Description

SHORT SUMMARY

Thesis

1. Premium to SOTP: Vedanta Plc is a holding company with no operating assets. It trades at a 108% premium to its Sum of the Parts Value (major asset is stock in a publicly listed company with a US$10bn market capitalisation and >$20m average daily liquidity);

2. Margin calls on major shareholder: Vedanta’s major shareholder (70% shareholding) has received two margin calls in the past month requiring additional collateral to be pledged (as Vedanta’s share price has fallen). Further share price falls could result in a “death spiral” and forced selling

3. Very High LTV / Low Asset Coverage: Vedanta Plc has total assets of US$8.7bn versus US$7.5bn of debt. This represents 86% Loan To Value (or 1.16x asset coverage). A small fall in the value of its listed subsidiary and debt will exceed asset value

4. Insufficient cash flow to service interest on debt: Vedanta receives ~US$225m of dividends from Sesa-Sterlite plus ~US$200m of interest on an inter-company loan. This is insufficient to cover interest payable on its external debt of ~US$465m

5. Debt covenant breach: approximately 50% of Vedanta’s EBITDA is generated from oil. At the current oil price Vedanta will breach the Net Debt/EBITDA covenant in its bank debt facility in 2015;

Trade Recommendations

• Short Vedanta Plc equity or credit

• The convexity on a short credit position is especially compelling – the current credit spread is 1,000 bps)

• For those looking for a hedge / looking for a relative value opportunity you can buy stock in Sesa-Sterlite (which represents the vast majority of Vedanta’s asset value) and Vedanta is trading at a material premium to its Sum of the Parts Value (of which Sesa is the vast majority of the asset value)

  • For Vedanta to have any value Sesa-Sterlite must be at least worth its current valuation

Catalysts

• Margin calls on major shareholder: These will accelerate if the Vedanta share price continues to fall. One could easily envisage a “death spiral” and forced selling if the share price continues to fall;

• Debt covenant breach: Vedanta is relying on the oil price increasing to avoid breaching debt covenants;

• Inability to service interest payments on debt plus debt maturities: Vedanta has historically relied on additional debt drawdowns (including inter-company loans) to fund negative cash flow. This will be more challenging when the company is in breach of debt covenants (note: the last inter-company loan attracted regulator attention and disapproval from minority shareholders). The company also has material debt maturities commencing in 2016;

• Dividend suspension: Further to the point above Vedanta does not have sufficient cash flow (without borrowing) to service interest let alone dividend payments. This also feeds into the point about margin calls above and the major shareholder’s ability to service its margin loan;

• Ratings Downgrade: this is a virtual certainty if the oil price does not increase. This is more relevant for a short credit position

The full write-up below starts with a company overview and then addresses each of the five points in the thesis above.

COMPANY DESCRIPTION

Vedanta Plc is a London listed holding company. The Vedanta group is controlled by the Agarwal family (Anil Agarwal), which owns 70% of Vedanta. Vedanta has no operating assets. Its only three assets are: 

1. 62.5% shareholding in Sesa-Sterlite Limited (“Sesa”). Sesa is an Indian listed company (with US ADRs) with a market capitalisation of US$10 billion;

2. 79.4% shareholding in Konkola Copper Mines (“KCM”). KCM is a non-listed company that owns copper mining assets in Zambia

3. An inter-company receivable from Sesa. At 30 September 2014 this receivable was US$2.7bn

Sesa is also mostly a holding company. The majority of Sesa’s value is derived from equity stakes it owns in two other Indian publicly listed companies, Cairn India (US$7bn total market cap) and Zinc India ($11bn total market cap). The diagram below shows the organisational structure. All of the entities shaded in blue are publicly listed.

Very Important Note

Please note that despite owning less than 100% in many of these entities Vedanta’s reporting fully consolidates the entire group. This has two important implications regarding Vedanta’s reporting:

1. EBITDA is overstated relative to Vedanta’s economic interest in the underlying assets

2. Net Debt was understated relative to Vedanta’s economic interest because:

   1. most of the group’s cash is held in Zinc India (in which Vedanta has a 41% economic interest) and Cairn India (in which Vedanta has a 37% economic interest); and

   2. most of the group’s debt is held by Vedanta (the holding company)

The table below illustrates the difference between full consolidation (Vedanta reporting) and proportional consolidation (Vedanta’s economic interest). In summary proportionally consolidated LTM EBITDA reduces to $1.9bn (vs. $4.4bn fully consolidated) and proportionally consolidated Net Debt / EBITDA increases to 5.2x (vs. 2.1x fully consolidated).

Below is a brief description of the company’s major assets.

