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Coal India Limited
Growing with India; Initiating with Overweight Rating
Proxy for India’s growth: Our Overweight
recommendation on Coal India (CIL) is driven by our
conviction that the company’s strong interdependence
with India’s economic growth and earnings strength and
stability will increasingly be recognized in valuations. In
addition, we do not think the stock price fully captures
possible gains from the following factors: (i) CIL’s
changing market mix, which we believe can contribute
meaningfully to realizations and margins; and (ii) solid
cash flows adding to an already strong balance sheet to
allow the healthy payout we expect from F2H13.
Where CIL has an edge: (1) Strong earnings growth –
we estimate EPS CAGR of 29% in F2011-13; (2) Large
reserves base – CIL is the world’s biggest coal producer,
backed by the largest coal reserves, which are assessed
to last for more than 45 years with substantial upside;
and (3) Low operating costs.
We expect CIL to be rerated over next 3-4 quarters as
the market becomes increasingly aware of the relatively
low risk in CIL’s earnings performance in view of the
close correlation with economic growth. The stock is
trading at a F12E EV/EBITDA of 7.6x, a 9% discount to
our global coal coverage universe and a 26% discount to
NTPC. Our DCF-based price target of Rs387 indicates
potential appreciation of 22% from current levels and a
target F12E EV/EBITDA of 9.5x. We are more positive
than the Street on CIL’s coal price trends, OBR
treatment, and valuation. We believe that the current
stock price is unfairly reflecting CIL’s inability to pass on
next year’s staff cost increase.
Key catalysts: (1) Improved performance in quarterly
results from F4Q11; (2) Rise in benchmark prices
following wages hikes, in F2Q12.
Less favorable aspects: (1) Low volume growth – we
expect 4.3% CAGR in F10-13; (2) Risks – on the
regulatory front and relating to expansion and pricing.
Why We Are Overweight
We expect stock to be rerated as
investor appreciation for CIL’s strengths
increases, specifically:
• Attractive vehicle for participating in
India’s economic growth;
• Strong long-term positives – large
mine reserves, low and falling
production costs, favorable geological
characteristics;
• Healthy and accelerating earnings
growth – we expect earnings CAGR of
29% in F11-F13, with low downside
risk.
Key Value Drivers
• Change in sales mix: We expect the
share of market-linked sales volume to
rise to 34% in F13 from 22% in F10.
• Lower price discount: We estimate
discount to import parity prices will fall
to 68% in F13 from 71% F11E.
• Higher staff costs: Our model
assumes a rise from Rs386/t in F10 to
Rs493/t in F13.
• Muted production growth: We
forecast 4.3% CAGR in F10-F13.
• Regulatory environment.
Potential Catalysts
• Quarterly results from F4Q11 should
display improvement in realizations
and rebound in volume growth.
• We expect an increase in notified
prices in F2Q12 to accompany wage
revisions.
Downside Risks
• Regulatory, law and order and /or
logistical issues cause CIL’s volumes
to dip.
• The government does not allow CIL to
raise prices in the next two to three
years because of inflation concerns.
• CIL undertakes a large and
value-reducing acquisition abroad.
Key Issues
Investment Debates
1. How quickly can the market mix improve?
Market view: Any improvements will be sluggish
at best.
Our view: We expect the share of market-linked
sales volumes to grow rapidly – to 34% in F2013
from 22% in F2010.
Leading indicators: Imported share of India’s coal
may rise to 18% in F2013 from 13% in F2010.
Where we could be wrong: If the government
becomes alarmed about inflation and, at the same
time, the rate of power capacity additions falls,
volumes sold via market-linked prices may not
increase. This scenario could be prompted or
accompanied by a slowdown in economic growth.
2. Will government ease controls over coal
pricing?
Market view: No, and so the increase in notified
prices would not exceed the historical pace of
4.9%.
Our view: We think CIL’s notified prices could
increase at a CAGR of 6.3% in F2010-13 and
5.7% in F2013-16 as the government relaxes
some of its controls over prices.
Leading indicators: There is already evidence of
some easing, for example, with the introduction
and growing proportion of e-auction coal.
Where we could be wrong: The government may
become concerned about inflation. Coal demand
may slump.
