Sterlite Industries: TP: INR193 Buy: Motilal Oswal

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Investment in group companies remains return dilutive
Maintain Buy
 Metal volumes grow but ASR remains at just 7% over FY07-11.
 Zinc business to improve RoIC but power and aluminum businesses lose
money.
 RoIC will improve from 26% in FY11 to 31% in FY13 and RoCE will improve
in FY12 due to better performance by the zinc business.
 Valuations attractive, maintain Buy.
Metal volumes grow but STLT's ASR remains at 7% over FY07-11
Sterlite Industries (STLT) delivered strong volume growth across metals over FY07-
11 but its ASR (annualized stock returns) was just 7% . Its attributable zinc, lead and
silver production volumes (under HZ and Zinc International) posted CAGR of 24%,
13% and 31% to 535kt, 48kt and 95 tons respectively. STLT posted saleable power
CAGR of 81% to 4.7b kWh over FY07-11. With ongoing capacity expansion at HZ
and Sterlite Energy (STLE), we expect metal and power generation to grow strongly
over FY11-13. Although aluminum production was stagnant due to moth-balling of an
uneconomical smelter at Balco, STLT expanded Balco's capacity by 325ktpa over the
past few years. However this smelter expansion (along with Vedanta Aluminium's
new 1.25mtpa smelter) has been on hold since October 2010 due to non-allocation of
bauxite for VAL's refinery and subsequent denial of forest clearance from the Ministry
of Environment and Forests (MoEF). Besides, uncertainties and controversies
surrounding a ~USD8b Vedanta Aluminum project affected the stock performance
over the past few quarters. Delays in commissioning its power project and unavailability
of linkage coal at STLE also affected ASR.
Attributable EBITDA declined from INR65b in FY07 to INR55b in FY11 due to higher
stripping and coal costs at HZ, lower LME zinc prices (over USD3500/t in FY07) and
lower contribution from Balco. Return ratios also declined due to delays in project
execution and dilution of equity. Over FY07-11, STLT generated USD6.2b of cash
flow from operations and invested a similar amount in capex. Out of USD6.2 capex,
HZ invested ~USD1.7b on expanding zinc and lead capacities, Balco's capex was
~USD1.2b and USD1.1b was invested in STLE. Despite sufficient cash inflow, STLT
raised USD3.4b of equity over FY07-11, which also impacted return ratios.

Zinc business to improve RoIC but power, aluminum businesses lose money
STLT's RoIC is expected to improve over FY11-13 due to superior performance by the
zinc business, but the power and aluminum businesses are losing money due to unavailability
of linkage coal and captive bauxite. RoIC will improve from 26% in FY11 to 31% in FY13.
RoCE will also improve in FY12 due to a rising IC/CE ratio, but we expect it to see some
deterioration in FY13.
Other positive triggers for the stock are the timely opening of Balco's captive coal mine
and commissioning of a 1,200MW power plant. We expect the coal mine to become
operational by December 2011 and STLT plans to commission the first unit of its 1,200MW
project in 4QFY12, which will lead to a quantum jump in profits.

As per CEA's monthly power generation report for August, STLE commissioned the third
unit of 600MW at Jharsuguda. Although overall utilization declined MoM at STLE, we
expect STLT to find a long term, feasible solution to source coal for the project. Coal India
recently cut its linkage from 55% to a mere 25% for STLE's project, which has led us to
cut our STLE FY12 PAT estimate to INR1.8b from INR5.5b, earlier.


Valuations
STLT is expected to post earnings CAGR of 16% over FY11-13, driven by strong operating
performance of the zinc business. RoIC and RoCE will improve. Over the next two years
STLT will generate ~USD4.3b operating cash flow and invest ~USD1.6b in capex. Net
debt will increase to USD3.2b in FY13.

STLT traded at a premium to its NAV (taking into account replacement costs for fixed
assets) until FY10. However, since then it has started trading at a discount to NAV due to
delays in commissioning of STLE's power units, inability to secure captive bauxite and
coal linkages. At a CMP of INR116, the stock trades at a 20% discount to NAV. Earnings
from the aluminum and power business are vulnerable to shortage of coal and unavailability
of bauxite. Investor concern over capital allocation to high risk projects of group companies
has de-rated the stock. It trades at attractive valuations of 3.4x EBITDA and 0.8x BV.
We maintain Buy with a target price of INR193 based on a SOTP analysis.

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