The Easy Part May Be Over For Vedanta Resources

| About: Vedanta Resources (VDNRF)
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Vedanta shares have rallied more than 20% on optimism over base metal prices, self-improvement efforts, and a new pro-business government in India.

Management still has much to do to improve costs and production in copper and aluminum, and it's still unclear if consolidating Hindustan Zinc will move forward.

Vedanta looks about 5% to 10% below its NAV fair value, but weak Q1 production and EBITDA numbers are a reminder of the execution risks still present.

India-focused Vedanta Resources Plc (OTCPK:VDNRF) (VED.L) has come along pretty nicely since I identified it as an undervalued resource company back in December of 2013. After a 20% run that has outpaced peers like Glencore Plc (OTCPK:GLNCY), Rio Tinto (NYSE:RIO), and BHP Billiton (NYSE:BHP), I'm not quite so bullish on the shares. Although Vedanta has much to gain from more efficient operations, a more pro-business government in India, and stronger base metal prices, ongoing operating challenges in copper, aluminum, and iron ore are not to be ignored. There's still a lot of self-improvement potential here, but it won't be light work and investors will have to have some patience.

A Weak Fiscal Q1 Update

Vedanta hasn't really helped its cause with its latest production and EBITDA update. Pretty much everything but aluminum came in below expectations in terms of production volumes, with copper about 15% below expectations (combining Indian and Zambia) and combined zinc production coming in about 20% below. Oil and gas production was about 6% below expectations, but up 3% yoy.

Not too surprisingly, lower than expected production has led to lower than expected EBITDA. EBITDA for the first quarter rose 1% yoy and fell 9% sequentially, missing the average estimate by 6%. Oil/gas saw 1% EBITDA growth (and chipped in more than 50%) and aluminum EBITDA rose 74%, while zinc profits fell 14%.

Will The Indian Government Be More Cooperative?

Governments are often heavily involved in the operations of mining companies, and India is no exception, though it skews far more negative than most and has become one of the worst-rated mining jurisdictions in recent years. There is hope now that the newly-elected and generally pro-business BJP government will change things. Given the considerable intersection of Vedanta's operations and the Indian government, that would be a welcome improvement.

Vedanta has long wanted to buy out the government's 29.5% stake in Hindustan Zinc, a move that would improve transparency and significantly improve the ease of moving capital across the business. It would likely also allow for more efficient operations and cost controls, though the government does not wield operating authority. The BJP has traditionally been pro-privatization, in contrast to the prior government's decision to drag its feet, but there are still regulations and uncertainties as to whether Vedanta will be able to acquire all of this stake and on what terms.

Vedanta is also hoping for better operating conditions for its aluminum operations. The company wants a captive supply of bauxite (likely in Orissa) to improve its cost efficiency, but government authorities have resisted this. The company would also like to use its own power plant to power its own smelter, but hasn't been able to due to a requirement to pay grid access charges to the state power company. While this requirement was confirmed by the Supreme Court, there is some hope that the laws could be amended - a significant potential development for Vedanta, as those access charges are a meaningful value-destroyer.

Last and not least, more sanity in the iron ore sector would be welcome. A mining ban in Karnataka was lifted in late 2013 and the Goa was lifted earlier this year, but Vedanta is still looking at a 10% revenue surcharge to local governments and a 30% export duty, as well as overburden dumping restrictions. Absent big improvements in local demand for iron ore, this is going to limit the value Vedanta can hope to create from its iron mining operations in the near term.

Can Vedanta Benefit From Stronger Base Metals?

Base metals have gotten more popular recently, helped by Indonesia's decision to implement an export ban on ores including copper, bauxite, alumina, zinc, and nickel. Freeport-McMoRan (NYSE:FCX), a major copper miner in Indonesia, is trying to work with the government to ease the ban at least in part, but it has provided a nice tailwind for copper-focused companies like First Quantum as well as companies with significant zinc exposure like Hudbay (NYSE:HBM) and Teck Resources (TCK).

What has been a boon for First Quantum, Hudbay, and Teck may prove far less advantageous for Vedanta. For starters, Vedanta's lack of captive bauxite production leaves it vulnerable to higher market prices for bauxite and alumina that it may well not be able to offset with higher aluminum prices. Second, zinc production levels have been declining (down 23% in India in Q4, and down 32% in Q1) and costs have been rising, reducing the company's leverage to better pricing. Likewise, and even more so, in copper. Production in India has been picking up, but so have costs and Vedanta is only in the very early stages of addressing significant cost issues in its Zambia operations.

Given their relative positions in terms of production and production costs, I expect First Quantum, Hudbay, and Teck to benefit from this base metal tailwind considerably more than Vedanta. That said, seeing these missed opportunities go by is likely to incentivize the company (and perhaps the Indian government) to get their houses in order to optimize production and production costs.

Self-Improvement Potential, But No Certainty

BHP and Freeport-McMoRan both have sizable oil and gas operations for a mining company, but Vedanta generates more than half of its EBITDA from oil/gas and more than 30% of its estimated net asset value. Cairn India (the oil and gas operations) is still highly exploration-focused, and while that raises the possibility of significant discoveries, reserve additions, and projected future cash flows, it also represents the risk of rising costs and exploration disappointments (as investors in Tullow Oil (OTCPK:TUWOY) know quite well).

I am expecting Cairn to be a pro-growth operation, and I do have bullish leanings about Vedanta's efforts to improve its India-based zinc and copper operations. I'm less hopeful about the Zambian copper operations and the Indian iron ore operations, though I'd acknowledge that there's almost nowhere for that business to go but up.

Due in large part to these self-improvement efforts, I still believe Vedanta has above-average EBITDA growth potential and that this growth merits a higher multiple than I'd normally give to a large mining company (7x fiscal 2015 EBITDA). That doesn't support a tremendous fair value today, and neither does the net asset value calculation, which has improved about GBP 0.50/share since my last write up (to GBP 11.50/share or about $19.50/ADR). Within that NAV estimate, oil & gas and zinc/lead account for nearly equal amounts (about 30%), with power, copper, and aluminum all worth more than 10% each.

The Bottom Line

I still like base metals, but Vedanta, Anglo American (OTCPK:AAUKY), and Glencore have all run to a point where I just don't see that much obvious undervaluation left in the shares. Higher prices, lower costs, and better overall operating results will be needed to take the shares further and that's going to require more effort and execution from management. Accordingly, I don't hate Vedanta by any means, but Freeport-McMoRan, Hudbay, and Thompson Creek (TC) could all be names to consider to play the same them with perhaps better value in the investor's favor.

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

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