Sterlite: A Strong Buy At Compelling Valuations

| About: Vedanta Ltd (VEDL)
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Before discussing the key factors for believing that Sterlite Industries (SLT) can double from current levels, I would like to list down some key operating and valuation metrics for the company compared to the industry average.

Besides these key metrics, Sterlite is also trading at just 0.57 times its book value and at 2.16 times the EV/EBITDA (EV calculated on June 7, 2013). Considering these metrics, there is no doubt that Sterlite is trading at cheap valuations. A more important analysis is the reason for trading at current valuations and the probability of trading at fair value in the foreseeable future.

Reason For Cheap Valuations

Closure of the Copper Smelter

On March 29, 2013, Sterlite's Tuticorin copper smelter was ordered to be shut by the Tamil Nadu Pollution Control Board after the alleged leak of noxious sulfur dioxide gas. The copper smelter, which produces 400,000 tonnes of copper every year, is among the top 15 copper smelters in the world and the largest in India. The copper smelter accounts for more than half of India's industrial production of copper. The shutdown of the smelter is one of the primary reasons for depressed valuations for Sterlite.

The good news for Sterlite is that the environmental court has allowed the company to reopen its copper smelter. According to Livemint -

Sterlite Industries (India) Ltd won interim relief on Friday from an environmental court that allowed it to reopen its copper smelter in Tuticorin, Tamil Nadu, pending a final judgment on the fate of the plant, which was ordered to shut two months ago after the leak of a noxious gas.

The plant, India's biggest copper smelter, is likely to reopen in around a week's time after the National Green Tribunal's ruling, with a rider that a committee will be formed to check its emissions and submit a report. The tribunal ordered the panel to meet within a week and be present at the plant when production resumes.

The committee will visit the plant at least three times and prepare a report on the functioning of the plant, as also the functioning of the anti-pollution equipment installed there. It will also study the emergency plan in and outside the plant, the order said.

The Supreme Court order had also observed: "The plant of the appellants contributes substantially to the copper production in India, and copper is used in defence, electricity, automobile, construction and infrastructure, etc."

The bench, headed by Chairperson Swatanter Kumar, said the order will be in force until a final judgment is announced. The court will issue a final order after 10 July, he added, to follow Friday's interim order.

Considering the interim order and the stress by the court on the fact that Sterlite contributes significantly to copper production in India, it is very likely that the final order will be in favor of Sterlite. The final order should trigger upside for the stock from current valuations, which is extremely cheap. It is important to mention here that the closure of the smelter has resulted in demand-supply imbalance and sales should be more robust on the resumption of the smelter operations.

Impending Merger of Sesa Sterlite

The Sesa-Sterlite merger, which will create one of the largest diversified natural resource major in the world, has been impending since 2012. Delay in approval by various courts and stakeholders have resulted in the merger being still impending. This uncertainty has depressed stock prices to some extent. However, as the table below shows, the merger is on a verge of completion and it will result in significant synergies. These synergies are expected to generate cost savings of $200 million per annum. Further, the consolidation is expected to be earnings accretive to Sesa Goa, Sterlite and Vedanta shareholders immediately post completion.

Slowdown In India And China

Besides these two major factors, another reason for depressed valuations is the current economic scenario in India and China. Since Sterlite caters primarily to these two countries, the slowdown has had an impact on valuations. The chart below gives the FY13 revenue breakdown by geography for the company.

With the factors discussed for the current valuation, I would now shift focus on the proposed merger, its impact on the Sterlite ADS and the details of the post merger entity.

Impact on Sterlite ADS

According to proposed merger deal, the Sterlite ADS (listed in NYSE) will have the following impact -

Sterlite will merge into Sesa Goa to create Sesa Sterlite, through the issue of Sesa Goa shares to shareholders of Sterlite via a scheme of arrangement under Indian law (see below). Sterlite shareholders as of the record date, to be determined after obtaining all necessary approvals, are expected to receive 3 Sesa Goa shares for every 5 existing Sterlite shares. Sesa Goa also intends to establish an ADS facility comparable to Sterlite's current ADS. This would allow holders of Sterlite's ADS as of the record date to receive Sesa Goa ADS with appropriate adjustments to reflect the foregoing exchange ratio. The merger is subject to compliance with all applicable laws, including the legal requirements of all the jurisdictions in which the distribution is made, and the rules and regulations of all applicable stock exchanges. Each Sterlite ADS currently represents four equity shares of Sterlite.

New Group Structure After Merger

The chart below gives the new group structure post merger with the parent company (Vedanta Resources) holding a 58.3 % stake in Sesa Sterlite (the merged entity). The backing of a strong parent company serves as a long-term positive for the merged entity.

Asset Portfolio Post-Merger

The merger will result in Sesa Sterlite having total assets of $36 billion with $1.9 billion of net income and an EBITDA margin of 47% (FY13). Further, the cash and liquid investments for the merged entity will be $7.7 billion (considering the March 2013 cash position) with a net debt position of $6.6 billion. The chart below gives the company's asset portfolio post-merger. As evident, Sesa Sterlite will have a presence and operations in the zinc, lead, silver, aluminum, copper, iron-ore, oil & gas and commercial power segment.

Long-Term Outlook

India's growth has been negatively impacted by a global slowdown coupled with policy paralysis in the country. With elections due in 2014 and a high probability of regime change, India's growth trajectory can improve going forward. This will help Sterlite, which has major investments and a strong position in India in sectors, which are necessary for economic growth. Sterlite has a leading market share in the production of zinc, lead, aluminum and copper in India. Also, with a 58.8 % stake in Cairn India, Sterlite is a key player in the oil and gas industry.

Considering the significant growth prospects, Sterlite will be investing $3 billion each in the oil & gas sector and the metals & mining sector in the next three years. Going forward, this will translate into a significant revenue upside for the natural resources major.

Conclusion

Considering the long-term growth prospects, the synergies of an impending merger and the positive court ruling, Sterlite is trading at very cheap valuations. A PEG ratio of 0.29 does indicate that the stock is meaningfully undervalued with respect to its future growth potential. With the completion of key events discussed above, Sterlite has a potential 100% upside from current levels. Investors can consider exposure to this growing natural resources entity at current levels for handsome returns in the medium to long-term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.