My pick for the New Year is Vedanta and it’s a recognition of the fact that one of the biggest commodity rallies has just commenced globally. Coming after a 10-year bear cycle, the metals major is a good proxy to play the rally.
While metal stocks have had a dream run since the start of 2016, we believe the rally is far from over for non-ferrous stocks. Vedanta is well-placed to benefit from the buoyancy in the commodity cycle given its presence across different commodities, advantage of scale and a healthy balance sheet. We believe the upswing in commodity prices and capacity ramp-up in zinc, aluminium, oil and power businesses will
improve the company’s bottomline.
Given the strong industry fundamentals, cost competitiveness and huge potential, zinc has now become the cash cow for Vedanta and accounts for bulk of its profit as well as valuation. In a span of just two years, the fortune of the zinc industry has changed with the closure of two large mines in Australia (Century mines) and Ireland (Lisheen mines). The closure of these mines has pushed the industry into deficit and global inventories at both the London Metal Exchange and Shanghai Futures Exchange have hit 10-year lows, leading to a sharp rise in zinc prices that have doubled from $1,600/tonne to over $3,000/tonne in two years.
Expansion at zinc mines of both Hindustan Zinc and Zinc International will also be a key growth driver for the company. In India, Vedanta plans to increase capacity to about 1.2 million tonne by FY20, translating into about 13% sales volume CAGR over the next two years. At Zinc International, expansion of the Gamsberg project in South Africa is likely to start in mid-CY18 with about 100,000 tonne volume in FY19 and a further ramp-up to about 250,000 tonne by FY20. With prices expected to remain at these levels, Vedanta will be raking in profit in the zinc segment, given its low-cost structure.
In the aluminium business, prices have rallied to over $2,000 a tonne and are likely to remain firm on the back of Chinese government’s crackdown on illegal aluminium capacity, rising input prices and production cuts announced by China. Going forward, this segment can create a big delta for Vedanta in terms of cash flows as with higher ramp-up, production cost will come down and the miner will benefit from higher operating leverage.
The company plans to increase overall production in this segment from 1.7 mtpa to 3 mtpa by FY20, indicating a significant jump in volumes. Though we believe higher prices will benefit the company, its cost structure is higher compared with peer Hindalco as it relies on external sources for both bauxite and alumina besides importing a large part of its coal requirement. The company has given up on the Niyamgiri (Odisha) mines and, hence, the key trigger for the company to reduce cost will be to win bauxite mines, when the government puts some mines on the block or to enter into an agreement with Nalco to source alumina locally.
The company is also very optimistic on the growth of its oil and gas business. We expect a significant ramp-up in production through enhanced oil recovery projects within existing fields. The management has undertaken cost-efficient measures and has closed down small unviable projects. Consequently, the new projects undertaken have become viable even at a crude price of $40 a barrel. But an overhang in this segment remains that the production sharing contract (PSC) for its Rajasthan block (which accounts for 90% of overall volumes) will be up for renewal in May 2020 and the new hydrocarbon exploration licensing policy requires additional 10% increase in profit sharing with the government. Currently, the extension of PSC the for Rajasthan block is under arbitration since Vedanta is seeking an automatic extension of the contract for 10 years without any changes in financial terms, in lieu of improved visibility on commercial gas production.
We believe Vedanta is in a sweet spot as the current upswing has turned the tide in its favour and is likely to aid improvement in earnings and help the metals major in deleveraging. Vedanta has committed a capex of $1.2 billion, which is almost double that of the previous year (FY17). Of the capex, 50% is being spent on zinc, 30% on oil and gas, 10% on copper and the balance for the aluminium business.
On the back of rising commodity prices, the company also reduced its debt by Rs.11,460 crore. Given the deleveraging and strong earning performance, the miner’s net debt/EBITDA at 0.6x is the lowest across Indian and global peers. Further, given the significant improvement in the balance sheet, Vedanta has committed a minimum dividend payout of 30%, which is further value accretive for shareholders.
The stock is currently trading at one-year forward EV/EBITDA multiple of 4.5x, which is not only lower than its historical average but is also trading at a discount to global aluminium and zinc peers. The stocks of BHP Billiton, Rio Tinto and Glencore are all trading above 6x. We have valued the company on a sum-of-the-part basis. The bulk of the value in the stock comes from its zinc operations in India and the oil and gas division. Given the positive outlook on all commodities and a ramp-up in production, we arrive at a value of Rs.450 a share. The key risk to our call is a likely fall in zinc and aluminium prices, lower volume growth, and an increase in cash cost, especially in the aluminium business. However, we believe the other trigger for the stock could be the sale of residual equity stake of the government in both Balco and Hindustan Zinc.
The writer has no position in the stock, but Elara Capital has recommended the stock to its clients