Investment Debates
3. What is the probable staff costs trend?
Market view: At this time, the market seems to be
either ignoring this issue or considering it an
unknown. However, the Street expects 3-4%
annual reduction in CIL’s headcount.
Our view: We expect a staff cost increase to be
implemented from July 1, 2011, as scheduled. We
assume a 45% increase for non-executives
(which translates into an average increase of
about 40% across the employee base), in line
with the wage inflation incorporated in the
increases that took effect from 2001 and 2006.
We assume headcount CAGR of -3.5% in F10-13,
largely in line with Street expectations.
Where we could be wrong: Excessive union
pressure and/or rampant inflation in the next six
months could cause the staff cost increment to
exceed our forecast.
4. How will the OBR (overburden removal)
adjustment change and how should it be
accounted for?
Market’s view: The company has been guiding
that the OBR adjustment would be withdrawn post
the IFRS adoption, and we believe that the market
is rightly calculating that this would aid CIL’s
earnings performance. However, the market is
not adjusting profit estimates for this figure.
Our view: CIL’s profits should be assessed after
adjusting for this figure since (a) no other mining
company in India, and possibly globally, follows
this practice; and (b) as this is a non-cash item, it
is unfair not to adjust for it, in our view. We think
reported profits for CIL will improve once this
practice is stopped.
Investment Debates
5. Which are the most appropriate valuation
peers for CIL?
Market view: Shenhua
Our view: Shenhua, NTPC, and other coal
companies globally. We think CIL should be
treated as a commodity company with noticeable
utility characteristics. While its RoE is not
guaranteed – as it is with many utility companies –
it still has high earnings visibility. The improving
market mix offers high growth potential but with
relatively low dependence on global coal prices
6. Will the profit-sharing proposal be effected
and what is likely impact on CIL?
Market view: Yes. CIL’s profits could fall 25%.
Our view: Possibly yes, but in a changed format –
the profit impact would be less than 2-2.5%. Due
to uncertainties involved here, we are currently
not factoring this into our base case.
Where we could be wrong: If the proposal is
implemented and remains in the current form, CIL
may find it difficult to pass on more than 60-70%
of the consequent burden to customers.
7. How will CIL utilize its large cash pile?
Market view: For acquisitions.
Our view: At best, a small portion will go for
acquisitions. A large share of the cash will be
returned to shareholders via special dividends in
F13-15, we believe, as we think the acquisition
process would be protracted given the complex
approval procedures that would be required. We
note that CIL has stated that it hopes to utilize a
large part of its cash for acquisitions and that it
may not give special dividends.
Investment Issues with Diminishing Relevance
Given that CIL was listed only recently, understandably some
issues have taken centre stage even though they may turn out
to have little relevance for the stock. Below we summarize
some such topics that are being debated currently but will likely
decline in relative importance as the street realizes that they
are only fringe issues.
1. There are concerns about CIL’s sluggish volume
growth. What is the outlook?
Our view: We expect production volume CAGR of 4.3% for
F10-13.
Why we think this issue will become less relevant: (1)
CIL’s sales volume target of 6.5-7% itself is modest. (2)
Earnings sensitivity to volumes is low. To compensate for a 1%
price change, volume needs to change by 4.5%, based on our
F12 forecasts. Even if the growth target of 6.5-7% is missed by
half, the earnings miss would be just 5-6%. (3) There is not
much controversy surrounding this issue – we believe the
difference between the most optimistic and most pessimistic
estimates for volume growth is no more than 3-3.5%.
2. Will the company change its strategic course once the
current chairman cum managing director (CMD)
retires?
Our view: No.
Why we think this issue will lose relevance: In early 2011,
the current CMD will retire, as has been announced. As with
most public sector organizations, CIL is likely to show
continuity in its strategic direction since senior managers will
not change and guidance from the Ministry of Coal via
representatives on CIL’s board and elsewhere will remain as
previously. While we – and probably most of the street –
believe the current CMD has played a strong role in the solid
performance of CIL, we expect the successor to carry on the
good work.
What’s in the Price
Inability to Pass On Staff Cost Increases in F2012
Based on our DCF-based model, we calculate that the current
stock price reflects (i) salary per head of non-executives rising
by 45% on July 1, 2011, and (ii) CIL’s ability to raise its
stipulated coal prices by only 7%, leading to an average
year-over-year price increase of 8%. Effectively this implies
that CIL would be unable to pass on staff cost inflation and
hence F12E EBITDA would fall by 13% YoY. In our view, this is
an unlikely scenario.
