Sesa Sterlite Looks More Attractive After Correction

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Nov 14, 2014

I have been bullish on Sesa Sterlite (SSLT, Financial) in the past and I am more bullish on the stock as a correction provides an excellent long-term buying opportunity. From peak levels of $21.16 in 2014, Sesa Sterlite has corrected by 26% to current levels of $15.77. This article discusses the reason for the correction and the reasons to remain bullish on the long-term prospects for the company.

To understand the reason for the decline in the stock in the last few months, it is important to look at the company’s key EBITDA contributing segments. For the second quarter of 2015, 42% of the company’s EBITDA contribution came from the oil and gas segment and 36% EBITDA contribution was from the zinc business.

The decline in oil prices in the recent past has been the single biggest factor that has contributed to the decline in the stock price. For 4Q14, the oil and gas segment had an EBITDA margin of 78%. The EBITDA margin declined to 70% in 1Q15 and to 68% in 2Q15 (July 2014 to September 2014).

To offset this decline to some extent, the EBITDA margin from the company’s zinc business (India) increased from 45% in 1Q15 to 53% in 2Q15. The zinc business (international) EBITDA margin also improved from 27% in 1Q15 to 33% in 2Q15.

The company’s overall EBITDA margin however declined from 49% in 4Q14 to 47% in 1Q15 and to 46% in 2Q15. I believe that the reversal in EBITDA margin will come as oil prices recover and I am confident of a reversal in EBITDA margin as the company oil & gas project is well on track with a robust production profile.

As of FY14, 28% of India’s crude production came from Cairn India (where Sesa Sterlite holds a 59.9% stake). The production from the company’s assets is likely to increase further in the foreseeable future and with the government’s positive announcement on the gas pricing policy, Sesa Sterlite stands to benefit.

Sesa Sterlite has planned to invest $2.4 billion until 2017 in the oil and gas project with $2.1 billion investment directed towards proven and high margin Rajasthan block. With these investments, the company is planning a 150% reserve replacement over the next three years. Considering the performance of the oil and gas assets this far, the high reserve replacement is likely and should take the stock higher.

A significant positive for Sesa Sterlite from a financial perspective is that the company’s net debt to EBITDA was just 1.3 as of 2Q15. This means that the company has the financial flexibility to make big investments that have been planned for the next three years.

Further, the EBITDA and EBITDA margin are likely to improve in the next few years and this will keep the company’s leverage under control.

From a valuation perspective, Sesa Sterlite is trading at a TTM EV/EBITDA of 4.3 and this is inexpensive. The company’s price to sales and price to book ratio of 0.93 and 0.98 respectively also suggest that the stock is undervalued at current levels. The correction is clearly overdone and Sesa Sterlite is due for a recovery in terms of stock price over the next few quarters.

Freeport-McMoRan (FCX, Financial) currently trades at an EV/EBITDA of 5.6 and can be considered as a good peer for Sesa Sterlite. The company is also in the business of copper, but is expanding its oil & gas operations significantly. Freeport-McMoRan also trades at a price to sales and price to book ratio of 1.34 and 1.37 respectively and all the valuation metrics show that Sesa Sterlite is relatively undervalued.

I would therefore not be surprised to see Sesa Sterlite move significantly higher from current levels considering the fact that the company’s growth outlook is more robust as compared to Freeport-McMoRan. From a long-term investment perspective, both the stocks look good and are value buys.

In conclusion, Sesa Sterlite is an excellent stock to buy and hold for the next few years. The stock looks very cheap at current levels and has ambitious growth plans. The management has proved in the past that they can execute plans well and I believe that the next few years are likely to be big for the company.