Sterlite: A Buy on Valuation?

Nov. 5.09 | About: Vedanta Ltd (VEDL)

Sterlite (SLT) is trading at a very reasonable value; no doubt higher than the bad bear values, but with sufficient upside potential for both long term investors and speculators. Please access “The Quant Report” here (or link straight through to the Sterlite file) for data based on which below commentary is based.

Operating Risk

SLT has low levels of operating risk. Between March 31, 2000, (fiscal 2000) and March 31, 2009, the company has delivered annualized earnings growth of 20.55%. The dividend has grown an abysmal annualized rate of 0.23%. Including estimates for the year ended March 31, 2010, the annualized growth rates are 12.6% and 0.21% for earnings and dividends respectively. The six year median earnings levels between the year ended March 31, 2005, and 2009 has grown at 42.91% annualized and growth in six year median earnings at the end of March 31, 2010, is expected to clock in at 35.22%. SLT is cyclical and strongly influenced by the economic cycle - the annual rate of earnings growth (year on year) was huge during fiscals 2003 (235.88%), 2004 (65.8%), 2006 (96.3%) and 2007 (246.9%). During fiscals 2008/09/10, growth has been negative at 18.9%, 26.8% and 39% respectively. This is a high degree of volatility even for a cyclical stock. High volatility creates the perception of high risk. This can have a significant impact on valuations in that it sets up beautiful entry points for long term investors and equally appealing trading gains over shorter time horizons.

Its cyclical nature will create good entry opportunities and good exit opportunities as it dances to the song of the economic cycle. Normally the Materials sector tends to outperform off bear market bottoms, about 6 to 12 months before a typical recession ends. After the recession ends, Materials will normally outperform for another 12 months or so before returning to a market-perform cyclical phase. We are presently headed for a period when Materials can be expected to out-perform. For SLT, this could mean a period of significant speculative (short term) gains over the coming 12 months. SLT trades at a very modest premium to 2010 projected fair value. However, buy and hold investors need to be aware that bear values lie far below fair value as a result of the great historic volatility in earnings.

Future Growth Potential

All told, I believe SLT has put in a solid long term performance. As regards the future, I believe SLT in can return to 12% year on year growth with little to no risk. Growth could be higher given that the payout from significant investments during fiscal 2008, have yet to fall through to the bottom line. SLT is seeking to acquire Asarco LLC, which is a potential growth trigger. However, this deal has been so volatile that I would not count on it happening. As it happens, I believe SLT is reasonably valued even ignoring growth from Asarco. Sterlite has raised capital twice during the few months, including once only a few weeks ago. These monies are not to repair a damaged balance sheet but to grow earnings through significant investment in copper. Copper as we know, leads out of recessions, and SLT’s strong presence in India gives it a brilliant market in which to grow. In India the infrastructure sector is going through a huge period of growth. In my view, infrastructure in India is very fully valued, but material providers are still fairly valued.

Creation & Return of shareholder value

What is great is that a long term investor, who purchased shares at annual average prices during fiscal 2000 and diligently re-invested dividends in shares, would have made an annualized return of about 16.9%. This compares with Sensex which has returned 14.41% over the same period. I do expect SLT to outperform the Sensex for the next 12 months.

The growth in earnings and core long term earnings potential has been reasonable for SLT. Dividend growth has been delivered at disappointing rates but when you consider the scale of long term investments undertaken and the prudent balance sheet, it is understandable. Payout ratio has run at median levels of 8% to 9%; this level of payout is fully acceptable when you consider the need for investment in future growth. All in all SLT has done a satisfactory job in value creation and return.

Financial Risk

Growth requires investment and investment needs cash. A company's capital structure indicates how the cash is raised. What part of it is equity, what part of it is debt and what part of it is hybrid (debt with characteristics of equity or vice versa).

The Modigliani-Miller theorem says that the value of a levered company is equal to the value of an un-levered company plus the marginal rate of tax multiplied by the market value of debt. Simply put, if a company borrows money as part of its capital structure, it will be worth more than if it finances its capital structure 100% equity. The rational is simple, when you borrow, you pay interest; this is tax deductible. The dividend on equity is not. Thus the market value of a levered company must be higher. In numbers it works like this; if you buy an asset for 100 and expect it to generate 10 (14.29 pre-tax) in post tax cash flow in perpetuity, and the cost of equity is 8%, the future value of cash flows is 125; this is your market value. This assumes a tax rate of 30%.

Now if you have a tax rate of 30% and you borrow 30 at 10% and use 70 from equity costing 8% the picture changes. You now have post tax cash flow in perpetuity of 7.9 (14.29 pre-tax cash flow, minus 3 in interest charges and minus 3.39 in tax). At an 8% cost of equity, this is worth 98.75. And the debt is worth 30 (3 in perpetual interest cash flow with a 10% cost of debt); so the total worth is 128.75 compared with 125 previously. For the equity holder, in an un-levered company 100 is worth 125 (Market Value to Book Value of 1.25); in a levered company 70 is worth 98.75 (Market Value to Book Value of 1.41). So you can see that leverage is an important tool to create shareholder value.

