Buy Sesa-Sterlite, JSPL; shun SAIL, NMDC: Espirito Santo

Analysts are positive on Sesa-Sterlite scrip in the non-ferrous pack going forward. Ritesh Shah of Espirito Santo Securities says that the management will be in a better place on the cash flow front once the merger is complete in a couple of months.

He also told CNBC-TV18 that it had upgraded the company’s outlook to ‘buy’ from ‘neutral’. The firm is negative on SAIL and NMDC. On the ferrous side, it recommends buying JSW Steel and Jindal Steel and Power (JSPL). Also read: Sesa Goa trims early losses, replaces Sterlite in Sensex Below is the edited transcript of his interview to CNBC-TV18. Q: What is the approach and target price on the merged? A: The merger offers more breathing space to the management, given it solves the cash fungibility issue. The management has walked a tight rope on the cash flow front. The funding gap was being met by dividends from Hindustan Zinc and Cairn India. Once the transaction is complete in a couple of months, nearly USD 1 billion plus of Hindustan Zinc's free cash flows can be accessed. It will ease out cash flow situation for the company. We have recently upgraded our stock call from neutral to buy. Our fair value stands at Rs 180 factoring USD-INR at 60. If one factors in USD-INR at 10 percent depreciated value at 65, it increases to Rs 220. It remains our top pick in non-ferrous sector right now. Q: What if the merger of Hindustan Zinc doesn’t go through. How does that change your approach? A: If the transaction doesn’t go through, our fair value drops down to Rs 190, factoring the rupee impact. We will be cautious. It is the best bet to play on the sector, if the deal is complete. Q: Majority of the gains are at the EBITDA level. Will that be then eaten up by high interest costs? A: There will be an incremental USD 4 billion of debt when the process is complete, which will be used to fund transaction. Hindustan Zinc is sitting on USD 4 billion cash. It incrementally throws USD 1 billion of free cash flows. Roughly, the interest cost increases by USD 4 billion. So there’s another USD 600 million for deployment. The interest coverage ratio is going to be double for the merged entity. Q: What about regulatory issues such as iron ore and bauxite availability. Have you factored that in? A: We changed our call from neutral to buy taking into cognizance the fundamental issues that are with the company. We are looking at seven million tonne of iron ore volumes for this year. The Goa mining may not open anytime for the rest of the year. However, the company will be able to liquidate nearly 3-3.5 million tonne of inventory in the ports and mines soon. We expect Supreme Court to turn the lift over next to few months. In Karnataka, they have approval for A Narayanan’s mine, which is 2.3 million tonne and they have the logistics in place. Even if the mines open up in Karnataka as late as December, it wouldn’t be a problem for them to achieve seven million tonne of mark for the fiscal. On the aluminium front, the fundamental issue of refining, smelting mismatch still continues. Bauxite availability is still a problem. We have built enough cushion in our estimates. In terms of costing, Vedanta Aluminium will be nearly at USD 850-875 against USD 1,675 reported in the last quarter. We are building a significant premium to domestically availability of bauxite. Another key problem for the company is fuel security. We do not factor in Durgapur, Taraimar commissioning this year, but have enough cushioning for the issue. Q: How has rupee depreciation impacted your working of the estimates in the non-ferrous and the ferrous space? What is the pecking order? Will you prefer ferrous or non-ferrous? A: One should go overweight on non-ferrous. We recommend Sesa Sterlite in the non-ferrous sector, where we see significant upside from current levels. Ferrous pack is not going to be as favourable due to weak economic and demand conditions. Steel players will be able to increase prices on back of rupee depreciating. It will adversely impact the ferrous majors. However, a bit of caution here, for something like Tata Steel Europe, it can be favourable if tapering will go through and Euro Great Britain pound (GBP) will depreciate against USD. You will definitely see a shift on operating profits for Tata Steel Europe. There may be more comfort on production volumes as exports for Europe become more competitive. We like Sesa-Sterlite and have been structurally negative on SAIL and NMDC. On the ferrous side we have buy ratings on JSW Steel and Jindal Steel and Power (JSPL). However, we are a bit cautious given even base risks here.