After bottoming out at $3.66 on Feb. 11, Vedanta (VEDL, Financial) stock has been surging and is currently higher by 177% at $10.14. Even after the big upside, Vedanta still has upside in the medium to long term, and its stock is still appealing from a three- to five-year investment horizon.
It is important to understand the reasons for the stock trading at $3.66 in February and the reason for its subsequent upside. The first factor to note is that Vedanta has a long impending merger with Cairn India (in the oil and gas exploration business). With the merger being delayed, the stock was depressed. However, the terms of merger are now finalized and Vedanta expects the merger to be completed by early 2017. This provides more clarity to investors and is one of the reasons why the stock has been surging higher.
The second point to note is that the company’s oil and gas division contributed to 33% of EBITDA in the first quarter. While the EBITDA contribution from the division declined to 22% in first quarter 2017, the energy sector is one of the key EBITDA drivers. It is worth noting that oil bottomed out on Jan. 20 and Vedanta also bottomed out around the same time. Further, depression in prices of industrial commodities also kept the stock price at lower levels.
Coming to the present scenario, the merger issue is resolved and oil prices have been gradually trending higher. With low per barrel production cost, Vedanta is well positioned to benefit. Just to put things into perspective, Vedanta oil and gas division reported EBITDA margin of 42% for first quarter 2017 (April to June 2016).
If oil trades above $50 per barrel in the next six to 12 months, the oil and gas division will see strong EBITDA margin. Cairn India has quality assets in India and is well positioned from a financial perspective to scale up investments once oil trends higher.
In addition to oil and gas segment being the EBITDA driver, I expect the zinc division to serve as a major stock upside trigger. The company’s zinc India business reported EBITDA margin of 44% for first quarter 2017 with zinc international reporting EBITDA margin of 55%. In particular, I am bullish on zinc India with the country’s per capita consumption of zinc still significantly lower compared to the rest of the world. With big urban and rural development planned for the coming years, zinc India division will also remain a key EBITDA driver.
From a financial perspective, Vedanta is comfortably placed with net debt to EBITDA of 1.7 as of June. This gives the company strong financial muscles to increase investments across business segments when sentiments turn bullish.
The company’s capital investments still remain robust with fiscal year 2017 target investment of $1.0 billion. Going forward, I expect capital investments to be concentrated in the high EBITDA margin business like oil and gas, zinc, iron ore and power segments.
In addition to the positives related to the business that can trigger stock upside, Vedanta also pays a dividend of 43 cents per share that translates into a healthy dividend yield of 4.31%. In the coming years, I expect the dividend payout to swell with strong commodity markets as one of the key conditions.
From a valuation perspective, Vedanta has surged from oversold levels and still trades at an attractive EV/EBITDA valuation of 5.47. Freeport-McMoRan (FCX, Financial) is also a diversified commodity company and currently trades at an EV/EBITDA of 14.5. Therefore, I see more upside for Vedanta in the coming quarters and the company’s India focused operations serve as a big long-term advantage.
Disclosure: No positions in the stocks discussed.
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