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Coal India (COAL.BO)
Initiate with Buy: A Coal Colossus; Mining Multiple Seams
Initiating at Buy (1L); large, growing and changing — We believe Coal India (CIL)
has significant opportunities: 1) huge resources (64.2bn tonnes); 2) India’s
growing demand (10.7% CAGR FY10-12E) with CIL (431mt in FY10) controlling
80%+ of India’s output; 3) ~5% CAGR volume growth, FY10-13E (Citi est); 4)
coal pricing at a discount to global prices; 5) increasing value addition through
washing/market-driven pricing; 6) high return, structurally low-cost operations
($17/t); 7) US$8.7bn net cash.
Target price Rs358 — CIL looks well positioned, and the coal outlook is strong.
The stock trades at a premium to Asian peers (8-15x PE) and there are near-term
challenges (environment/infrastructure), but stock price should be supported by
structural upsides on pricing and value addition. We value CIL using: 1) DCF+30%
and 2) 12x FY12E PE, weighted 60:40, as we believe PE alone cannot fully
capture fair value given the mine life and long-term benefits from washing.
Growth plans — CIL has aggressive plans 1) increasing exploratory drilling targets;
2) 185mtpa of additional capacity; 3) 111mtpa of washing capacity (FY13-18); 4)
coal beneficiation for new open-cast mines >2.5mtpa; 5) overseas acquisitions.
CIL’s expects 6% production CAGR (FY10-13) and 40% washed coal by FY17. Our
estimates are more conservative: 5% production growth and 33% washed coal.
is globally the third-largest producer (532mt in FY10) and consumer of coal
(582mt) with 277bn tonnes of resources, and is a net importer. Power consumed
71% of coal in FY10. The Ministry of Coal estimates 10%+ demand growth, 8.8%
supply CAGR (FY10-12), suggesting India will remain high demand, short supply.
Risks — Forest/environmental clearances, 26% profit sharing, land acquisition,
logistical constraints, auction for future reserves, restricted ability to raise prices.
Investment Thesis
Strong fundamentals
Initiate with Buy / Low Risk (1L) and target price of Rs358. CIL is the world’s
largest coal producer (431mt in FY11) with 18.9bn tonnes of proven and
probable reserves (64.2bn tonnes of resources) according to the JORC
classification. ~92% of its coal output is thermal (used for power) and only 8%
is coking coal (used for steel making).
Key strengths
It is dominant in India, accounting for 82% of FY10 coal production.
Coal is the major source of India’s power generation (52%), and India’s
coal/power deficit is an opportunity.
Low production cost of $17/t in FY10. 90% of output is from open-cast
mines and average stripping ratio is less than 2.
Domestic prices are at a significant discount to international prices, leaving
scope for price upside.
Stable EBITDA margins of 20-25% during FY07-10 (except FY09).
Net cash of Rs392bn (US$8.7bn) as of Sep-2010.
Promising future
The global coal outlook is positive. Citi estimates thermal coal prices to
average $100-110/t in FY11E-12E (vs. $70/t in FY10). Coking coal prices
are expected to be $220-225/t in FY11-12E (vs. $128/t in FY10). CIL’s
average realization should grow at a 6% CAGR FY10-12E.
While production growth may be subdued in FY11, raw coal dispatches
should rise at a 6% CAGR in FY10-12E and 5% CAGR through FY17E.
More market-driven pricing longer term. The proportion of washed coal
volumes should rise from 5-6% through FY10-13 to 33% in FY17E. Washed
coal sells at a significant premium relative to FSA coal, although washing
cost is marginal.
With gradual cost increases going forward, margins should remain ~26% till
FY14E and expand thereafter as the benefit of washing kicks in.
Importing coal through planned overseas acquisitions (Mozambique,
Australia, Indonesia, US) to help bridge India’s demand/supply gap.
Initiate with Buy (1L)
CIL is well positioned, and the coal outlook is strong. We initiate with Buy / Low
Risk (1L). The stock trades at a premium to Asian peers (8-15x PE) and there
are near term challenges concerning environmental issues and infrastructural
bottlenecks − but the stock price should be supported by structural upsides on
pricing and value addition.
