Vedanta: Capital Allocation Overhang Clouds Yet Another Strong Quarter

Summary

• Vedanta Ltd. posted another robust set of quarterly results, benefiting from the continued commodity pricing strength.
• Planned capacity expansion is a step in the right direction as well and should boost earnings growth.
• While a dividend hike is on the cards, the outsized debt load at parentco Vedanta Resources means capital allocation risks remain.

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Vedanta Ltd. (NYSE:VEDL), a leading diversified resource player globally, recently delivered another solid quarter, benefiting from the continued commodity pricing strength. And with spot prices higher than FQ1 ’22 on average, FQ2 ‘22 is shaping up to be another strong quarter as well. On the back of recent strength and the de-levered balance sheet, I view the increased aluminum capex (allocated across a 0.4MT smelter expansion and a new carbon facility) as a positive step.

Looking ahead, I do acknowledge that the current global aluminum supply-demand balance could sustain, in turn, driving upside risk to current consensus estimates. However, I remain neutral on account of governance concerns related to capital allocation and the limited visibility into the commodity pricing cycle ahead.

Riding the Favorable Commodity Pricing Tailwind

For its latest quarter, Vedanta outperformed yet again across the top and bottom lines on the back of strength in aluminum, international zinc, and iron ore, all of which proved sufficient to offset underperformance in Zinc India and oil & gas. By product, aluminum posted adj EBITDA of Rs37.3 billion (+36% Q/Q) due to higher aluminum prices (c. 14% higher Q/Q), offsetting modestly lower volumes (down c. 2% Q/Q to 533kt). The higher earnings were partially offset by higher alumina and other manufacturing costs, which increased the production cost by $56/t Q/Q to $1,590/t. As a result, EBITDA/t stood at $952, a significant Q/Q increase.

Source: Vedanta Ltd. FQ1 ’22 Earnings Presentation Slides

On balance, aluminum remains the swing factor for profitability - about 80% of incremental EBITDA (excluding Hindustan Zinc) was contributed by aluminum (implying a c. 58% EBITDA contribution ex-HZ), with most of the remainder from international zinc. With power earnings also normalizing in FQ1 ’22, much of the impressive sequential growth in EBITDA (ex-HZ) was due to higher commodity prices. Encouragingly, the volume guidance points toward further strength in FQ2 ‘22 across the underlying businesses, outweighing any production cost impact from commodity inflation.

Planned Aluminum Expansion is a Positive Step

After years of limited capex spend, Vedanta has bucked the trend with its recent announcement of plans to complete the c. 5MT alumina expansion in the next one or two years and initiate a c. 0.4MT smelting expansion at its BALCO site (for a cost of c. Rs66 billion). This stands in sharp contrast to peer Hindalco (OTC:HNDNF), which opted not to increase its smelting capacities and instead remains focused on downstream operations at Novelis. I view Vedanta’s capex restart as a positive, especially in aluminum, as increasing capacity restrictions in China could signal the favorable aluminum supply/demand balance sustaining over the near term.

Source: Vedanta Ltd FQ1 ’22 Earnings Presentation Slides

Also notable were plans for the ESL Steel business to double its steel capacity from 1.5MT to 3MT per annum, with the pig iron business in Goa also reaching a production run-rate of 0.8MT per annum. Additionally, Vedanta also plans to increase chrome ore mining in FACOR through the debottlenecking of existing furnaces. And following the recent acquisition of Gujarat NRE coke, Vedanta is now one of the largest merchant coke producers in India.

Going forward, expect more capital allocation in this space as well and perhaps even a ramp-up in oil output following the recent O&G capex upgrade. Assuming management executes well per project-level targets, Vedanta’s growth investments in India should prove accretive to future earnings growth.

Source: Vedanta Ltd. Investor Presentation Slides

Dividend Increase on Track but VRL Debt Remains the Key Overhang

Encouragingly, the balance sheet is improving, with net debt to EBITDA (excluding Hindustan Zinc) improving to a record low of 1.5x (annualized for FQ1 ‘22). While the aluminum strength has helped, the c. Rs15 billion debt repayment (intercompany) from parentco VRL ("Vedanta Resources") has also moved leverage levels in the right direction. As a result, consolidated net debt to EBITDA now stands at c. 0.6x – the record low leverage is significant as it was achieved without a cash infusion from subsidiary Hindustan Zinc and leaves Vedanta with attractive growth optionality across its key business lines.

Source: Vedanta Ltd. FQ1 ’22 Earnings Presentation Slides

However, I would note that net debt at the parentco level remains a concern at the current c. $8.2 billion. As servicing of this debt load will likely be top of mind for management, expect a pass-through of the dividend paid by HZL in fiscal 2021 before year-end, along with incremental dividends from the upcoming year’s FCF. While management has outlined targets to maintain net debt/EBITDA below the 1x threshold for Vedanta (vs. the current c. 0.6x), its target for parentco VRL stands at 2-2.5x net debt/EBITDA, which implies higher leverage levels ahead at Vedanta to service VRL debt.

Final Take

While it is hard to fault Vedanta for yet another solid quarter, parentco VRL’s debt refinancing remains a key concern, and the possibility of more inter-company loans is a concern. However, in a scenario where the parentco returns the inter-company loans, it should allow Vedanta to revert to a high dividend payout strategy amid the current favorable backdrop, likely driving upside to the shares.

At c. 4x attributable EV/EBITDA, the valuation is attractive, but pending clarity on Vedanta’s capital allocation policy, I remain on the sidelines. Potential catalysts include a return to the (previously failed) delisting scenario – in particular, the promoter could further raise its stake, having already upped its shareholding to 65% in the last year, which could result in an eventual delisting of the shares.

Data by YCharts

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.