Sterlite Industries’ healthy cash reserves, capacity expansion plans and power foray provide cushion from further downside.
The international metal prices have fallen by 50-60 per cent on account of the slowdown in global demand. This along with worries pertaining to project funding due to tight liquidity, possible delay in capex plans and downgrades in earnings, have been key reasons for the 75 per cent drop in the share price (from Rs 1,084 peak levels in January 2008) of India’s largest non-ferrous metals producer, Sterlite Industries. While most of these worries are reflecting in the share price, the decline in input prices should see margins stabilise soon. Thereafter, a possible recovery in metal prices, expected in the next 3-4 quarters, could rub-off positively on the stock. Nevertheless, there are other triggers, which along with the company’s strengths in its businesses make this stock an attractive long-term investment.
End of meltdown?
Despite the slowdown in demand and decline in metal prices, Sterlite is placed comfortably as it is amongst the lowest cost producers globally, having its own mines. The company’s diverse presence in aluminium, copper and zinc should enable it to balance any adverse impact in either of the businesses. For now, the good news is that raw material prices are also falling. Like in the case of Zinc, which contributes about 70 per cent of the consolidated operating profit, the fall in zinc realisations should be partly compensated by the decline in input prices.
Sterlite’s zinc business is represented by its 64.9 per cent subsidiary, Hindustan Zinc (HZL), which enjoys a 60 per cent share in the domestic market. International zinc prices have corrected 60 per cent from its peak of about $2,825 per tonne to current levels of $1,130 per tonne. Little wonder, that during Q2, FY09, the company’s EBIDTA margin fell to 53.6 per cent from 71.6 per cent in Q2, FY08. Estimates indicate that margins may correct further to 40-45 per cent in H2, FY09 and thereafter stabilise or improve in FY10. Notably, the business remains profitable as the company is among the lowest cost producers globally, producing zinc at $884 per tonne (including royalty) as against the global average of about $1,000-1,100 per tonne.
Further, the recent correction in international prices of raw materials like met coke and coal leaves room to save on production cost. For instance, coal prices (about 40 per cent of cost of production) have corrected from $200 per tonne to about $70 per tonne now.
While realisations in FY09 would be lower as compared to FY08, the pressure on margins could ease and perhaps get better in FY10. Also, growth in volumes, aided by capacity expansion, will help sustain absolute profits.
| MARGIN FORECAST | ||||
| EBIDTA/tonne | 1HFY09 | 2HFY09E | FY10E | FY11E |
| BALCO $/tonne (aluminium) | 1,134 | 509 | 766 | 614 |
| HZL $/tonne (zinc) | 1,265 | 612 | 828 | 1,213 |
| Sterlite $/tonne (copper) | 1,130 | 695 | 473 | 466 |
| E: Analyst estimates | ||||
Prospects in aluminium
Sterlite’s aluminium business is represented by its stake in Balco (51 per cent) and Vedanta Aluminium (29.5 per cent). Balco currently contributes about 16 per cent to Sterlite’s consolidated revenues. With the international aluminium prices down by over 50 per cent, EBIDTA per tonne is expected to fall to $509 in H2, FY09 as compared to $1,134 per tonne in H1, FY09. Notably, margins are expected to improve in FY10, led by recovery in aluminium prices. Meanwhile, lower alumina and fuel costs should lead to savings of about 20-30 per cent in production costs in this business.
The weakest link
There are equal concerns for Sterlite’s standalone copper business. The copper business comprises smelting and processing of copper and, production of its by-products like sulphuric and phosphoric acids. Sterlite generates about 47 per cent of its consolidated revenues from the copper business, but it only contributes about 14.5 per cent to the operating profits. The deficit in copper concentrate (raw material used in copper refinery) and falling copper demand as well lower prices has resulted in a drastic fall in refining margins.
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Sterlite’s Tc/Rc (treatment and refining charges) margins have fallen from about $0.31 (or 31 cents) per lb in FY07 to $0.16 per lb in FY08 resulting in lower profits from the copper business. Add to this, prices of sulphuric and phosphoric acids, too, have fallen. Going forward, the outlook for the copper business remains weak on account of lower volumes and lower prices. The only respite is in the form of a likely improvement in global Tc/Rc margins in FY10, which should help in reporting healthy margins in the business.
Jewel in the crown
While there is medium-term concern regarding the core metal business, Sterlite’s foray into commercial power provides a strong trigger for the stock. Sterlite Energy, a wholly owned subsidiary of Sterlite Industries, has envisaged ambitious plans to develop power projects with a combined capacity of about 10,000 mw over the next five-six years. Of this, the development of the 2,400 mw thermal power plant is at advance stage.
While some of this capacity will take 3-5 years to get commissioned and reflect in revenues, the first phase of 600 mw of its 2,400 mw power plant is expected to come on stream by December 2009; the rest three units (600 mw each) will follow over subsequent quarters (by September 2010, full 2,400 mw will go on stream). Even at a blended selling price of Rs 2.5-3 per unit and a plant load factor (PLF) of 70 per cent, the revenue potential in the power business is Rs 3,500-4,000 crore or about 16 per cent of FY08 consolidated revenues.
Investment rationale
The concerns regarding Sterlite’s core metal business will take some time before things stabilise, which is why analysts have cut the company’s earnings estimates by 30-40 per cent and the stock has taken a beating. As against the valuation of 10 times its EV/EBITDA and 12-13 times trailing PE multiple seen in January 2008, the stock is now available at 2 times EV/EBITDA and PE of 5 times its FY09 estimated earnings.
Although valuations look reasonable, the company also holds significant cash equivalents of about Rs 12,000 crore (after adjusting for debt), which is about Rs 170 per share. The high cash levels combined with annual cash profit of over Rs 4,000 crore, not only provides cushion from further downside, but also acts as ammunition to fund growth plans and acquisitions (America’s copper major Asarco, remaining stake in Balco and HZL).
To sum up, there is limited down side to the stock on account of low valuations, cost leadership across businesses, embedded value of subsidiaries and, healthy cash position. At Rs 275, the stock is a value buy for the long term.