Our target price of Rs358 is arrived at using (1) a valuation based on DCF +
30% premium (Rs448/sh) and (2) a 12x FY12E PE based valuation
(Rs225/sh), with a 60/40 weighting. Our DCF valuation is enhanced by 30% to
account for probable reserves (8.3bn tonnes – an additional 78% over the
proven reserves) that we have not incorporated in our valuation. We have not
taken a terminal value and thus also use a PE based valuation as it assumes
new reserves replace the ones exhausted. The lower weightage to PE seems
justified given CIL’s limited exposure to international prices and that the
benefits of beneficiation are likely to have a meaningful impact only after 2-3
years – thus PE alone cannot fully capture a fair valuation.
Risks
Risks of restrictions imposed by regulators related to forest clearance and
environmental safeguards.
Difficulties in obtaining reserves/resources; auction for future reserves
A proposed 26% profit-sharing requirement contained in the New Mining
Bill.
Land acquisition.
Logistical constraints including rail transport bottlenecks.
Restricted ability to raise coal prices.
Non-availability of critical equipment.
Company Overview
CIL is the world’s largest coal producer, with a production of 431mt (+6.8%
yoy), dispatches of 415mt (+3.6%) in FY10 and 18.9bn tonnes of proven and
probable reserves. It has eight subsidiaries in India – seven of which carry out
coal production and CMPDIL (Central Mine Planning and Design Institute
Limited), which provides technical expertise and consultancy to CIL/others.
CIL was established in 1973 and 90% is currently held by Indian government.
It was conferred Navratna status in 2008-09, which enhances the board's
power to incur capital expenditure without reference to the government.
Non-coking coal accounted for ~92% of production in FY10 and accounts for
~95% of the company’s reserve estimates.
CIL accounted for 82% of India’s coal production in FY10 and looks well
positioned to meet growing domestic demand, as India is likely to remain a net
coal importer over the next few years. Power accounted for 80% of CIL’s raw
coal dispatches (including captive power plants) in FY10. CIL has longstanding
relationships with its five biggest clients (48-51% of FY08-10 dispatches) all of
which are public-sector power-generating companies. NTPC is its largest
customer and accounted for 27% of its raw coal dispatches in FY10.
~90% of CIL’s production is from open-cast mines, where production cost
($12/t) is significantly cheaper than underground mines ($62/t). Its average
cost of production was $17/t in FY10 vs. Indonesian producers at $32/t (open
cast mines, stripping ratio 9x).
The company had planned to grow its output at a 6.2% CAGR through FY12E
to 487mt – however it is likely to miss the target based on trends so far and
issues surrounding environmental clearances and infrastructure bottlenecks.
65-68% of CIL’s production during FY07-10 was low-grade ore (E&F) and sold
at a significant discount to the landed cost of imported coal. Current
beneficiation capacity is 39mtpa. CIL plans to set up 111mtpa in phases during
FY13-18 at a capex of Rs23.3bn. Additionally, all new open-cast mines with
capacities >2.5mtpa, which are not linked to pit-head customers, will have coal
beneficiation facilities. CIL hopes to beneficiate ~40% of its volumes by FY17.
Coal can be beneficiated at a marginal cost, but sold at a significant premium.
Average price per ton of raw coal in FY10 was Rs1,045/t ($23) – at a discount
to international prices even after adjusting for calorific value. CIL intends to
price the washed coal at a premium to unwashed coal of similar grade, but at a
discount to the imported coal. CIL sold ~12% of its FY10 raw coal volumes via
E-Auction (based on market pricing), at an average price of $35.
Rail is the main mode of transport used by CIL and accounted for 47% of coal
dispatches in FY10. Road accounted for 29% and the Merry-Go-Round (closed
loop rail) system for 21%. Freight costs (beyond 3km) are borne by customers.
Employee costs accounted for 47% of CIL’s expenses in FY10. CIL had ~397k
permanent employees as of 31 March 2010. This should gradually decline over
the next few years through natural attrition, helping improve productivity.
CIL had ~US$8.7bn of net cash as of 30 September 2010. Despite selling most
of its coal at a discount to international prices, it has earned EBITDA margins
ranging from 20-25% during FY07-10 (a low of 10% in FY09). An increasing
trend to market-driven pricing should help margins if costs remain stable.
Valuations
We calculate our Rs358 target price based on two metrics:
a valuation based on DCF + 30% premium (Rs448/sh)
a 12x FY12 PE-based valuation (Rs225/sh)
…which we then combine based on a 60/40 weighting.
