COAL INDIA: Met business heads; Buy :: Motilal Oswal

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Highlights of the report:

• 1QFY11 e-auction revenues are up 28% YoY largely given price increase to Rs1748/t; and will contribute to ~28% of the earnings growth in FY11 (expect consolidated net profit up 22% YoY in FY11).
• Adjusted for the OB removal and treasury income, at Rs325/share, CIL would trade at 17.6x FY11E and 15.7x FY12E core business earnings
• The company has large cash balances, resulting in high treasury income, which constitutes ~17% of adjusted earnings
• Near term earnings growth to be driven by e-auction, cost efficiencies; washed coal remains a strong structural story
• We arrive at a price target of Rs325/share, valuing Coal India at Rs2,055b

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COAL INDIA: Met business heads; strong structural positives despite near term disappointments; maintain Buy

In our pursuit to further understand the business model and earnings framework for Coal India, we met several business heads across divisions including Corporate Planning, Production, Project Monitoring, Coal Washing, Finance, etc in Coal Bhavan, CIL’s head office at Kolkatta. The meeting reinforces our belief of strong structural macro positives, robust business fundamentals, Utility Model in Commodity business and our positive view on the stock; despite near term disappointments given operational challenges. Attached also please find our recent i) Initiating Coverage detailed report and ii) Update on 1HFY11 operational performance of CIL.

Key Takeaways:

-       During FY11, production and dispatches are now expected at 450m tons (up 4.5% YoY) and 435m tons (up 4.7% YoY); and are largely in-line with our estimates. This compares with CIL’s targeted FY11 production of 460m tons (up 6.7% YoY) and dispatches of 460m tons (up 10.8% YoY). During 1HFY11, dispatch growth stood at 2.9% YoY and residue growth to achieve our estimates is 6.8%; which looks possible.

-       Land acquisition continues to be a challenge, as during FY08-10 CIL acquired just 7000 hectares vs targeted acquisition of 66000 hectares for Eleventh Plan (FY08-12). However, the company continues to be comfortably positioned to achieve incremental targeted production; as of the 150,000 hectares required for ongoing expansion and planned projects, 70,000 hectares is already in possession. A large part of these lands were acquired in mid 1990s given expectations of accelerated pace of power capacity additions in the following plan periods; which did not materialized then.

-       E-auction volumes are expected to remain at ~10% of dispatches, given the continued shortages in terms of coal linkages. However, 1QFY11 e-auction revenues are up 28% YoY largely given price increase to Rs1748/t; and will contribute to ~28% of the earnings growth in FY11 (expect consolidated net profit up 22% YoY in FY11).

-       Underground mines report net loss of ~Rs45-50b pa given the legacy issues; and the company is targeting to enhance productivity / increase mechanization, phase out unviable mines, etc in a calibrated manner. This will entail that the reported losses in absolute amount will decline / remain stagnant over a period. Given the robust reported profitability of open cast mines at ~Rs125-130b; the consolidated profitability will witness a much superior increase going forward.

-       Adjusted for the OB removal and treasury income, at Rs325/share, CIL would trade at 17.6x FY11E and 15.7x FY12E core business earnings; and in addition, cash and investments stand at Rs64/share as at FY10. Assigning a PER of 15x to core adjusted earnings (in line with utility companies), plus cash of Rs64/sh gives a target price of Rs375/sh. We have a target price of Rs325/sh on the stock.

A] Evacuation infrastructure is the bottleneck; 1HFY11 OB removal up 12% YoY; our estimated dispatch growth of 5% looks possible

-          In 1HFY11, overburden (OB) removal grew 11.7% YoY while production growth stood at 0.7% YoY. In comparison, FY10 OB removal growth was up 7.8%, largely in line with the production growth of 6.8%. The mismatch in 1HFY11 is largely due to evacuation bottlenecks, particularly railways which impacted production growth.

-          In the past, inventory at pit heads had increased to 63m tons in FY10, from 23m tons in FY05 given evacuation constraints. Higher OB removal growth has resulted in increased coal seams being exposed in 1HFY11, which will enable the company to ramp up production meaningfully as these constraints get addressed going forward; and is also a secondary mechanism to create inventory. Hence, the lower production growth in 1HFY11 (and also partly in FY10) is not due to the inability of CIL to ramp up production, but largely given the infrastructure bottlenecks.

-          We believe that the existing bottlenecks particularly in coalfields of Talcher (MCL), Sambalpur (MCL), etc are likely to continue for some time. These fields are expected to contribute 40-45% of the incremental production till FY12E. Amongst the interim measures, CIL has adopted a three pronged strategy: i) Using inland waterways for  coal transportation, particularly in MCL ii) Moving coal from East to West coast through sea transportation, vs railways iii) Increased wagon availability through own investments and improved co-ordination with railways, etc.

-          During FY11, production and dispatches are now expected at 450m tons (up 4.5% YoY) and 435m tons (up 4.7% YoY); and are largely in-line with our estimates. This compares with CIL’s targeted FY11 production of 460m tons (up 6.7% YoY) and dispatches of 460m tons (up 10.8% YoY). During 1HFY11, dispatch growth stood at 2.9% YoY and residue growth to achieve our estimates is 6.8%; which looks possible.

