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Igniting India growth story
NTPC with pricing options
We initiate coverage on Coal India Limited with Outperform rating and a target price of
Rs338. Coal India Limited (CIL) is the world’s largest coal company and India’s largest
corporate employer, with nearly 400k employees. It has total coal resources of over 65bn
tonnes, it has been producing at a CAGR of 5.5% for the past decade, and it is expected to
fuel India with 440mt of coal during the financial year of 2011. We think CIL represents a
low risk opportunity. It doesn’t have the usual risks associated with other commodity
stocks. It has no commodity price risk, nor does it suffer from any fluctuations in demand. It
is a pure secular play on the India growth story. The listing of this entity might actually spur
better accountability and, hence, possibly more growth and a better pricing environment.
Comparable with utility company NTPC (NATP IN, OP, CMP: Rs194, TP: Rs248,
covered by Jeff Evans), but with a pricing option: Given CIL’s low risk nature, we
believe that it more resembles a utility company. NTPC is an ideal comparison as both are
government-owned companies, are plays on the India growth story, and have stable
regulated returns. However, the key difference is that Coal India has a pricing option that
will enable it to sell part of its production at market linked rates, which gives CIL an
opportunity to earn higher than the regulated returns.
We use NPV as our prime valuation methodology, supported by PER and replacement
cost. We value the company on an NPV basis at Rs338/share. At this, it would trade at
19x and 16x PER on its FY12E and FY13E, respectively.
Low coal price risk
Linking more coal to market prices: The main purpose of CIL until now has largely been
to be a coal supplier with not much focus on profitability. Given this, it has always limited
itself to pricing products to only cover for inflation and to earn a reasonable profit.
Currently, CIL is selling coal at a deep discount of 50%+ to the import parity price and thus
has virtually no downside risk to its realisation. CIL has increased its base coal price at a
CAGR of 4.9% since 2000, in line with inflation, but its average realisation has increased
by 6% due to various initiatives to obtain a market linked price for a higher proportion of its
production. We foresee more intensive efforts by CIL going forward to get a higher
proportion of its coal sold at market prices.
⇒ Increased sale under eAuction: Since 2007, CIL has sold around 10-12% of its
production under eAuction, which has fetched prices up to 50-60% higher than base
rate. CIL can actually sell up to 20% of its production under eAuction. Many of the non
priority sectors like cement are increasingly looking to source part of the coal under
eAuction as prices are still below the import parity price.
⇒ Increased beneficiation of coal: CIL plans to increase the capacity of its washeries
to 111mtpa by adding 20 washeries in the next five years. CIL also proposes setting
up additional washeries alongside all its new mining projects, with production capacity
in excess of 2.5mtpa. As per the new coal distribution policy, CIL is allowed to sell high
grade coal at market linked prices. Also, environmental norms prohibit the use of coal
with ash content higher than 34% for power plants based more than 1,000km away
from coal mines. This gives CIL an option to enter into exclusive sales contracts at
nearly market prices (a 15% discount to the import parity price).
Low mining cost risk
Employee costs: Due to legacy issues, CIL has a large employee base of ~400k. This is
after CIL has reduced its workforce considerably from 560k over the last few years. Thus,
staff and wage costs account for 45% of total mining costs. The company expects to
reduce manpower by another 25% over the next 10 years, and we believe this will provide
it with a significant hedge to inflation-led cost increases.
Royalties and taxes: Outside of mining costs, the other main costs are usually transport
and royalties. Here, because the transport cost is largely borne by consumers and royalties
and taxes are charged over and above the base rate, these costs do not affect CIL much
directly.
Low resource and volume risk
CIL has 65bn tonnes of resources, and at its current production of around 440mt, it has
a mine life of more than 150 years. This gives CIL enough scope to increase its production
over the next few years. It currently has 77 ongoing projects with a proposed addition of
184mtpa in production. As of now, 32 of these projects with a capacity of 104mtpa have
been implemented and contributed 57mtpa in FY10. Thus, over the next few years, we
expect the company to ramp up to full capacity, which means an additional 47mtpa. In
addition, CIL has 25 more projects under implementation that are to be completed by FY12
and that have capacity of 47.5mtpa. For FY13-18, 20 new projects have been approved for
implementation, and they have a combined capacity of 33mtpa.
Risks and concerns
We believe that the key risk factors for CIL are timely execution of new mines overcoming
the clearance issues, addressing growing disruptions due to Naxal activities, avoiding loss
of coal due to illegal mining, increasing royalties and taxes and, lastly, avoiding union
opposition that could lead to a disruption in operations, which may arise due to downsizing.
The most important of the above factors is the possibility of the imposition of a 26% tax on
profits for the development of the local area and to benefit the local people, as is being
discussed under the new mining policy. If this is not passed on, it could reduce NPV by
18%. Although CIL has enough scope to pass on this tax, given the discount to market
prices at which it sells its production, it can be constrained by the government if inflation
worries persist.
We use NPV as our prime valuation methodology, supported by PER and replacement
cost. We value the company on NPV basis at Rs338/share. At this, it would trade at 19x
and 16x PER on its FY12E and FY13E, respectively.
Earnings multiple approach: Coal India’s peers are currently trading at PER of 21x and
11.4x FY11 and FY12 earnings estimates, respectively. We believe that the stability of
Coal India earnings should fetch it a premium over its peers. We also argue that Coal India
more resembles a utility company, which would be more appropriate for comparison.
Replacement cost analysis: Finally, as a sanity check measure, we have done a
replacement cost analysis, valuing Coal India’s 65bn tonnes of resources based on what
global peers are trading at as well as on the recent deal metrics. On a replacement
valuation basis, we estimate that the company is valued at US$1.02/t compared with $6-
$9/t for global peers. While this may appear to be too inexpensive, CIL’s profitability is also
extremely low right now.
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