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Result below estimates; coal costs dent EBITDA

FSA linkage coal reduces in 1Q leading to higher costs in Aluminum business

* Vedanta (VEDL) reported the highest ever first quarter EBITDA but missed our estimates by 9%. Consolidated revenue grew 36% YoY but declined 3% QoQ to INR386b in 1QFY23. Consolidated EBITDA stood at INR102b, flat YoY but down 25% QoQ. Attributable PAT (Post-MI) was flat YoY but down 28% QoQ to INR44b. While revenue was 5% above our estimate, EBITDA and APAT were 9% and 5% lower than our estimates, respectively.

* LME prices remained the driving factor for profitability in the quarter. On a YoY basis, average LME prices in 1QFY23 for zinc/lead/aluminum were higher by 34%/4%/20%, respectively. Brent was up 65% YoY during the same period. The company has hedged 28% zinc, 34% aluminum, and 33% oil (gross basis) at more than USD4,100/t, USD3,600/t, and USD100/bbl, respectively for 2QFY23, which is an attractive rate in current environment

* Sales volumes of zinc/lead/silver/aluminum/power rose 10%/10%/11%/ 4%/32%, respectively, while steel sales volume decreased 13% YoY in 1QFY23. Profitability of the Aluminum business slipped as linkage coal declined to 22% QoQ from 63% in 4QFY22.

* Net debt increased to INR268b from INR210b at end-Mar’22. The net debt ex-HZL grew INR92b QoQ to INR482b (it was INR389b at end-Mar’22)

* The company declared strong result amid a challenging environment, though the aluminum business disappointed after a stellar 4QFY22. However, the current slowdown in China clouds the outlook for commodity. We believe the stock is fully valued in the current environment. Reiterate Neutral with an SoTP-based revised TP of INR260 (v/s 225 earlier). Lowering of input costs in the near term, namely coal costs, will likely support profitability.

O&G continues to disappoint, Aluminum/Steel are misses led by coal costs

* Aluminum EBITDA at INR23b (down 40% YoY and 57% QoQ) was 28% below our estimate of INR31b. The CoP for aluminum was up 22% QoQ as higher coal cost eroded profitability. COAL’s e-auction prices continue to remain elevated in 2QFY23 as well. We believe VEDL’s power cost will remain high in 2Q but start dropping from 3Q onwards with: a) reduction in COAL’s prices, and b) opening of own captive coal mine especially Jamkhani, which the management expects to open in 2QFY23.

* Oil and Gas business continues to disappoint as the natural decline in the oil fields are only partly compensated with infill. The management remains optimistic on the oil and gas business despite natural decline in the oil fields and imposition of special additional excise duty (SAED) of USD40/bbl initially (later revised down to USD30/bb) by the government. The windfall gain tax in addition to a declining output from the oil wells will continue to pose a challenge to the company.

? Steel profitability was adversely impacted by: a) the imposition of export tax leading to sudden drop in steel prices and consequently EBITDA, coupled with higher coking coal costs in the quarter and lower sales. The company took a shutdown in the quarter to increase capacity by 0.2mt as the sales dropped 13% QoQ.

Valuation and view

* We have reduced our FY23 EBITDA/PAT estimates by 9%/7% led by moderation in our key LME assumptions (refer Exhibit 7), reducing our metal price assumptions for zinc, lead, aluminum, and copper. We also lower our oil production estimates by 15% for FY23, further keeping the remaining volumes largely unchanged (barring copper volumes that are raised by 8%). Aluminum became the largest contributor to the consolidated EBITDA briefly in 4QFY22, but it was relegated back to second spot as zinc business retook its share contributing about 50% to the consolidated EBITDA.

* The outlook on commodities remains soft as China continues to battle Covid and lockdowns remain a regular feature for the country. There are no visible signs of the administration giving up the zero-tolerance policy on Covid and neither there are any signs of any meaningful stimulus by the government to kick start the slowing economy. The USD220b stimulus largely preponed funding due from Jan’23 to now, essentially borrowing funds from next year, which we believe is insufficient to propel the economy.

* However, we note two important factors which can probably stall further down tick in the commodities. Fear of recession in the US, after second consecutive negative print for the GDP growth rate, will likely put a delay or slowdown the quantitative tightening (QT) that has been announced by the US Fed. Secondly, we believe with Presidential elections coming up in China, there could be a bout of stimulus that can stem the slide in the commodity prices.

* The outlook for the profitability for VEDL can improve significantly if its coal availability from the FSA improves over the next few quarters. Management has also highlighted that it is planning to open three coal mines over the next two years, which will reduce coal costs by two-thirds from current levels. The first mine, Jamkhani, is likely to be opened next month. We await ramp up of the mine to ascertain how it will improve profitability of the aluminum division.

* We have raised the EBITDA multiple for the aluminum business factoring its volume growth and cost reduction initiatives, namely captive thermal coal mines. The stock trades at 4.6x our FY23E EV/EBITDA, which is below its last 10-year average multiple of 5.2x. Reiterate Neutral with an SoTP-based revised TP of INR260 (v/s 225 earlier). 

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