THESIS POINT 1: VEDANTA TRADES AT A PREMIUM TO SUM OF THE PARTS VALUATION

• Vedanta Asset Value: Vedanta Plc has three assets (per description above). The aggregate value of these assets is US$8.7bn

•  

  62.5% shareholding in Sesa: $6.0bn (based on today’s closing price; note: >$10m of stock traded today)

   

   

  • Intercompany loan receivable from Sesa: $2.7bn (face value)

     

  •  

    79.4% shareholding in KCM: $0 (at 10x LTM EBITDA KCM has zero equity value)

     

• SOTP Value: Subtracting Vedanta Plc’s net debt results in an equity value of US$1.2bn

• Vedanta Market Value: Vedanta’s current market value is US$2.5bn

• SOTP Premium: 108% ($2.5bn/$1.2bn)

• Table below shows SOTP premium using LTM EBITDA multiples of 8-20x to derive the Value of KCM. In all cases Vedanta trades at a material premium to SOTP

  • Note: Copper miners trade at EBITDA multiples of

THESIS POINT 2: VEDANTA’S MAJOR SHAREHOLDER IS GETTING COLLATERAL CALLS ON A MARGIN LOAN

• Vedanta’s major shareholder is Anil Agarwal. Mr Agarwal owns 70% of Vedanta through Volcan Investments Limited (his private investment vehicle)

• Volcan has received two margin calls in the past month:

1. 27-Nov-14: “ON 27 NOVEMBER 2014, PURSUANT TO A FINANCING ARRANGEMENT WITH BANK OF AMERICA NA, LONDON BRANCH ("BAML") VOLCAN INVESTMENTS LIMITED ("VOLCAN") GRANTED SECURITY OVER 5,151,500 ORDINARY SHARES IN THE CAPITAL OF THE COMPANY (REPRESENTING 1.91 PER CENT OF THE ORDINARY SHARES IN THE CAPITAL OF THE COMPANY, EXCLUDING SHARES HELD IN TREASURY) ( THE "SHARES") IN FAVOUR OF BAML. THE ARRANGEMENT INVOLVES THE TRANSFER OF THE SHARES TO MERRILL LYNCH INTERNATIONAL ("MLI") AS CUSTODIAN FOR VOLCAN WITH SECURITY PROVIDED BY VOLCAN OVER ITS CUSTODY ACCOUNT WITH MLI IN FAVOUR OF BAML.” (http://phx.corporate-ir.net/phoenix.zhtml?c=175137&p=irol-newsArticle_Print&ID=1993452)

2. 16-Dec-14: “ON 16 DECEMBER 2014, PURSUANT TO A FINANCING ARRANGEMENT WITH BANK OF AMERICA NA, LONDON BRANCH ("BAML") VOLCAN INVESTMENTS LIMITED ("VOLCAN") GRANTED SECURITY OVER 6,243,327 ORDINARY SHARES IN THE CAPITAL OF THE COMPANY (REPRESENTING 2.31 PER CENT OF THE ORDINARY SHARES IN THE CAPITAL OF THE COMPANY, EXCLUDING SHARES HELD IN TREASURY) ( THE "SHARES") IN FAVOUR OF BAML. THE ARRANGEMENT INVOLVES THE TRANSFER OF THE SHARES TO MERRILL LYNCH INTERNATIONAL ("MLI") AS CUSTODIAN FOR VOLCAN WITH SECURITY PROVIDED BY VOLCAN OVER ITS CUSTODY ACCOUNT WITH MLI IN FAVOUR OF BAML.” (http://phx.corporate-ir.net/phoenix.zhtml?c=175137&p=irol-newsArticle_Print&ID=2001137)

• The margin call that occurred on 16 December 2014 was not announced to the market until 6.30pm on 19 December 2014. A reasonable person might ask why this information was delayed for release until 6.30pm on a Friday night?

• If the Vedanta share price continues to fall there will be further margin calls. One could envisage a “death spiral” and forced selling if the share price continues to fall

THESIS POINT 3: VEDANTA LTV RATIO IS DANGEROUSLY HIGH

• Asset Value: Vedanta Plc has three assets (per description above). The aggregate value of these assets is US$8.7bn (per thesis point 1 above*)

• Debt: Vedanta Plc had $7.5bn of debt outstanding at 30 September (see slide 31 here for details: http://www.vedantaresources.com/media/169888/vedanta_fy_2015_interim_results_presentation.pdf)

• Loan-To-Value: Loan To Value = 86% ($7.5bn/$8.7bn). A small reduction in the value of Sesa-Sterlite will result in impairment to Vedanta’s creditors (and zero recovery for equity)