RESIDUE GROWTH OF 6.8% FOR DISPATCHES AND 7.3% FOR PRODUCTION IN 2HFY11

PRODUCTION (m tons)					DISPATCH (m tons)
	FY11	FY10	% YoY			FY11	FY10	% YoY
1H	186	184	0.7%		1H	200	194	2.9%
2H	264	246	7.3%		2H	236	221	6.8%
FY	450	430	4.7%		FY	436	415	5.1%

B] Land acquisition, Environment clearances, etc continue to be key challenges; robust pipeline provides a strong base

-          Land acquisition continues to be a challenge, as during FY08-10 CIL acquired just 7000 hectares vs targeted acquisition of 66000 hectares for Eleventh Plan (FY08-12). However, the company continues to be comfortably positioned to achieve incremental targeted production; as of the 150,000 hectares required for ongoing expansion and planned projects, 70,000 hectares is already in possession. A large part of these lands were acquired in mid 1990s given expectations of accelerated pace of power capacity additions in the following plan periods; which did not materialized then.

-          Environment clearances have also become challenging, given the issues surrounding demarcation of Go / No Go areas, debate over permitting mining operations in dense forests, etc.While environmental issue is more procedural and will require policy framework; while land acquisition remains a real issue to be addressed on the ground level.

-          The Board of CIL has accorded investment approval for 149 projects, which will entail incremental production of 250m tons over next few years. Mining procedures have been demarcated and basic infrastructure work has commenced. Further, 113 projects are awaiting Stage 1 environment clearance and 54 projects awaiting Stage 2 clearances; which can provide incremental production of 175m tons over the Twelfth Plan period (FY13-17). Thus the sanctioned pipeline is robust, and CIL is building a strong base to ramp up production as these pertinent issues along with evacuation bottlenecks get addressed over a period of time.

C] Near term earnings growth to be driven by e-auction, cost efficiencies; washed coal remains a strong structural story

-          Existing washed coal capacity of 39m tons is largely outdated (last facility commissioned in 1998), resulting in lower utilization rates of ~40%. CIL is in the process of renovation and technology upgradation, etc which will lead to some marginal improvements. Of the 20 new projects with 111m tons of new coal washing capacities, one tender has been awarded and balance awards expected over the next 2 years (all tenders have been floated). Given the construction time period of 18 months, this capacity enhancement will start contributing from FY14/FY15 in a meaningful manner.Thus, coal washing remains a strong structural story for CIL, and will lead to robust margin expansion over a period of time (margins in washed coal at ~2x raw coal).

-          E-auction volumes are expected to remain at ~10% of dispatches, given the continued shortages in terms of coal linkages. However, 1QFY11 e-auction revenues are up 28% YoY largely given price increase to Rs1748/t; and will contribute to ~28% of the earnings growth in FY11 (expect consolidated net profit up 22% YoY in FY11).

-          Given the wage negotiations expected in July 2011, staff cost is expected to increase by ~22-26%. This time, the management is making serious attempts to finalize the wage revisions in time, vs historical average of ~20-22 month delays. If successfully implemented, reported profitability for CIL will not be impacted in the interim, as price increases could be simultaneous.

-          Underground mines report net loss of ~Rs45-50b pa given the legacy issues; and the company is targeting to enhance productivity / increase mechanization, phase out unviable mines, etc in a calibrated manner. This will entail that the reported losses in absolute amount will decline / remain stagnant over a period. Given the robust reported profitability of open cast mines at ~Rs125-130b; the consolidated profitability will witness a much superior increase going forward.

SALES MIX TO LARGELY REMAIN IN A RANGE TILL FY13E

Earnings and Valuation Framework, Maintain Buy

CIL makes provisions for OB removal based on average stripping ratio and these provisions constitute ~21% of PBT. We arrive at adjusted earnings by adding OB provisions to reported earnings. The company has large cash balances, resulting in high treasury income, which constitutes ~17% of adjusted earnings. We deduct treasury income from adjusted earnings to arrive at core adjusted earnings. Our analysis indicates the following: CIL's core adjusted earnings are just as robust as its reported earnings, with FY10 core earnings at Rs98b (EPS of Rs15.5). Adjusted RoE for FY10 was 36% v/s reported RoE of 40%, and adjusted core business RoE was infinite, given the negative capital employed. This was achieved despite sale of 85% of production through notified pricing, inefficiency of legacy mines (with meaningful losses), etc, and is commendable.

CORE EARNINGS FOR CIL TO GROW AT HEALTHY CAGR OF 12% V/S REPORTED PAT CAGR OF 13%

We arrive at a price target of Rs325/share, valuing Coal India at Rs2,055b based on DCF methodology. At this price target, the stock would trade at 17.4x FY11E and 15.4x FY12E earnings, at par with utilities like NTPC, PGCIL, etc. Adjusted for the OB removal and treasury income, at Rs325/share, CIL would trade at 17.6x FY11E and 15.7x FY12E core business earnings; and in addition, cash and investments stand at Rs64/share as at FY10. The stock quotes at 4.3x FY11E and 3.5x FY12E adjusted BV, with adjusted RoE at 32.6% and 29%, respectively.

CIL: COMPARATIVE VALUATIONS

CIL: FINANCIAL SUMMARY