Thursday, 13 November 2008

Sterlite Industries, attractive bet for long-term investors

Institutional Holding: 13.6%

Dividend Yield: 1.38%

P/E: 12.8

M-Cap: Rs 17,439 cr

CMP: Rs 246

The commodity cycle has taken a U-turn and so have the stock prices of many companies producing these commodities. A full-blown global financial crisis has further blighted their beleaguered fortunes, as investors have taken a hurried flight to safety.

As earnings of metal producers are highly co-related to economic cycles, there has been a sharp fall in stock prices of most metal companies. In many cases, the fall in stock prices hardly matches the expected fall in earnings of the commodity producers in the near-to-mid term. On the other hand, the market capitalisation (m-cap) of a stock like Sterlite Industries has fallen so sharply that the sum-of-parts valuation makes the scrip very attractive. This throws open attractive opportunities for longterm investors to accumulate the stock at current levels.


Sterlite Industries mainly produces non-ferrous metals, especially copper, aluminium, zinc and lead. Its copper business contributes 50% to the topline, but only 10-15% towards operating profit. This is because Sterlite mostly gets treatment and refining charges in copper, which are relatively lower. Zinc is the most profitable business out of the three and accounts for 30% of the company’s revenue and 60% of the total operating profit.

Sterlite operates the zinc business through its listed subsidiary, Hindustan Zinc. In the aluminium business, Sterlite has a production capacity of 0.4 million tonnes (mt) and plans to expand it further. In the aluminium and zinc business, it is an integrated player (partially in case of aluminium) and is one of the lowest cost producers in the world. The average unit cost of production for zinc and aluminium is $686/tonne (excluding royalty) and $1,750/tonne respectively. The cost of production for aluminium will further come down once Sterlite completes its backward integration by CY09.


The company’s net sales (on consolidated basis) have more than tripled over past three years to Rs 26,400 crore. The net profit increased by seven times during the same period. Interestingly, it has never made any loss in the past 15 years, not even at the bottom of the last commodity downward cycle. It is also the largest zinc producer in India with an operating margin of 55-60%.

Even at the current price level (~$1,200 per tonne) of zinc, which is much below the marginal cost of production for many players across the globe, Sterlite can manage to maintain an operating margin in the range of 40-45%. The company has an operating margin of 25% in the aluminium business, which is a little lower than its competitors like Nalco and Hindalco. This is because it is still not fully integrated backwards in the aluminium business and meets its alumina requirements partly from the open market. It has a return on capital employed (RoCE) of around 25%, with the highest being in the zinc business (~90%).

Expansion plans:

Sterlite is ramping up its zinc and aluminium capacity significantly. The company will increase its zinc capacity to 1 mt by FY10. Similarly, the aluminium smelting capacity in Korba in Chhattisgarh will expand by 0.32 mt — almost double that of the current capacity.

Post-expansion, the aluminium production capacities at Jharsuguda and Lanjigarh in Orissa, which fall under Vedanta Alumina (VAL), will also increase by 1.25 mt. Sterlite holds 29.5% in VAL and will benefit to that extent. Its parent company, Vedanta Resources, has recently obtained clearance for mining bauxite reserves in Orissa, which will help it lower the cost of aluminium production. The merchant power generation business will be another growth driver. The first phase of the 2,400-mw power plant is expected to get commissioned by the end of calendar year ’09.


Since Sterlite holds stakes in different operating subsidiaries and also operates on its own in certain business lines, ETIG valued the company by the sumof-the-parts (SOTP) and the discounted cash flow (DCF) methods. It holds a 64.9% stake in Hindustan Zinc, a listed entity. At its current price level, the stake is valued at around Rs 8,662 crore. Further, Sterlite had investments in different liquid mutual fund (MF) schemes valued at Rs 7,700 crore at the end of March ’08.

The net asset values of many of these fund schemes (mainly debt funds) have either remained flat or have increased over the past six months. The overall portfolio was discounted by 10% to arrive at a conservative current market value of Rs 7,000 crore. Sterlite’s stake in Hindustan Zinc and its MF investments add up to Rs 15,662 crore of the company’s total value. Further, Sterlite’s earnings before interest, depreciation, amortisation and tax (EBITDA) has been taken as proxy for its operating cash flow for its copper and aluminium businesses.

Assuming a conservative 5% growth in EBITDA level for seven years, a flat terminal growth rate and 25% discounting factor, Sterlite’s present value comes close to Rs 13,000 crore, as per the DCF model. If the values arrived at from the SOTP and DCF methods are combined and further adjusted for Rs 3,200 crore of debt, Sterlite’s fair m-cap comes to Rs 25,575 crore, much higher than the current mcap of Rs 17,439 crore.

The values that are expected to be realised from the energy business, zinc and aluminium expansion plans were excluded to arrive at the fair value. These will certainly add much more value to Sterlite in the future, once the expansion process concludes. Long-term investors can include this stock in their portfolio.

Source: EconomicTimes

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DISCLAIMER: The author is not a registered stockbroker nor a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity, index or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. The author recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and that you confirm the facts on your own before making important investment commitments.