Zinc profits not enough to stem
VAL drag; acquisition of Cairn
costlier on INR depreciation
Action: Downgrading to Neutral due to too many near-term issues
We downgrade Sesa Goa to Neutral as we believe that the company has
lost value on account of: 1) the iron ore mining bans in Karnataka and
Goa; 2) worsening aluminium business due to the shortage of bauxite
mines; and 3) forex losses due to the transfer of Cairn India acquisition
debt from Vedanta Resources. While zinc operations are going strong and
the power business is steadily improving, it won’t be enough to outweigh
the above negatives, in our view. We also lower our target price to INR179
from INR220 to account for the worsening operating environment.
Catalyst: No near-term triggers
We don’t believe that there are near-term triggers for the stock price.
However, few events which could create value are: 1) the merger of HZ
post the stake sale by the government; and 2) allotment of a bauxite mine.
Valuations: Sum-of-parts valuation at INR179/share
We value the stock at INR179/share using sum-of-parts valuation. Our
valuation accounts for the restructuring of operations and for the merged
entity SESA Sterlite.
On our valuation, the stock would be trading at ~5.4x FY14F P/E. We
think a lower multiple is justified given: 1) the overseas zinc business
(which we value at 4.5x P/E) has a low mine life; and 2) a holding
company discount is applicable to its stakes in HZ and Cairn India.
Operating environment deteriorates…
SESA Sterlite (the merged entity) is going through a tough phase with its various
businesses facing operational and regulatory issues. While aluminium operations remain
a drag on the consolidated company, even its iron ore operations are clouded due to the
mining bans in Karnataka and Goa.
While we note that the zinc business continues to perform strongly and the power
business is also showing steady improvement, the overhang of weak aluminium and iron
ore businesses outweigh these positives, in our view. We also note that the transfer price
of the Cairn India stake from Vedanta Resources has increased due to the depreciation
of INR. As a result, we reduce our target price to INR179 (from INR220) and downgrade
the stock to Neutral.
Since we set Sterlite Industries’ target price according to the merger ratio of 0.6x SESA’s
target price, we also reduce STLT’s target price to INR107 (from INR132) and
downgrade that stock to Neutral as well.
Operational upside possible only from the aluminium
business…
SESA Sterlite as a merged entity will have a diversified business portfolio with exposure
to zinc, oil, power, aluminium and copper. On one hand, it has highly profitable zinc and
oil operations, while on the other hand it has been dragged down by the weaker
aluminium business and worsening operating environment for the iron ore business.
We built in the potential restarting of iron ore mines in the next six-nine months; however,
total production is likely to be capped at ~15mtpa (against the company’s plan to expand
it to 30mtpa by FY15-16). Therefore, even with normalized operations, we don’t expect a
major upside from the iron ore business. Similarly, most of the expansions at zinc and
power operations are complete and value creation from them is unlikely, in our view.
The aluminium business is the only segment with the potential for value creation as
current operations are reeling under the pressure of high production cost and stuck
expansion plans. We don’t see near-term solutions for the issues plaguing Vedanta
Aluminium (VAL).
However, problems compound at VAL, no respite in sight
Vedanta Aluminium continues to make losses as the cost of production remains high.
While there is no positive development on the allotment of bauxite mine for the company,
even the mine acquired by the company from Larsen & Toubro is at early stages and
would take at least two-three years to start production.
The operating environment for Vedanta Aluminium has further deteriorated with the
shortage of bauxite. The company has restarted the alumina refinery (after shutting down
operations for a week earlier) with some bauxite supply from Balco and OMDC –
however, this would only be enough to run the alumina refinery at ~60% utilization rate
and if the company is not able to secure further bauxite, it may have to close down the
refinery again by December, in our view.
With the likely alumina refinery closure, the cost of aluminium production would further
increase by USD100/t, in our view. Due to the likely closure of the alumina refinery and
little clarity on the expansion plan, we reduce our estimate for Vedanta Aluminium’s
enterprise value from INR174bn to INR120bn. The impact is INR18/share reduction in
our target price.
Iron ore business: Operations halted with the ban in Goa
The iron ore business has also seen a deteriorating operating environment with all the
operations of Sesa Goa now suspended due to the mining bans in Goa and Karnataka.
Karnataka mines have been closed for the past 15 months, but now even the Goa
operations have been suspended. While the company has guided for the Karnataka
mine to start operation sometime in Q4FY13, there is not much clarity on the Goa
operations. Even when mines are allowed to start production, there would be a cap on
mining capacities at both Goa and Karnataka, in our view.
As a result, we lower our valuation for the iron ore business from INR130bn to
INR90.6bn. The iron ore business contributes INR29.8/share to our target price of
INR179 (vs. INR42.7 earlier).