The problem with the words of wisdom of Messrs Modigliani & Miller is that their wisdom is often not understood or misused. In the real world, debt holders want their money back; your operating cash flows need to be sufficient to pay back both the interest and principal. You can replace debt by borrowing as you pay down debt, but the cost of debt changes as the economy transitions through its cycle. In addition, during times when the yield curve is inverted and risk aversion is at high levels, access to debt might be very constrained. At the same time, earnings and operating cash are volatile over the course of an economic cycle. This acceptance of volatility is one reason why equity investors demand a higher return expectation compared with debt providers; volatility implies risk and risk demands a return premium. Debt is a two edged sword. Using debt enhances shareholder value, but using too much debt can cause future dilutive events which will destroy shareholder value.

In July 2009, SLT raised $335 million through ADR’s. As I mentioned previously, this capital raising is unlikely to be dilutive because it will drive earnings growth from expansion of SLT’s copper portfolio. During October raised a further $500 million. The threat of dilution caused the market to worry. In a sense, SLT could have raised non dilutive debt without damaging is balance sheet. But why should they; the convertibles (debt to convert to ADR’s) are issued at a 40% premium to the market price on the date of issue; the coupon is low at 4% and you can be sure that the growth coming from investment of funds will ensure there is no dilution. I believe a prudent balance sheet makes sense at present, especially considering the capital which might be required to acquire Asarco if the deal comes to fruition.

At the end of fiscal 2009, SLT had a strong un-leveraged balance sheet, net of cash and cash equivalents. At the end of fiscal 2009 the company was very lightly leveraged with a debt to debt plus equity ratio of just over 5%. In my view, there is potential to add leverage and acquire growth. In the unlikely event that M&A activity is not on SLT’s mind, adding leverage to a 20% of debt plus equity level is fairly safe even in the present climate; it can enhance shareholder value. The funds raised could be returned via dividends, buybacks or a combination of the two.

Economic Risk

In my view, the economy has recently entered an early phase of expansion. While the expansion might be less robust than bulls predict and the next contraction may be harsher than the bears expect remains to be seen. What I do see is an expansion commencing, and one that is good for at least six months. The signs for reversal will be watched for, but personally, I expect signs of trouble to emerge no earlier than 2012; of course I could be wrong.

SLT is considered a large cap in India which is its principal market of trade; this adds a touch of defense. SLT is a cyclical stock; the earnings volatility adds a level of risk. This brings me to valuation risk; which is modest for long term buy and hold investors but possibly very low for speculators. I refer a modest valuation risk for the long term investor, but do keep in mind that huge earnings volatility has caused SLT to trade well below fair value on several occasions. I do believe that going ahead earnings volatility will normalize to a level more consistent with the sector; the past few years have had massive growth and investment and abnormally high standard deviations on earnings is an outcome one must expect.

Financial risk is low as a result of a strong balance sheet. But keep a watchful eye on news flows and M&A activity; the strength of a balance sheet can quickly change and since Indian companies do not include balance sheets in their quarterly reporting, investors do not always have good visibility on leverage until the year end.

This brings me to valuation risk.

Valuation Risk

SLT trades at near Rs 800 per share. In my view, 2010 fair value of the share is near Rs 750. Let's be clear, my fair value calculation is based on an adjusted version of Gordon's Dividend Growth Model. I use 6 year median EPS as a base long term earnings. I use a notional payout ratio of 40% as reflecting the notional dividend; if the actual payout is lower, it's not a problem because the lower payout will drive future growth higher than growth rates assumed in my calculation. The future notional dividend flows together with growth in notional dividends at a rate equaling the forward nominal GDP growth expectations (12% for India), are discounted back to today at rates equaling a slight premium the long term return (16% for India) on the main market of trade. This discounted value is fair value; fair value is a level where markets rarely trade; but when they do, it is time for long term investors to consider buying.

The share price is well below forward fair value expectation (Rs 1,344) projected out to 2014. So I can call SLT a buy on valuation for long term investors.

Persons who trade can take speculative positions for the upside potential left in this economic cycle. In my view, over the course of economic cycle, the stock has a potential price target of Rs 1,600 with potential to rise to 2,150. Over 12 months, the gain potential is in my view to Rs 1,200 levels; keep in mind that Materials can be expected to out-perform during the coming phase of the economic cycle.

In US SLT is trading at $16.93 which is close to the Rs 800 in India.

Disclosure: Long indirect positions in SLT, with intent to add small speculative positions at Rs 800 or below.