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m Our second case assumes that the shareholder and other regulatory approvals come through swiftly and the merged entity is formed before CY12 end, which would mean that the stocks should trade at their derived fair values (based on merger specifics: see our valuation table below) and also trade according to the merger ratio of 0.6x. Now we observe that this is not happening and if investors were to sell Sesa and buy Sterlite, they would clearly benefit from this situation (as Sterlite shares are trading at ~19.6% discount to their derived merger price from Sesa’s current stock price). Also, investors can chose to go long on both Sesa and Sterlite as both stocks are below their merger fair value targets (discount being much more in Sterlite’s case) and in the event of merger not going through, the upside can be very sharp in both the stocks (with Sterlite upside being more).
We see the present stock price scenario (see discount calculation table on right) as a unique win-win situation for investors and from a tactical as well as portfolio point of view, we would suggest investors to shift their investments from Sesa Goa to Sterlite industries and also buy Sterlite industries at this point of time. The proposed merger is pending shareholder an some regulatory approvals and is expected to get completed before the end of CY12.
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Sterlite Industries
Buy
Target Price: Rs125
CMP: Rs91
Upside: 37.1%
Sesa Goa
Buy
Target Price: Rs208
CMP: Rs182
Upside: 14.5%
Unique opportunity for investors to benefit from merger overhang; shift from Sesa to Sterlite
We see a unique opportunity for investors to benefit from the ongoing merger overhang of Sesa Sterlite by shifting their investments from Sesa to Sterlite as we see Sterlite shares trading at a discount of ~19.6% to their derived price from Sesa Goa’s current market price based on the proposed merger ratio of 0.6x with Sesa Goa. Stocks of both Sesa Goa and Sterlite industries have underperformed the benchmark indices significantly (by ~10%) since the announcement of their merger and simplification of Vedanta group structure on Feb 25 2012. We had already noted this event (Refer our report on Sesa Sterlite merger dated 27 February 2012) as being more beneficial to Vedanta group with limited benefits to the consolidated entity and its shareholders on account of huge debt and skewed EBITDA profile of the proposed entity. We had downgraded both the stocks and reduced our targets after the event but after a significant correction in the stocks, both Sesa and Sterlite are trading well below our fair value target prices and we see a unique opportunity for investors to benefit from the current situation.
We see two situations emerging as the companies seek shareholder approvals for the merger in June:-
m In the first case, shareholders of Sesa might reject the merger offer considering that VAL merger at an unrealistic valuation is not beneficial to the merged entity by any stretch of imagination, which in turn would lead to investor delight and lead to a sharp rally in the stocks of both Sesa and Sterlite.m Our second case assumes that the shareholder and other regulatory approvals come through swiftly and the merged entity is formed before CY12 end, which would mean that the stocks should trade at their derived fair values (based on merger specifics: see our valuation table below) and also trade according to the merger ratio of 0.6x. Now we observe that this is not happening and if investors were to sell Sesa and buy Sterlite, they would clearly benefit from this situation (as Sterlite shares are trading at ~19.6% discount to their derived merger price from Sesa’s current stock price). Also, investors can chose to go long on both Sesa and Sterlite as both stocks are below their merger fair value targets (discount being much more in Sterlite’s case) and in the event of merger not going through, the upside can be very sharp in both the stocks (with Sterlite upside being more).
We see the present stock price scenario (see discount calculation table on right) as a unique win-win situation for investors and from a tactical as well as portfolio point of view, we would suggest investors to shift their investments from Sesa Goa to Sterlite industries and also buy Sterlite industries at this point of time. The proposed merger is pending shareholder an some regulatory approvals and is expected to get completed before the end of CY12.
Valuation: We remain positive on the prospects of zinc, lead and silver businesses and expected increase in power volumes going ahead but remain concerned on lower iron ore volumes and profitability of VAL (which would become the 100% subsidiary of the merged entity). Huge debt servicing also remains a key balance sheet concern. We have used FY14E EV/EBITDA valuation (see table below) to arrive at a SOTP fair value of Rs208 for Sesa Sterlite and corresponding fair value of Rs125 for Sterlite (based on 0.6x Sesa Sterlite value). Stocks have seen substantial correction post the merger announcement and we recommend Buy on Sterlite industries with a target price of Rs 125. We also suggest that investors shift their investments from Sesa Goa to Sterlite industries to benefit from the current unique stock price situation.
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