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  • Stock Recommendation | Vedanta - BUY - Target price : 330

    Publish date: NOVEMBER 01, 2018

    Weak quarter; expect a better 2H.VEDL's earnings were weak due to (1) lower volumes in zinc, and (2) high production costs in zinc and aluminum operations. The company's zinc volume growth is expected to increase from 2HFY19 onwards led by commissioning of mines in India/RSA in 2Q/3QFY19-we expect strong increase in zinc earnings from 2H. Aluminum EBITDA was weak largely due to limited coal availability and high alumina costs-while near-term earnings will be subdued, it is unlikely that the alumina-price-index can sustain at record historical highs for long. We cut our TP to Rs330 (from Rs360 earlier) and maintain BUY rating. Stock in inexpensive at 4X FY2020E EV/EBITDA.

    VEDL's 2QFY19 earnings were lower than our estimates-company reported EBITDA of Rs52 bn (-8% yoy, -17% qoq) and net-income of Rs11.4 bn (-44% yoy, -26% qoq) against our estimate of Rs57.6 bn & Rs13.6 bn, respectively. Earnings were weak due to:
    ▶ Lower aluminum earnings. Aluminum EBITDA declined 68% qoq to Rs4 bn (-13% yoy) due to 9% qoq increase in costs to Rs141,300/ton due to higher alumina and power costs. EBITDA/ton declined to US$144/ton (US$424/ton in 1QFY19) due to higher costs and lower prices. Aluminum volumes increased 6% qoq to 494,000 tons (+29% yoy).
    ▶ Decline in zinc earnings. EBITDA at Zinc International declined 81% qoq to Rs160 mn (-96% yoy) due to (1) lower volumes of 28,000 tons (-35% yoy) and increase in production costs to US$2,428/ton (+65% yoy). HZ reported a muted quarter as well with 14% qoq decline in EBITDA to 23.3 bn (-23% yoy) due to 6% qoq decline in zinc volumes and lower prices.
    We expect strong improvement in VEDL's zinc earnings in 2HFY19 led by (1) ramp-up of Gamsberg project-VEDL expects 75 kt of volumes in 2HFY19 at low production cost of US$800-1,000/ton, (2) increase in Skorpion, BMM volumes at Zinc International as 1H was impacted by higher waste mining, low grades-this should aid in significant reduction in costs too. Management expects close to 100 kt of volumes in 2H from these mines at production costs 500,000 tons (444,000 tons in 1HFY19) led by commissioning of production shafts at Rampura Agucha and SK mines and new mills.
    VEDL's 2QFY19 aluminum earnings reflects the sharp earnings squeeze faced by non-integrated smelters globally due to the rise in the alumina-price-index to >25% (versus long term 16- 18%). At spot aluminum-alumina spreads, most of the non-integrated smelters are burning cash-we expect this to normalize once Alunorte refinery and a few other projects restart. We cut our EBITDA estimate by 2-6% for FY2019-2021E and target price to Rs330 (from Rs360 earlier). Maintain BUY.

    Changes in our estimates
    Exhibit 8 highlights key changes in our estimates, here's a summary:
    ▶ We cut our aluminum EBITDA/ton estimate to US$220/ton, US$360/ton and US$390/ton for FY2019E, FY2020E and FY2021E from US$220/ton, US$410/ton and US$430/ton, respectively. The lower EBITDA/ton reflects higher alumina prices-though we expect alumina prices to decline from >25% in FY2019E to ~19% in FY2020-21E. We highlight that a large number of non-integrated aluminum smelters globally will be incurring cash losses at API index of >20%.
    ▶ We incorporate our revised estimates of Hindustan Zinc in Vedanta model-see our note dated October 23, 2018.
    ▶ In Zinc International, we have adjusted our volumes, costs for FY2019-21E.
    ▶ We have factored in (1) lower O&G volumes versus earlier assumptions given indicated delay in commencement of growth projects, and (2) higher crude prices.
    These changes result in 3-6% cuts in our EBITDA estimates to Rs273 bn, Rs331 bn and Rs341 bn for FY2019E, FY2020E and FY2021E. Our EPS estimate is cut by 11-18% for FY2019-20E due to higher interest costs, depreciation charges beside lower EBITDA. We estimate EPS of Rs22.5, Rs33.1 and Rs34.1 for FY2019E, FY2020E and FY2021E.

