Monday, October 18, 2010

IPO - Coal India - (The Hindu Business Line Report)

Coal India — IPO: Invest at cut-off

Investors can subscribe to the initial public offer of Coal India, the only unlisted navaratna public sector company. Coal India is the largest coal mining company in the world in terms of reserve-base and annual production.

This is by far the largest IPO in India (Rs 15,100 crore). Coal India is a holding company for 11 subsidiaries which are engaged in the development and operation of coal mines as well as exploration and design, making it an integrated coal mining company.

Coal India is a near monopoly with 82 per cent share of India's total coal production. Its fundamentals are strong, given the widening demand-supply gap for coal and the company's improving operating metrics. High return on equity (38 per cent for 2009-10), despite significant cash balances, too bolster prospects.

At the likely cut-off price (upper end of band), after factoring in a 5 per cent discount, the price for retail investors works out to Rs 232.75. This price values the company at a modest 10.8 times the estimated FY-12 earnings (consolidated). The EV/EBITDA for FY-12 works out to 4.8 times. This places it at a discount to global peers such as China Shenhua Energy, China Coal Energy, Yanzhou Coal Mining (China) and Peabody Energy (US).

According to Bloomberg estimates, the EV/EBITDA multiple for the calendar year 2011 for these companies were in the range of 6.5-9 times. Coal India may deserve to trade at a marginal discount to peers in light of the higher realisations of the overseas players due to better quality reserves and market-linked prices.

The operating margins of these companies for the calendar year 2009 ranged from 18.7 per cent to 39 per cent as against the 22 per cent (for 2009-10) of CIL.

The company has huge cash coffers of Rs 39,000 crore (around Rs 62/share) to fund future capex and overseas mine acquisitions.

Business overview


According to SRK Consulting, a UK-based mine auditor, the current resource base of Coal India is 64 billion tonnes with 21 billion tonnes of extractable reserves. The extractable reserves are sufficient to sustain current levels of production for 50 years.

Coal India operates 471 mines, of which 163 are open cast mines, 273 under-ground and 35 mixed mines. More than 90 per cent of the present production comes from open cast mines, which have a low stripping ratio. Stripping ratio is the ratio between thickness of coal seam and above lying strata.

This reduces the time required for development and allows high mechanisation that improves productivity. This improvement in development and operational parameters has been the key factor underpinning Coal India's financial performance. Despite having two sick subsidiaries (negative net worth) under its belt, it continues to be among the most profitable companies.

The sales grew at 14 per cent, compounded annually over the period FY2007-10, while the net profit clocked a 32 per cent growth. The company's operating margins stood at 22 per cent for the year ended March 2010, which is expected to improve on the back of rising realisations and falling costs.

Of the 142 mines to be tapped over the next decade, 77 are being developed and have already received environment approvals. Almost 90 per cent of the land for the projects coming up in Eleventh Plan is also owned by the company, reducing execution risks.

Demand-supply gap

According to Ministry of Coal, the domestic demand-supply gap of coal for 2009-10, at 67 million tonnes or 11.5 per cent of demand, was bridged through coal imports.

The gap is expected to widen to over 120 million tonnes by 2012 despite domestic production ramping up.

Coal India may see its production increase from 435 mtpa (million tonnes per annum) to 643 mtpa (a 6 per cent CAGR) over the next seven years.

Demand on the other hand is expected to grow in double digits, translating into better realisations. According to the offer document, non-coking coal and coking coal demand are expected to grow at a compounded rate of 11.3 per cent and 9.7 per cent up to FY-2014.

The company is looking at overseas acquisitions to augment supplies. It entered Mozambique through its subsidiary to develop coal in that country and is exploring opportunities in Indonesia, Australia and the US. While the majority of power projects are attempting to tap captive coal mines, these projects are still in the drawing board stages. In the near term, they have to turn to imports or buy in e-auction at market determined rates (from which CIL is a beneficiary).

Realisations to go up

To improve the production and reduce costs, Coal India is reviewing legacy mines and negotiating with buyers for higher coal prices that can ensure at least a 12 per cent return.

The proportion of expensive under-ground mines has fallen from 13.3 per cent in 2005-06 to 10 per cent as of March 2010.

The impact of this on the cost structure is quite high as the current cost of mining per tonne from open-cast mines is at Rs 520 per tonne compared to Rs 2,145 per tonne in under-ground mines.

Mechanised open cast mining trims employee costs for the company; the employee base is already down 3.7 per cent over the last three years and a net reduction of 11,000 employees is expected this year; from the current base of 4 lakh.

CIL also plans to add 111 million tonnes of coal washeries which would improve the beneficiated coal output, which has higher calorific value.

The average price realised for beneficiated coal (Rs 2134/tonne in FY-2010) is almost double the average price for the entire output, with only marginal addition to costs for washing. Currently the high grade coal is sold at import parity price unlike cost plus in case of low-grade coal.

The proportion of coal sold through e-auctions is also expected to go up to 20 per cent from the current 13 per cent, owing to the demand-supply gap.

While the existing fuel supply agreements (FSAs) with power projects stipulate that Coal India meet 90 per cent of its commitment or else pay a penalty to the clients, the commitment is lower at 60 per cent for non power sectors.

New power FSAs too have a 50 per cent commitment. This allows room for Coal India to sell larger quantities through e-auction.

Risks

Investors have to bear in mind that the coal mining business is fraught with risks, apart from requiring long gestation periods.

Execution delays may crop up owing to regulatory, legal and environmental hurdles, land acquisition delays, political risks and social disturbances.

Geographical concentration of resources may impose logistical problems. ECL and BCCL, wholly owned subsidiaries, despite turning profitable recently have negative net worth of Rs 6015 crore and Rs 5400 crore respectively. These companies' contributed 36.4 per cent to the overall employee costs but only 13.4 per cent to the revenues of the parent.

The new MMDR Bill may require Coal India to set aside 26 per cent of the profits for resettlement and rehabilitation activities of project affected persons. However, given the company's monopoly status and pricing power, the additional costs can be passed on to consumers.

The accounting treatment for over-burden removal may change once IFRS accounting principles are adopted.

This would mean charging the expense in the same accounting year, instead of spreading it over the life of the project. There may be a dip in profits once IFRS is adopted from April 2011 and profits may also be lumpy on account of the same.


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