Deal valuation inexpensive for Vedanta: Centrum Broking

Cairn India ’s EV/BOE stands at USD 10 a barrel versus the international average of USD 13 a barrel and Verma says that lifting the cost of USD 7-8 a barrel for the company is lower than its international peers. “Profit after tax per barrel realisation for Cairn is in fact double than that of its international counterparts,” she adds.

Cairn India, Verma says is a good long-term bet. However, a good upside in price is seen, she adds.

Centrum Broking has hiked Sesa Goa ’s earning per share in financial year 2011 to Rs 62 a share and to Rs 74 a share in financial year 2012.

Below is a verbatim transcript. Also watch the accompanying videos.

Q: What is your sense, are you bullish or skeptical now?

A: The market is trying to find a balance and the balance is coming from various external and internal factors, that is keeping a lid on the market. Going forward the external factors like the imported inflation is going to be a significant headwind for the markets. Right now the global markets, lot of the economic market are throwing up mix signals.

The commodity markets are following that so again there are a lot of mix signals from there to. What we are seeing is imported inflation in the form of higher oil prices or higher commodity prices are actually going to act as headwind going forward. What India needs is a benign or softer prices in the form of crude and commodities over the next six-nine months and if we have there then the markets will head higher.

Already what we have right now is that we are just coming off the food inflation that we saw so on the one hand we have an easing of food inflation, but what we don’t want right now is a sharp spike up in oil or commodities. One of the reasons why in July India underperformed the rest of emerging markets was precisely same the reason. What India doesn’t want is a sharp pickup in economic recovery in the West and sharp expansion in China. Hopefully if we have that under control and we have commodities and oil under check we should do well.

One important thing that is critical is wage inflation. Already wage inflation is creeping up and you can see that in the recent numbers and by next year this time Indian corporate we will have to battle wage inflation significantly. In an economy which is growing, wage inflation is fine to a certain extent. What you don’t want is imported inflation under which India has no control and India’s economy cannot absorb a sharp spike there.

Q: What kind of tactical stance would you take then in this period of consolidation? Would your leaning be towards a breakout for the market or do you think all these issues are pointing to a dip down?

A: All these issues are pointing to a sideways market. A dip down will happen only if the economic recovery in the West is sharper than expected. That is important. The expectations right now are quite low in terms of economic recovery. On the one hand you have Germany throwing up good gross domestic product (GDP) numbers which is better than the expectations.

On the other hand you have UK’s GDP forecast being cut down and all the softer economic data or weaker economic data from the US. You have kind of mixed signals. That’s why the market is actually reacting to that. You have an up and down day what we have seen over the last month or so.

The tactical stance at this point in time would be better than the defensives to some extent and then see how the whole thing plays out. The key thing for India is the inflation number is coming quite high and inflation numbers are getting revised upwards so you don’t know what the real underlying inflation is in the first place.

Probably we are at a higher double digit, maybe 11-12% we don’t know. The headline inflation will come down and that’s just because of the base effect whereas the underlying inflation number or consumer index is pretty high. Also the central bank’s ability to control that would also show a way forward.

The bottomline is the earnings revision cycle which is one of the key internal factors that we are looking at, is actually trending down and in the last few months we are seeing that. What the market needs is earnings upgrade in FY12 and at this point in time and earnings upgrade for FY12 probably maybe a bit early at this point in time. We may need to see one-two more quarters of lower inflation number, lower imported inflation and gradual but not a sharper recovery in the Western markets. That will lead to earnings upgrade for FY12 and that’s what will drive the markets higher.

Q: What kind of sense do you have on the liquidity front? We have seen foreign institutional investor (FII) flows being quite strong over the last six-eight weeks? What is your sense of where this is coming from and whether it’s likely to continue?

A: The liquidity flow will probably continue for some more time. It’s mainly into exchange traded funds (ETFs) and long-only funds. At this point in time even with emerging markets there are very few investible countries as such. You want to be where the growth is.

India is showing growth, China has slowed down quite a bit. The money is probably chasing growth at this point in time. At some point you will probably see an ease off some of the external and internal factors that are more specific to India and how India is going to be positioned toward that takes a centre stage.

