Vedanta: Attractive Valuation Allows For 15% Returns Over The Next 5 Years

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About: Vedanta Limited (VEDL)
by: The Growth Guy
Summary

Vedanta Limited is the largest diversified resource company in India - and one of the largest globally.

The company's top-tier mines have allowed them to be the lowest cost zinc producer globally, allowing them to survive regardless of the overall market.

Most importantly, the company is currently undertaking large investments, which should allow them to grow their different businesses substantially over the coming years.

Cash flows are increasing, yet the stock price is not, due to the cyclicality of the mining industry. Once this improves, the stock price should easily double to $20.

Although many risks are present, they are simply too valuable to be ignored. Due to the stock price being a falling knife currently, investors' best bet is to average down until the cycle turns.

Thesis

Vedanta Limited (VEDL) is one of the largest diversified resource producers globally. Although their parent company Vedanta Resources (OTCPK:VDNRF) is based in London, its focus and main operations are in India, where it owns many top-tier large production mines (along with South Africa, which we will look at shortly). Due to the low operating costs in many of them, the company becomes a cash cow when metal prices are high, and they are protected against any downturn in the markets. In fact, the CEO Anil Agarwal had even said:

“I’m not obsessed with commodity pricing because I always say to my people, ‘you should be so efficient and your costs so low that you are the last one standing, and you should know how to take a shower with a bucket’”

So, as it stands, Vedanta should continue to generate substantial cash flow over an average business cycle. Where things get interesting is the potential they have to grow in the future. Just like China has experienced over the past 30 years, India is expected to need to increase its demand for resources substantially over the coming decades, with per capita consumption of the vast majority doubling by 2030.

Vedanta is very well positioned to meet this large demand, and the company is currently investing heavily to allow it to do so over the next few years. Should they manage to achieve this growth, EBITDA could easily increase by up to 100% over the cycle, allowing for increasing dividend distribution and overall share price growth in the future. This, on its own, would be enough for the company to be a good investment. However, by taking advantage of the cyclical nature of the business, investors should be able to buy the company at rock-bottom prices, setting them up for substantial returns once prices recover. This is why I believe that even conservative investors should be able to double their money in this stock over the next 5 years - or a 15% compound return over this period.

Business overview - Zinc India is the lion's share of the company's earnings, but the rest of the businesses have great potential

Vedanta Limited is comprised of 6 main business segments - Copper (primarily smelting with the company owning the largest one in India), Zinc India/Zinc International, Aluminium production, Oil and gas production, Power generation, and Iron ore mining. At first glance, no one section of the company seems to have a large impact on the overall company's performance, since even the largest segment by revenue - copper - only comprises around 30% of their overall total.

Yet, as their profit statement above highlights, one segment does stand out amongst the rest: Zinc India/International. Although only being roughly 25% of revenues, due to it having EBITDA margins of 55%, it produces over 50% of the company's overall profits. Because of this, it is by far the most important thing to analyze when looking at the company and is the reason the stock price closely follows the commodity's movement.

As the name suggests, Vedanta's Zinc business is split between both its domestic and international operations. Zinc India is the term Vedanta uses to refer to its 65% stake in Hindustan Zinc, which operates 5 Zinc-Lead-Silver mines in the country. This is again mainly made up of just two mines, Rampura Agucha and Sindesar Khurd. With 50 million tons of reserves (at a grade of 14%), Rampura Agucha is the crown jewel of Vedanta, and has the status of the largest zinc mine in the world. Due to such high reserves, the mine is expected to remain in operation for many decades ahead, giving the company plenty of room to grow. In fact, whilst it and the company's other mines currently produce 947,000 KT worth of metals, this is expected to increase to around 1.2-1.5 MT worth over the next few years. Moreover, as I have already mentioned, the company is in the lowest quartile for prices, making this a very attractive opportunity.

The picture is similar internationally, with Zinc International consisting of the company's 74% stake in both Black Mountain mining and Skorpion mining. These are both based in South Africa (making me wonder why the subsidiary isn't simply called South Africa Zinc?), in its northern Cape province. In total, the mines in the region produced 157,000 KT worth of metals last year, which, despite not close to the scale of their domestic operations, is still a relatively large amount.

Most importantly, for the international business, and the reason it is an area of the company that is seeing increasing amounts of time dedicated to it lately is the potential growth of the Gamsberg Mine. Acquired by the company for $1.3 billion from Anglo American (OTCQX:AAUKF) in 2011, it is one of the largest undeveloped zinc deposits in the world. It had been avoided for good reasons - the mine's high manganese content would mean that potential operators faced high penalties from smelting. Yet, by sending this section of their ore to the companies own refinery, Vedanta has managed to get around this problem, allowing them to develop this untapped resource.

With the mine starting production this year, the company expects production to increase to around 250KT. Once phase 1 of the mine's life has been completed (Phase 2 and 3 are planned but will not start being developed until after phase 1 is fully developed), this will again increase to 400KT - over doubling overall production (despite some of their other mines finishing over this time.) Moreover, management believes that, once Phase 2 and 3 are completed, the total production for the Gamsberg mine will be 600KT - quadruple what all the operating mines in the region currently produce. This is again another sign that Vedanta should be able to expand its zinc business for many years to come, truly proving this is a growth investment which should deserve a higher valuation over time (as opposed to being completely range-bound over the past 10 years).