* The asset value calculation is using a valuation multiple of 10x LTM EBITDA for KCM. At 30 September 2014 KCM had Net Debt / EBITDA of 11.5x. This exceeds the multiple that publicly listed copper miners currently trade at (e.g. First Quantum, Freeport-McMoRan, Teck and Antofagasta). KCM is a troubled asset that has experienced a series of operational issues over the past 5 years. EBITDA has declined consistently since 2011. Notwithstanding, some argue that KCM’s DCF value results in a positive equity value. While I think this is aggressive in light of actual results over the past 4-5 years, even using a more aggressive valuation for KCM does not change the LTV calculation materially. For example, if one were to assume KCM had an Enterprise Value of $1.5-2.0bn (21-28x LTM EBITDA) Vedanta’s equity would only be worth $0.5-0.9bn. The high end of this range would reduce LTV to just under 80%.

THESIS POINT 4: CASH INFLOW RECEIVED BY VEDANTA IS INSUFFICIENT TO COVER ANNUAL INTEREST EXPENSE

• Vedanta has two sources of cash inflow: (i) Dividends from Sesa and (ii) interest received on an inter-company loan to Sesa

  • Note: KCM is not a source of cash inflow – it has actually consumed capital over the past few years by way of capital infusion requirements (to avoid bankruptcy)

• Total cash inflows are expected to be ~US$425m

  • Dividends from Sesa: In FY2014 Sesa paid dividends of ~US$370m. Vedanta’s share of this would be ~$225m. Sesa is not generating much (if any) cash flow at current commodity prices. It’s difficult to see dividend policy changing materially;

  • Interest on intercompany loan: ~$200m (see slide 32 here: http://www.vedantaresources.com/media/169888/vedanta_fy_2015_interim_results_presentation.pdf)

• Interest expense is expected to be US$465m (see slide 32 here: http://www.vedantaresources.com/media/169888/vedanta_fy_2015_interim_results_presentation.pdf)

• Vedanta has historically relied on inter-company loans (and increasing external debt) to fund its negative organic cash flow

  • For example earlier in 2014 US$1.25bn was up-streamed by way of intercompany loan. (note: this created some angst with shareholders and the regulator: http://businesstoday.intoday.in/story/cairn-india-usd-1.25-bn-loan-to-vedanta-group-hits-scrip/1/208519.html)

• Given Vedanta is going to breach debt covenants in 2015 such inter-company transactions are likely to become more difficult (more on covenants below)

THESIS POINT 5: VEDANTA IS ON TRACK TO BREACH BANK DEBT COVENANTS IN 2015

• Vedanta Group EBITDA:

  • FY14 (Mar YE): $4.5bn

  • LTM (Sep’14): $4.4bn

  • H1’15 Annualised: $4.2bn

• Group Net Debt/EBITDA Covenant: http://www.vedantaresources.com/media/169888/vedanta_fy_2015_interim_results_presentation.pdf)

• Net Debt / LTM EBITDA (Sep’14): 2.1x

• ~50% of the Group’s EBITDA comes from oil and ~30% comes from Zinc. The Company discloses EBITDA sensitivities to movements in commodities (see slide 37 here: http://www.vedantaresources.com/media/169888/vedanta_fy_2015_interim_results_presentation.pdf)

• These are the sensitivities as disclosed by the company

• Marking to market for the movements in commodity prices the overall impact on H1’15 EBITDA is ~US$600m (or a 29% reduction) – see table below

• Using H1’15 annualised EBITDA of $4.2bn as the starting point Vedanta is comfortably in breach of its debt covenant at spot commodity prices – i.e. EBITDA reduces to ~$3bn and Pro Forma Net Debt / EBITDA is 3.0x – see table below

Catalyst

• Margin calls on major shareholder: These will accelerate if the Vedanta share price continues to fall. One could easily envisage a “death spiral” and forced selling if the share price continues to fall;

• Debt covenant breach: Vedanta is relying on the oil price increasing to avoid breaching debt covenants;

• Inability to service interest payments on debt plus debt maturities: Vedanta has historically relied on additional debt drawdowns (including inter-company loans) to fund negative cash flow. This will be more challenging when the company is in breach of debt covenants (note: the last inter-company loan attracted regulator attention and disapproval from minority shareholders). The company also has material debt maturities commencing in 2016;

• Dividend suspension: Further to the point above Vedanta does not have sufficient cash flow (without borrowing) to service interest let alone dividend payments. This also feeds into the point about margin calls above and the major shareholder’s ability to service its margin loan;

• Ratings Downgrade: this is a virtual certainty if the oil price does not increase. This is more relevant for a short credit position