The acquisition cost of Cairn India has increased due to INR
depreciation
The combined entity SESA Sterlite will hold a 58.9% stake in Cairn India. While a 20%
stake is already with Sesa Goa, SESA Sterlite will get a 38.9% stake from Vedanta
Resources which acquired the stake at INR355/share. Vedanta Resources will also
transfer the debt of USD5.9bn taken to acquire the above stake to SESA Sterlite. Please
note that at the current USD/INR rate of 53.5, the acquisition cost for SESA Sterlite
would be INR427/share.
As a result of the transfer of debt of USD5.8bn from Vedanta Resources, SESA Sterlite
would have a forex loss of INR20bn, i.e. INR7.8/share.
Zinc business strong – the key pillar of strength
Sterlite holds the zinc business through 64.9% stake in Hindustan Zinc and international
mining assets in Namibia, Ireland and Africa. The zinc business has been a strong
performer for the company with stable earnings despite a difficult operating environment.
The Indian zinc business has performed in line with the mining plan and we expect a
strong pickup in H2FY13 on account of higher grade ore. With our expectation of stable
zinc prices and cost benefits from operational leverage, we think that the zinc business
will remain attractive in the near future. The ramp-up of SK mines is also on track,
boosting lead-silver production, and we expect silver to emerge as a new growth driver
for the business.
And the power business is gradually picking up
Sterlite’s power business has been showing a steady improvement for the past 12
months as the company has commissioned three units of 600MW each and has been
able to ramp up plant load factor (PLF) to ~50% from 30-35% earlier. The fourth unit of
600MW is under trial run and should be commissioned in the next one-two quarters.
The company has seen an easing coal supply scenario with improved e-auction
availability and some stock clearance by Coal India. Though evacuation of power was a
bottleneck in Q2FY13, the company has guided for a resolution by Q3FY13. We expect
an EBITDA of INR6.9bn in FY13F and INR11.1bn in FY14F, up from INR3.8bn in FY12.
Upside potential – what would change the outlook?
While we believe that the company has several operational issues, it also has support
from strong zinc and oil businesses along with improving power operations. However,
aluminium operational issues are a big drain on the profitability as well as cash flows, in
our view.
The key development which would change our view on the stock is:
• Allotment of bauxite mine: The aluminium business is the biggest drag on the
company with losses of close to INR14bn at Vedanta Aluminium in FY13F. With captive
bauxite cost likely to be down USD200/t, the visibility on its stalled projects would also
improve, in our view. According to our estimates, allotment can add close to
INR25/share to the share price.
• Clarity on coal mine development at Balco/SEL: We have not built in any value from
the development of captive coal at Balco and Sterlite Energy. The company has been
waiting for the forest clearance for stage II for the past three-four quarters.
• Merger of HZ with SESA Sterlite: If Sterlite Industries is able to acquire the
government’s remaining 29.5% stake in Hindustan Zinc, SESA Sterlite will have close
to 94.5% stake in Hindustan Zinc and SESA Sterlite may opt to merge HZ into itself.
This would not only allow more productive use of the INR226bn cash in Hindustan Zinc
but also remove the value destruction due to the 17% holding-company discount
ascribed to HZ stakes, in our view
Valuation
We value Sesa Goa on sum-of-the-parts basis at INR179/share from earlier
INR220/share. With just 4% potential upside to our TP, we downgrade Sesa Goa to
Neutral rating from Buy.
We have revised upwards the value we assign to Hindustan Zinc to reflect its continued
stable performance (for details please see our HZ note) and the value we assign to
Sterlite Energy to reflect its steady improvement. However, we have reduced our
valuation of aluminium and iron ore businesses which are likely to be a drag on SESASterlite.
• In the zinc business, we value Hindustan Zinc at 10x FY14F earnings at INR661.9bn.
After 17% holding company discount, SESA-Sterlite’s 64.9% stake in Hindustan Zinc is
valued at INR356.5bn (INR117/share) vs our earlier valuation of INR104/share.
Overseas zinc business is valued at INR36.7bn, contributing INR12.1/share to our
target price. The drop in valuation from earlier INR17/share is on account of slightly
lower production.
• In the oil and gas business, Cairn India (58.9% stake) contributes INR127.5/share to
our target price. Our oil and gas analyst, Anil Sharma, has valued Cairn India at
INR792bn using DCF.
• The iron ore business has seen a deteriorating operating environment with all the
operations of Sesa Goa now suspended due to mining bans in Goa and Karnataka. We
have reduced the value we assign to the iron ore business to INR90.8bn using DCF
contributing INR29.9/share to the target price (earlier INR42.7/share).
• We have valued Sterlite Energy using DCF at INR43.5bn, contributing INR14.4 to our
target price vs. earlier INR8.5/share. The increase in value is primarily on account of
improved coal availability and sustained PLF improvement.
• We have valued Vedanta Aluminium using DCF at enterprise value of INR120bn –
earlier we had valued it at INR174bn. The drop in value is on account of increased cost
of production.
Please see the further details on valuation in the table below.
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