Aside from Zinc, many unappreciated opportunities exist for future upside

From the above, it is clear that the company's main Zinc business is strong. Even though not on the same scale, the company should also be able to expand in other areas, something I believe the market overlooks due to its focus on their main ventures.

A good example of this is the companies Silver business, which my fellow contributor Joshua hall discusses in this article. In summary, many of the company's planned and current operations contain large amounts of Silver alongside other commodities. This is effectively free money for the company, due it being a by-product of what would already be a very profitable venture. Furthermore, this isn't just a small bonus either - the amount of silver the company produces already gives a position in the top 10 largest silver producers in the world (9th), and should the company be able to deliver on its growth projections, it could easily be within the top 5 shortly. To put this into perspective, Fresnillo (OTCPK:FNLPF), the biggest silver producer in the world, currently trades at a valuation of $7 billion. Although Vedanta only produces around 40% of its total currently, (20 vs. 60 million ounces), this would result in its worth being 2.5 billion - around 25% of their market cap.

Add in the potential growth, and it is clear it will be worth even more. This is a clear example of the margin of safety with Vedanta's stock price and highlights how many of their other operations are worth a substantial amount on their own.

Also worth highlighting is:

The Aluminium business - very small margins, meaning small improvements can impact profits drastically.

Oil business - multi-billion-dollar investments should allow the company to double production in the next few years.

Valuation

With a solid growing business, it is clear to me that Vedanta should be valued progressively higher due to the increased average cash flows that it gains over the business cycle. Even though this would seem obvious, one glance at the stock makes it appear the market doesn't think so.

Chart Data by YCharts

Its share price has remained very range-bound over the past 5 years, with it peaking at $20 both in 2014 and 2018 before trending lower. It has also been very volatile over this time, with the price declining by over 75% only to rally 400% in the span of just a few years. Because of this, one needs to be certain that they invest in this company at the right time if they want to outperform.

As I have mentioned, the company's earnings are predominantly based on their zinc business. Because of this, the stock price correlates the fluctuations in the metal's price.

Image result for zinc prices 10 years

Despite this, the correlation seems to have diverged recently. Looking at the two charts above, it is clear that the price of Zinc has actually recovered recently, and yet Vedanta's stock price continues to decline. Judging by what the price was last time it was at this level, the shares should be trading at around $15 currently, not $9 as is actually the case.

Even though this suggests the company is oversold, there is still reason to be cautious in the short/medium term. Although zinc prices have held up on a longer-term basis, recent events mean the market is likely predicting prices to fall far lower, as they have started to do recently.

1 Month Zinc Prices - Zinc Price Chart

With the recent delay in trade war talks, and Trump saying that China "broke the deal", the optimism in global growth that has been present in 2019 is now reversing. Unless one side is bluffing, US tariffs on Chinese goods will be going up from 10% to 25% on Friday, which is certain to hurt both countries' economy and dampen demand for commodities in general. Moreover, if this does end up being the start of a recession, as some fear, Zinc prices could easily drop to $1 or lower, which would impact Vedanta's margins significantly.

Taking all of this into consideration, I believe it is fairly likely that, should the trade war not finish shortly, Vedanta could retest its 52-week low ($8.49.) For investors willing to stomach some volatility, this is a good entry point to open a position. However, due to it having the potential to drop far lower, possibly by up to 50%, this isn't for the faint-hearted. Dollar-cost averaging into a position is, therefore, advisable to take advantage, should it drop.

Ultimately, should the company be able to execute on its growth plans, its fair value should be around $20 in 5 years' time. This isn't taking into account the temporary increase in Zinc prices that have previously taken it to this level - with this ability to take it far higher, if lucky - but instead, an average over the whole cycle. Due to this, even an investment today should return 15% a year, translating to one doubling their money over 5 years, with the potential to return even more if it drops.

Risks

As with anything in life, there is no such thing as a free lunch when investing. For all the positives, Vedanta does have a few risks worth highlighting, all surrounding the company's management.

This is since last year, the CEO Anil Agarwal bought out the remaining stake in Vedanta Limited's parent company, Vedanta Resources, that he didn't already own, meaning it is now owned by Volcan, the family trust. This gives the family a controlling stake of 50.1% in Vedanta Ltd, which they seem to be using to their advantage. In January, it was announced that Vedanta was buying Volcan's stake in Anglo American for $200 million, which, whilst is a better investment than low return bonds (the company's reasoning for the decision), makes no sense when either paying off debt or buying back shares would be a better use of capital. This was quite simply Anil's way of funneling money out of the company for his own personal use, a bad sign for shareholders (shown by the stock falling 15% on the news)

Unfortunately, there isn't anything shareholders can do about this, meaning that similar deals could easily happen in the future. Luckily, the company does pay consistent dividends to shareholders (up to 10% in the good part of a cycle), which mitigates the damage events like this could do. Something worth taking into consideration, though, is that, with Vedanta being so cheap, Volcan may also look to buy it out in the future. Should the price fall, even a high premium would result in current shareholders losing out, which is a risk shareholders must take.

Conclusion

Vedanta is a solid growth investment, which, due to volatility, is now very attractively valued for long-term investors. Despite having its problems, the potential gains far outweigh the risks, and investments today should end up performing well once sentiment in metals recover. I personally plan to see how the trade negotiations play out over the coming days and initiate a position once I see a bottom in the stock starting to form, simply due to its potential to drop even further than it has currently in the short term, should recession risks grow.

Disclosure: I/we 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.