U.S. Markets open in 4 hrs 38 mins

Vedanta Will Continue to Outperform

- By Faisal Humayun

Vedanta Ltd. (VEDL) is a diversified natural resources major with an operational focus in India. In the last year, the stock has surged from oversold levels and has seen a rally of 183%. Even after the strong upside, I am bullish on Vedanta with a time horizon of three to five years.

The per capita consumption of industrial commodities in India is significantly below the global average, which is one key industry factor that can support upside for Vedanta.


While China is likely to see gradual economic recovery and is the biggest natural resources price driver, from a location perspective, Vedanta is well positioned to see strong demand. Additionally, as industrial commodities see relatively stronger prices, Vedanta stands to benefit.

Improving EBITDA margin

Before the current recovery in stock price, Vedanta was weak due to depressed commodity prices. Since January 2016 however, the company's commodity basket has moved higher by 57%, which has helped the company's EBITDA margin to improve and the stock to recover.

To put things in perspective, the company's EBITDA margin dipped to 26% in third-quarter 2016 and has subsequently seen gradual recovery. For third-quarter 2017, the company's EBITDA margin was at 39.3%. As a result, I expect the company's EBITDA margin to remain firm in the coming quarters.

Zinc and oil prices

For Vedanta, zinc is the biggest EBITDA driver. The surge in zinc prices has helped the company report strong margins. Prices are likely to remain strong through fiscal 2017 since there is a global deficit of zinc concentrate. Further, refined zinc inventory is at a six-year low. This will ensure the mineral trends higher or remains at current levels.

The second key EBITDA driver is the oil and gas segment. The company's merger with Cairn India (BOM:532792), an Indian oil and gas exploration company, was completed April 11. With this deal, Vendanta aims to invest in assets that generate high returns.

Based on these factors, I expect strong investments in the zinc and oil and gas segments. For the latter, I am bullish as Cairn India has a low operating cost. With oil likely to trend above $50 per barrel this fiscal year, the oil and gas segment will likely see an EBITDA margin in excess of 50%.

Expect growth in power sector

While the power sector does not significantly contribute to the company's EBITDA, I do see a lot of potential for growth. With a power deficit in several states in India, I do see the company using this opportunity to pursue further investments in the power sector.

In the recent past, one of the key advantages for the sector has been increased availability of domestic coal. This can potentially lower the costs of existing power plants as well as upcoming plants.

Strong fundamentals

Considering the consolidated entity, Vedanta India has total debt of $9.6 billion as of December 2016. For the same period, the company had cash and equivalents of $7.9 billion.

With net debt of just $1.7 billion, Vedanta is well positioned and has Crisil rating of AA-, which indicates external financing for any large-scale project is not a concern.

If the recovery in commodity prices sustains, Vedanta is likely to use financial resources for big investments in the zinc, oil and gas and aluminum sectors. I do believe the worst is over for industrial commodities.

Conclusion

Vedanta stock has seen big upside from oversold levels, but there is more potential considering the impending growth in India.

I expect zinc, oil and gas to be the key growth drivers for Vedanta in the coming years. Sectors like aluminium and power will also increasingly contribute to growth.

As GDP growth in India remains resilient and per capita consumption of commodities increases, Vedanta is well positioned to be an outperformer.

Disclosure: No positions in the stock.

Start a free 7-day trial of Premium Membership to GuruFocus.

This article first appeared on GuruFocus.