Q: Your thoughts on where Cairn has been left in this entire equation and the degree of disenchantment there was about that non-compete fee?

A: There are three-four parties involved in this. Purely from Cairn’s perspective I think it is very simplistic to say since operationally the company is not under going any change and there is only a change in the shareholding pattern. Things will continue as if nothing has happened. For Cairn that is a very simplistic assumption.

We had recently released a report where we put the fair value for Cairn at Rs 362 a share. Now assuming that this deal happens at Rs 405 a share, is it expensive from a valuation perspective for the Vedanta Group, since that is something that has been hotly debated for the last 48 hours or so.

My sense is that it is not necessarily expensive either from an EV/EBITDA or enterprise value (EV) per barrel of oil equivalent. If you look at a price of Rs 405 Cairn’s EV per barrel of oil equivalent that is Cairn India works out to USD 11. The global comparable EV per barrel of oil equivalent for international majors stands close to USD 13. So clearly my sense is that even at Rs 405 it is certainly not expensive. On EV to EBITDA basis I think it is more or less in sync and in line with global peers.

Q: What would you do with Cairn in the short-term and in the medium-term?

A: From a long term perspective, it is a no brainer that Cairn is a great bet. While we assigned a fair value of Rs 362 a share to the stock in our just released oil and gas sector report, valuing it at 5.8 times price to earnings (PE) and 3.7 times EV/EBITDA on FY12 estimates. That said two points which need to be highlighted here with respect to Cairn, is the fact, that the carrying or the listing cost for Cairn is just about USD 7.8 a barrel whereas the world average stands at anywhere between USD 10 to 11 a barrel. There Cairn certainly scores brownie points over its international and domestic peers.

Secondly, one thing which has not been mentioned by analyst who seems to be concentrating too much on discounted cash flow (DCF). I have been reading some of the competitions research which says that the DCF for Cairn works out somewhere between Rs 280 to Rs 320 a share. To that extent any price in excess to that is basically saying that Cairn is in the over valued zone. That again is a very simplistic way of putting things.

My personal sense is that in FY12, assuming an average bench crude price of USD 75 a barrel, the profit after tax (PAT) realization per barrel for Cairn works out to USD 37 which is the highest. The average PAT realization for international majors in FY12 will work out to no more than USD 12-13 a barrel.

My sense is that Cairn has a) a significant cost advantage because of bulk production from the onshore Rajasthan fields and b) the PAT realizations are more than 100% of what international majors and comparable peers enjoy. Based on this Cairn is an excellent long term bet.

Currently they are paying cess in protest to the tune of USD 8 a barrel and this is what we have factored in our assumptions while assigning Cairn a fair value of Rs 362 a share. Now were this cess that is being paid in protest to be rolled back even partially for some reason, then the upside to Cairn’s stock price from our fair value assumption of Rs 362 could be anywhere in the region of additional Rs 20-30. You are talking of Cairn actually trading at between Rs 405 to Rs 410 if not more. Cairn is a long term bet. It is certainly not for a faint hearted at this point in time, who are looking for short term gain.

From Vedanta’s perspective, it is true that with this deal it will make it one of the biggest leveraged mining companies in the world, with a debt on its books to the tune of USD 10.4 billion, given that it has been making acquisitions repeatedly. The last one being the acquisition of Anglo-American which it won against Xstrata last year, to the tune of USD 1.8 billion. For Vedanta it is an excellent bet because at Rs 405 a share including the controlling premium or non-compete fee, it still works out to and EV/barrel of oil equivalent price of just USD 11, which is a 15% discount in terms of what international majors trade at. All international companies are basically trading at an enterprise value per barrel of the equivalent (EV/BOE) of anywhere between USD 14 to USD 17. Petrobras and PetroChina are trading at USD 18-19 in terms of EV/BOE. So to that extent I think Vedanta has got a steal.

Yes, if you compare the price of Rs 405, with the last three months average price of Rs 310 odd, which is where Cairn has been trading at for the better part of the last three months, then it is a significant premium of 31%. When companies make strategic acquisition, you always tend to make a little bit more. Prima facie, while this acquisition from Vedanta’s perspective might seem expensive, from a long-term perspective it is a steal.