    Other highlights of 2QFY19 results, earnings call
    The performance across businesses was as follows:
    ▶ Oil & gas-lower-than-expected contribution due to decline in volumes. Oil and gas revenues and EBITDA increased 8-9% qoq to Rs34.8 bn and Rs20.3 bn respectively, albeit 6-7% below our estimates led by surprising 5% qoq decline in net production volumes to 118.7 kb/d, led by lower production from Rajasthan block; crude realizations were higher at US$69.5/bbl versus US$67.2/bbl in the previous quarter, at a lower discount of US$5.7/bbl to Dated Brent crude. Oil and gas EBIT increased to Rs14.3 bn in 2QFY19 from Rs12.8 bn in the previous quarter. The management indicated delays in award of projects in Rajasthan block, while sharply cutting its gross production guidance to 200-220 kboe/d in 2HFY19 versus earlier guidance of 220-250 kboe/d in FY2019.
    The government has granted ten-year extension for the PSC of Rajasthan block (RJ-ON- 90/1) effective from May 2020 onwards, under the existing policy framework, which mandates an increase in the government's share of profit petroleum by 10%; the matter remains sub-judice in the court, however, the company has sought the extension without any change in fiscal terms.
    ▶ Decline in aluminum earnings due to cost increases, lower prices. VEDL's aluminum EBITDA declined 68% qoq to Rs4 bn (-13% yoy, KIE: Rs6 bn) due to an increase in production costs which increased by 9% qoq to Rs141,300/ton due to higher alumina, power costs. Aluminum volumes increased 6% qoq to 495,000 tons (+29% yoy) led by ramp-up of Jharsuguda II smelter. EBITDA/ton declined to US$144/ton (from US$424/ton in 1QFY19) due to a combination of increased costs and lower prices. Management expects FY2019E production at 2 mn tons and costs at U$1,950-2,000/ton (US$1,978/ton in 1HFY19).
    ▶ Zinc International-lower volumes, higher costs. EBITDA at Zinc International declined 81% qoq to Rs160 mn (-96% yoy) due to (1) lower production volumes of 28,000 tons (-35% yoy, +12% qoq) and increase in production costs to US$2,428/ton (+65% yoy, +3% qoq). The management expects an improvement in 2HFY19 with full year production of 150 kt (53 kt in 1HFY19) and production cost at US$1,850-1,950/ton (US$2,393/ton in 1HFY19). Gamsberg production is not yet reflected in financials- management expects FY2019E production from Gamsberg at 75 kt and production costs at US$800-1,000/ton. The trial run of concentrator at this project commenced in September 2018. Management expects FY2020E production from Gamsberg at 250 kt.
    ▶ Hindustan Zinc-EBITDA declines 14% qoq. Hindustan Zinc's EBITDA declined 14% qoq to Rs23.3 bn (-23% yoy). The sequential decline in earnings was due to (1) 6% qoq decline in zinc sales volumes to 160,000 tons (-17% yoy), and (2) lower zinc realizations (- 13% qoq), lead realizations (-7% qoq) and silver realizations (-4% qoq). The company's mined metal volumes increased 9% qoq to 232,000 tons (+6% yoy) led by ramp-up of underground mines. Lower refined zinc output (162,000 tons, -6% qoq, -16% yoy) was due to a mismatch in zinc mined metal availability as mined production ramped up towards the latter half of the quarter. Lead production increased 17% qoq to 49,000 tons while silver production increased 25% qoq to 172 tons-increase in silver production was led by higher lead metal processing and increased ore production from SK mines (which has rich silver ore grades).
    Production costs increased 14% yoy to Rs72,449/ton (US$1,034/ton, +5% yoy) due to a combination of lower volumes, high fuel costs and wage costs.
    ▶ Power-weak earnings. Power EBITDA declined by 11% qoq to Rs3.8 bn (+3% yoy) due to (1) lower generation at Balco (600 MW) and Jharsuguda (600 MW) power plant, and (2) increase in generation costs. The lower generation, higher cost was largely due to limited coal availability. Plant availability at Talwandi Sabo improved to 94% in 2QFY19 from 91% in 1QFY19.
    ▶ Iron-ore (EBITDA at Rs980 mn). Iron-ore EBITDA declined 40% qoq to Rs980 mn due to lower volumes. Sales volumes declined to 0.4 mn tons (1.4 mn tons in 1QFY19, 0.7 mn tons in 2QFY18) due to closure of Goa mining operations and monsoons. Electrosteel reported EBITDA of Rs1.7 bn (Rs2.1 bn in 1QFY19) due to lower steel prices.
    Other points
    ▶ Net-debt and FCF. VEDL's net-debt declined to Rs264 bn in September 2018 from Rs299 bn in June 30, 2018 (this excludes buyer's credit of US$700-750 mn). The company earned operating cash flows of Rs38.9 bn during the quarter while cash flows were also aided by working capital release of Rs23 bn. The capex for the quarter was Rs25.5 bn.
    VEDL expects FY2019E capex at US$1.5 bn largely towards oil & gas and zinc operations. The capex in FY2020E can increase to US$1.8 bn due to US$600 mn expected investment for Electrosteel Steels expansion and Lajigarh refinery expansion to 4 mtpa.
    ▶ The company declared interim dividend of Rs17/share. The record date for payment will be November 10, 2018.

    Definitions of ratings

    BUY - We expect this stock to deliver more than 15% returns over the next 12 months.
    ADD - We expect this stock to deliver 5-15% returns over the next 12 months.
    REDUCE - We expect this stock to deliver -5-+5% returns over the next 12 months.
    SELL - We expect this stock to deliver

    Our target prices are also on a 12-month horizon basis.

    Other definitions

    Coverage view. The coverage view represents each analyst's overall fundamental outlook on the Sector. The coverage view will consist of one of the following designations: Attractive, Neutral, Cautious.

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    NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic transaction involving this company and in certain other circumstances.
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    RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock and should not be relied upon.
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    NM = Not Meaningful. The information is not meaningful and is therefore excluded.

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