Sesa Goa shares: Wedding bells, at last, but...

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SummarySterlite merger to diversify business and revenue mix, but market has already celebrated the event

Sesa Goa’s stock has rallied sharply (up 35%) in the past fortnight backed by regulatory clearances for its long pending merger of Sterlite into Sesa and expectations of the company receiving approval for the buyout of the government’s residual stakes in Hindustan Zinc and Balco. The merger approval should boost the company’s efforts towards simplifying its corporate structure and offer a much diversified revenue and Ebitda mix.

However, we believe that issues of cash fungibility across group businesses will remain as cash-rich zinc (HZL) and oil (Cairn India) businesses are housed in separate entities. Post-the sharp move in stock price, we see limited upside from current levels until there is more clarity on cost effective bauxite sourcing for the Jharsuguda aluminum operations (erstwhile VAL) or there is improved visibility on captive coal for the company’s power operations. We downgrade Sesa to Hold with a target price of R170/share (vs R166 earlier).

We continue to remain positive on HZL on the back of the improving outlook for mined metal growth and refined metal growth. We have increased our FY14e earnings for HZL by 10% to factor in a depreciated INR and reiterate our Buy rating with a revised target price of R144/share (vs R134 earlier).

The merger provides impetus to the group’s efforts towards simplification of the complex corporate structure. Sesa Sterlite, the new entity, will now house all the operating businesses in India and should help in better alignment of the promoter interest. But cash fungibility is likely to remain limited under the new structure as well. Since oil and zinc business are housed in separate entities, it should limit the group’s access to the impressive cash flows being generated by these world class businesses.

Also, the earnings prospects for the aluminum (VAL) and power business (Sterlite Energy Ltd) housed in the standalone Sesa Sterlite remain subdued with visibility remaining low on captive bauxite and coal supplies. With recent stock performance already factoring in benefits from the corporate restructuring and probable sale of government’s residual stakes in Hindustan Zinc to a large extent, we would wait for more clarity on steps to further optimise the corporate structure before becoming more positive on the stock.

A near-term trigger could emerge from the resumption of mining at Sesa's iron ore mines in Goa and Karnataka, which are awaiting various regulatory and judicial approvals. While our earnings estimates already factor in a restart of mining in H2FY14,

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