FY2012E

and FY2013E to be led by (1) revenues from 2400 MW (4X600 MW) Jharsugda IPP and (2)

revenues from 4X300 MW new captive power plant of Balco. Synchronization of the first

unit of 1200MW (4X300 MW) power plant of Balco will start by end-FY2011E, second in

1QFY12 and the remaining two units in 4QFY12. Sterlite management reiterated that it

has coal linkage for first two units of 2400 IPP and has tapering coal linkage for the rest.

For Balco CPP, management indicated that it has coal linkage for first two units of 300

MW each. In addition it expects Taraimar coal block to start by mid-2011 (aggressive

expectations and unlikely to be met). Total reserves of this coal block is 211 mn tons.

�� Copper segment. We model EBITDA of Rs7.2 bn each in FY2012E and FY2013E for the

copper smelting business. We expect Tc/Rc margin to remain under pressure for the next

2-3 years.

�� We upgrade our EPS estimate by 6.1% each for FY2012E and FY2013E, respectively.

Majority of the revision is driven by (1) increase in zinc-lead and silver price assumption; (2)

assumption of merchant power sales from Jharsugda IPP in FY2012E versus entire sales

assumed at Rs2.5/ unit to VAL earlier. Our estimates do not include acquisition of zinc

assets of Anglo American. We assume this acquisition to value neutral.

Discussion on divisional performance
Sterlite’s 3QFY11 result was better than our estimate. Performance was strong in the zinclead
business and weak in other businesses
􀁠 Zinc, lead and silver segment. HZ’s reported 3QFY11 net profit of Rs+12.9 bn (+12.3%
yoy, +35.9% qoq) was ahead of our expectation of Rs11 bn. EBITDA of Rs14.9 bn
(+9.3%yoy, 35.8% qoq) was also ahead of our estimate of Rs13.1 bn. Growth in
EBITDA/net income was led by (1) reasonable volumes—refined zinc production grew
1.1% qoq and 20.4% yoy to 178K tons; (2) higher realizations—zinc realization for
quarter was US$2,473/ ton (+14.8% qoq, 3.4% yoy) and lead realization was US$2,660/
ton (+17.6% qoq, 6.6% yoy) and (3) concentrate sales which was not factored in our
estimates. HZ’s 3QFY11 net zinc metal cost of production declined sequentially, though it
will remain at elevated levels till the Rampura Agucha mine strip ratio declines.
􀁠 Copper business. Copper EBITDA of Rs2.3 bn (+21.6% yoy, 7.7% qoq) was lower than
our estimate of Rs2.6 bn. Tc/Rc at 11.18c/lb was in line with our estimate. Production
declined due to temporary shutdown following High Court order. Mines metal production
in CMT Australia also declined to 4K tons from 7.2K tons in the earlier quarter. The
management attributed decline to seasonal factors and expects production to ramp up
again. We can expect volumes to pick up in the coming quarters. Copper smelting
business suffers from significant overcapacity; we expect flattish trends on Tc/Rc margins
over the next few quarters.
􀁠 Power business: Power business EBITDA declined 50% qoq and 70% yoy to Rs0.4 bn.
Realization decline to Rs2.7/ unit was steep and inexplicable. The company attributed the
decline to payment to clients on uninterrupted interchange demurrage and some
seasonality. We are still unable to reconcile the reasons for such weak performance
􀁠 Aluminium business, cost increase a concern. Aluminium segment reported EBITDA of
Rs1.58 bn (+13.1% yoy, 9.7% qoq), lower than our estimate. The steep increase in COP
(US$1,758/ ton versus US$1,667/ ton in the previous quarter) offset the benefit of higher
realization. We do not expect any meaningful decline in COP in the immediate quarters.
VAL made losses; attributable portion for Sterlite was Rs1 bn. COP of aluminium metal at
VAL is high at US$2,050/ ton. Management expects this to trend down to US$1,650/ to
over the next few quarters.