This Commodity Stock Can Provide Stellar Returns

Vedanta Limited has slumped on lower energy and commodity prices, but there are several stock upside triggers on the horizon

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Nov 16, 2015
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The industrial commodity sector as well as the energy sector has been depressed due to the China slowdown factor coupled with the fact that oil supply growth has been robust as compared to demand growth. The steep decline in stock price in these two sectors gives investors some good long-term investment opportunity. Any investment in the energy or commodity sector has to be with an investment horizon of three to five years. Stocks that are trading at attractive valuations and have a quality asset base can provide stellar returns in this time horizon. This article discusses a stock that has been beaten down from 52-week high of $16.02 to current levels of $5.26. Vedanta Limited (VEDL, Financial) is a value buy.

The first point that I want to mention here is that Vedanta is trading at an EV/EBITDA (trailing 12 months) of 3.08. Freeport-McMoRan (FCX, Financial) is another diversified natural resources company that is currently trading at an EV/EBITDA of 3.58. Further, for the next 12 months, Vedanta is likely to have an EV/EBITDA of 5.01 while international peers will be trading at an EV/EBITDA of 6.87. Therefore, Vedanta is undervalued on a relative basis, and this makes the stock interesting in the near term as well as in the long term.

The second point, as an upside trigger for the stock, is the impending merger of Cairn India (CAIRN, Financial) with Vedanta Limited. The merger was delayed as it faced resistance from some shareholders, and this is another reason why Vedanta stock trended lower. However, Vedanta now expects the merger to be closed by June 2016, and the stock should trend higher on merger. The key point to note here is that Cairn India has zero debt and $2.85 billion in cash reserves. On the other hand Vedanta Resources had $7.7 billion debt as of March 31 while its Indian arm Vedanta Limited has another $4.57 billion debt. The merger will reduce the net debt for the consolidated entity and also create cost synergies in the long term.

Looking further from a financial perspective, Vedanta generated $2.1 billion in free cash flow in 2015 and has generated $1.6 billion in free cash flow for the first half of 2016. With muted capital expenditure, the company has been able to improve its financial metrics even in difficult times for the industry. With zinc and oil and gas being the biggest EBITDA contributors, Vedanta is focused on investment in these two segments; an India centric company is likely to do well as growth gains momentum.

In particular, the company’s oil and gas assets have a low operating cost and can generate robust EBITDA once oil trends higher. While the company has reduced investments, there is significant scope to increase investment and production in the assets once oil trends higher. With Vedanta having cash and liquid investments amounting to $8.0 billion as of September, financial flexibility remains high for growth investments.

Another game changer for Vedanta is likely to be the power sector in the long term. In 2Q15, the power sector contributed to only 4% of the company’s EBITDA. That has increased to 7% of EBITDA in 2Q16. India still has a significant power shortage, and this creates big opportunity for a company that has the financial flexibility and resources.

In the coming years, India is likely to overtake China in terms of GDP growth. However, India’s key sectors still remain underdeveloped as compared to China, and this leaves immense scope for growth. Rapid urbanization, investment in infrastructure and investment in power can be some key growth triggers for Vedanta in the coming years. With the stock having slumped due to carnage in the commodity and energy sector, investors should use this opportunity to consider long-term exposure to this potential value creator.

Disclosure: No positions in the stock