This method incorporates both CIL’s asset valuation and also its earnings
potential. Our DCF valuation is enhanced by 30% to account for the probable
reserves (8.3bn tonnes – an additional 78% over the proven reserves) that we
have not incorporated in our valuation. We have not taken a terminal value and
thus also use a PE-based valuation as it assumes new reserves replace the
ones exhausted. The lower weightage to PE seems justified given CIL’s limited
exposure to international prices and that the benefits of beneficiation are likely
to have a meaningful impact only after 2-3 years – thus PE alone cannot fully
capture a fair valuation.
DCF-Based Valuation
We have modeled DCF cash flows out to FY26E based on CIL's existing proven
reserves of 10.6bn tonnes. Our DCF valuation is enhanced by 30% to account
for probable reserves (8.3bn tonnes – an additional 78% over the proven
reserves) that we have not incorporated in our valuation. We do not account for
any terminal value due to lack of visibility on future reserves. Our WACC is
11.8% which is calculated based on a beta of 1.0 (relative to Sensex), a riskfree
rate of 8.0% and an ERP of 6%, cost of debt of 6.8% (post tax), and a
target debt-to-total-capital ratio of 30%. We enhance our DCF-based valuation
by 30% to account for probable reserves of 8.3bn tonnes (an additional 78%
over the proven reserves) that we have not incorporated in our valuation –
resulting in a price of Rs448/share.
PE-Based Valuation
Chinese and Indonesian coal companies currently trade at 8-15x PE. Excluding
the outliers, the range would be 10-12x. We value CIL at 12x FY12 PE – at the
higher end of the trading range for the Indonesian and Chinese producers.
Reasons to value it at the high end of the range include:
CIL makes a higher provision for overburden expenses than actually incurred
− FY12E EPS would rise by 18% if we were to provide for only the actual
overburden removal expenses. Most Indonesian producers under-expense
their overburden costs – thus making their PE multiples appear cheaper.
No major downside risk to coal prices given the significant discount to
international coal prices.
High visibility on CIL’s mine life based on its proven and probable reserves.
Scarcity premium – CIL is a dominant coal producer in India and is well
positioned to benefit from India’s growing coal demand.
Our PE-based valuation results in a price of Rs225/share. The derived PE at
Rs225/share would be 10.2x, if we were to adjust for the excess overburden
removal expenses. Again, we would not use PE on a pure standalone basis
given CIL’s limited exposure to international prices; its long mine life and that
the benefits of beneficiation are likely to have a meaningful impact only after 2-
3 years.
Derived Target Price
Our target price is based on a 60/40 weighting between both methods (DCF
and PE) − giving a value of Rs358/share. At our target price of Rs358, CIL
would trade at FY12E PE of 19x and EV/EBITDA of 11x. Excluding the impact of
the overburden adjustment removal (over expensing the overburden removal
costs), would result in a derived PE of 16.2x. Asian peers currently trade at 8-
15x PE.
Coal India
Valuation
Our target price of Rs358 is arrived at using (1) a valuation based on DCF +
30% premium (Rs448/sh) and (2) a 12x FY12 PE based valuation (Rs225/sh),
with a 60/40 weighting. This method incorporates both CIL’s asset valuation
and also its earnings potential. Our DCF valuation is enhanced by 30% to
account for the probable reserves (8.3bn tonnes – an additional 78% over the
proven reserves) that we have not incorporated in our valuation. We have not
taken a terminal value and thus also use a PE-based valuation as it assumes
new reserves replace the ones exhausted. The lower weightage to PE seems
justified given CIL’s limited exposure to international prices and that the
benefits of beneficiation are likely to have a meaningful impact only after 2-3
years – thus PE alone cannot fully capture a fair valuation.
Risks
We rate Coal India shares Low Risk. Although our quantitative risk rating
system suggests a Speculative rating based on the shares’ short trading history,
we believe CIL’s stable margins, mine life visibility, limited risk of coal price
downside, low costs and net cash position warrant a Low Risk rating.
Downside risks that could prevent the shares from reaching our target price
include, but are not limited to: risks of restrictions imposed by regulators
related to forest clearance and environmental safeguards; difficulties in
obtaining reserves/resources; a proposed 26% profit-sharing requirement
contained in the New Mining Bill; land acquisition; logistical constraints
including rail transport bottlenecks; restricted ability to raise coal prices;
disruption of operations in politically unstable areas; auction for future
reserves; and non-availability of critical equipment.
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