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Deleveraging at the holding company in focus, dividend may rise

In our recent meeting with the management of VEDL, it emphasized three key points:

* Capital allocation between capex, dividend, and M&A;

* Net debt reduction at the parent level; and

* Focus on volume growth and cost reduction on a sustainable basis

Capital allocation – Focus on growth capex and dividend

* VEDL announced a capex policy with a focus on growth capex and dividend, while avoiding the ICD route to support its parent.

* The company plans to allocate USD1-1.5b annually in growth capex, which will result in: a) a volume expansion, b) cost reduction, c) increase in share of value added products, and d) improve ESG standards. Capex is likely to continue even during a downturn to support these initiatives.

* The management plans to declare a dividend of ~USD4b over the next three years, which should help it deleverage at the parent level. Debt repayment of USD1b is due to the parent entity (Vedanta Resources, VRL) in Jun-Jul’22. The management has said the same will either be paid or refinanced at least a quarter ahead of the deadline.

* Dividend from Hindustan Zinc (HZ) will be redistributed within six months.

* The management said M&A activities will be in the existing line of businesses only.

* VEDL does not plan to support its parent through the ICD route going forward.

Focus on volume growth and cost reduction to continue across the businesses

* Aluminum: VEDL plans to increase aluminum capacity to 3mt by FY24E from 2.2mt at present. At the same time, it plans to reduce the cost of production by ~25% to USD1,350/t from USD1,825/t through (a) increasing share of captive coal to 50% from 0% currently, b) increasing captive aluminum to 100% from 40% currently, and c) increasing share of domestic bauxite to 70% from 56%. VED plans to achieve all these by FY24.

* Zinc: VED plans to reduce the CoP of HZ to USD1075 by FY24 from USD1125/t currently and reduction of CoP at Zinc International (ZI) to USD 1100/t from USD1450/t. However, it needs to be seen how the management will achieve the sharp reduction of over 25% in the CoP at ZI over the next 2 years.

* Oil and Gas: While the management has set an ambitious target of achieving 3bnboe reserves and 500kboepd production in the long term, its FY24E target production of 300kboepd seems to be a tall ask. It has entered into partnership with top oil field services (OFS) companies like Schlumberger, Halliburton, Baker Hughes, among others by partnering with them from concept to execution. We will await results of this partnership before upgrading our volume estimates for the O&G business.

* Iron and Steel: VEDL has clubbed its iron ore mining, Steel business, ferro alloys, and nickel refining under the Iron and Steel vertical. It has tenements in Liberia and plans to start mining operations over there, with a final capacity of 12mt. It plans to increase capacity of its steel plant to 3.5mt from 1.5mt, expand capacity of its charge chrome facility to 150kt from 90kt, and nickel smelting capacity to 7kt . Other than the Steel business, the rest are small businesses at present and are unlikely to impact overall profitability significantly over the next two years.

Valuation is expensive and is at the peak of the commodity cycle

* The stock trades at 4.9x/5.4x FY23E/FY24E EV/EBITDA. At current prices, we do not expect a favorable risk-reward scenario in the stock. Oil, Steel, Aluminum, Zinc - all major commodities which VED produces are above the cycle averages and are supported by the Russia-Ukraine conflict. The related tightness may ease if the two nations agree to a settlement.

* The cost of production of Aluminum, Zinc, and Steel, however, may remain at elevated levels as coal/energy cost – the key cost for VEDL – may stay at higher levels for a longer duration due to a surge in demand, while supply remains muted. This is likely to keep its cost structure elevated for a longer period.

* A lower share of value added products in the portfolio will also keep margin subdued for a large part of its metals and minerals portfolio.

* Any reduction in commodity prices may restrict its ability of delivering higher dividend or continue with growth capex and could keep the leverage at the parent level elevated.

* The promoters already hold 69.69% stake in VEDL, all of which are pledged. There is a little scope for a further increase in its stake (up to 75%). At current prices, we do not expect promoters to raise their stake.

* We raise our FY22E/FY23E EPS by 2%/3% on the back of a USD10/bbl increase in our forecast for crude oil for both years, resulting in a 3% increase in our TP to INR459 (from INR450 earlier).

* Our TP of INR459 now comprises: a) INR195 for the Zinc business, with a 20% holding company discount, and b) INR265 for other businesses, of which the biggest share is that of the Aluminum business. We maintain our Neutral rating.

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