The stock has been cheap for a while (currently 0.7x F14 P/BV, a 40% discount to peers). But, we see three catalysts over the next 12 months to narrow the gap: (i) group restructuring and minority consolidation; (ii) improving sentiment in power and aluminum; and (iii) a bottoming in China?s outlook.
Value unlocking ahead: We expect the Sesa-Sterlite merger to conclude by Q4FY13. A simplified holding structure and healthier diversification (including a new 59% stake in Cairn India) will help lift sentiment. We also see an increased possibility that Sterlite may be able to exercise its call option on the government?s remaining stakes in HZL (Hindustan Zinc) and Balco following media reports that the government is now evaluating a sale. We calculate an option value of R4 per share and continue to include it in our base case, while it will also ease liquidity concerns for Sterlite by making HZL?s cash fungible.
Sentiment toward aluminum and power divisions may improve: Regulatory news flow seems near a bottom and could improve if the government accelerates its policy push. The power business should gain from rising utilisations despite continued coal crunch. Our FY14 earnings forecasts are 34% higher than consensus; if we exclude minority consolidation we are still 22% higher due to improvements in aluminum and power businesses and higher zinc prices.
Chinese data supportive of metals prices: China?s PMI for the month of November stood at 50.49, the highest monthly figure since Oct 2011. As the new regime gives a fresh push to infrastructure spending and to improve the quality and pace of urbanisation, metals prices may get some support. Our global mining team is circumspect on metals prices but is not calling for corrections from current levels.
Why Overweight? Restructuring should be completed by Q1FY14. We expect the simplification of holding structure and inclusion of high-return oil and gas business to drive an improvement in growth and sentiment. There is an increasing possibility of HZL and Balco stake purchase. If the stake sale were to be completed by Q2FY14, the value accretion could be R4/share for Sterlite.
Aluminum and power businesses have troughed. With aluminum prices increasing 12% since November 2012 and negative regulatory new flow bottoming, investor sentiment is unlikely to worsen further. At FY14e (estimates) P/BV (price-to-book value) of 0.7x (times) and EV/Ebitda of 4.0x, valuation seems to be reflecting an overly pessimistic view and ignoring positives such as Sterlite?s strong balance sheet and improving visibility on catalysts.
Value drivers: Prices of zinc, aluminum, power and silver; copper TC/RC (treatment and refining charges). Coal costs for 2,400MW power plant, bauxite sourcing, progress on VAL (Vedanta Aluminium) and copper projects. Stake purchase in Balco and HZL.
Potential catalysts: Movement in metals prices. Completion of restructuring. Decisive progress on stake purchase in HZL and Balco.
Key risks: Metal price trends, regulatory issues. Progress on commencement of coal mining and developments in coal and bauxite sourcing costs. Disappointment on restructuring and minority consolidation process.
How will the company change after the Sesa-Sterlite merger? Though widely expected, this event can still help in re-rating once it is concluded. We acknowledge that Sterlite will shift from a net cash position to net debt after the restructuring. We expect Cairn to contribute 45% of pro forma Ebitda in FY14 and 41% in FY15.
?Morgan Stanley