Investment Case
Proxy for India’s Economic Growth
As the supplier of more than 80% of India’s coal requirements
in F2010, CIL should increasingly be viewed as a proxy for
India’s growth, which causes and is, in turn, driven by growth in
power demand. In response to the concomitant increase in
coal demand, either (i) CIL will accelerate output; or (ii) coal
prices will edge up in India as demand tightens, imports soar
and customers are increasingly willing to pay more – which
again depends on the country’s income growth. Under either
scenario, or even a combination of the two, CIL’s earnings, as
well as valuations, will be enhanced, we believe.
Indian Coal Demand Accelerates: 9-9.5% CAGR in F10-14E
India’s power demand looks set for a sustained phase of high
growth as manufacturing growth picks up and urbanization
increases. To meet this demand, substantial power capacity is
being added in the country with a large portion based on coal.
Fast-growing capacity in steel and cement is also a driver of
coal demand. Our power and utilities analyst for India, Parag
Gupta, expects coal-based power capacity additions of 51GW
in F10-14 and 93 GW in F14-18 versus end-F2010 coal-based
capacity of 104 GW. We estimate India’s total coal demand will
expand at a CAGR of 9-9.5% in F10-14.
Long Mine Life + Cost Leadership + Minimal Specific
Capex Needs = Cash Machine
With a mine life of between 35 and 70 years (depending on the
reserves estimate) based on our F2013 production forecast,
CIL looks well placed to act as the main power source in India
over the longer term. Endowed with favorable geological
features, CIL’s average cost of production of US$17/ton
(open-cast mine production cost of US$11/t) seems quite
attractive, even after allowing for the inferior coal grade. CIL’s
incremental capacity additions are made at quite low capital
expenditures (US$8-12/t versus global norms of US$15-25/t),
allowing CIL to be a cash machine for the government.
EBITDA CAGR of 31% for F11-13E
We expect EBITDA CAGR of 31% in F11-13, driven by
average realization CAGR of 10.8% and despite muted volume
growth of 5.4% forecast for the period. We think our realization
assumptions face more upside than downside risk. The three
drivers of higher realizations are (i) increased sales in the free
market – to about 34% of sales by the end of F2013 from
around 22% currently; (ii) a narrowing discount in the free
market relative to import parity prices, and (iii) a faster increase
in notified prices than in the past.
High Degree of Confidence in Earnings Forecasts – Not
Reflected Fully in Stock Price
About 78% (but a falling share) of CIL’s sales volume is sold
under notified prices, and so EBITDA per ton in practical terms
is supported by the regulatory mechanism. CIL is permitted to
raise its quasi-regulated prices at least by the amount of its
cost escalation. The other side of the argument is that CIL
would not be a major beneficiary of a large increase in global
coal prices. However, the share of volumes sold in the
quasi-regulated market is gradually falling and could be down
about 63% by the end of F2014. In addition, in the free market,
CIL has so far been selling its product at a discount to import
parity prices. This discount will likely narrow in the next two to
three years, providing some clarity on CIL’s average realization
growth irrespective of global price trends.
Our global mining team is bullish on thermal coal prices,
forecasting increases of 7.1% in 2011 and 4.8% in 2012, an
outlook that further supports our positive stance on Coal India.
Key Risks
(1) Coal price risk: If inflation in India becomes a concern and
remains at uncomfortably high levels for three to four quarters,
CIL may find it difficult to increase its free-price volumes, thus
capping realizations. A sudden and large drop in industrial and
economic activity in India and globally could hurt demand for
and production of coal, pulling down coal prices in the free
market.
(2) Regulatory risks include hurdles in obtaining or complying
with environmental approvals, forest clearance, land
acquisition, production licenses and pollution norms. We
assume low volume growth, but if environmental issues
escalate, CIL may experience a decline in volumes, which
could put our price target at risk.
(3) Law and order: Should such issues escalate, they could
cause CIL’s output to stall or even be curtailed, boost security
and insurance costs and affect the ability to attract and retain
talent.
Investment Positives
World’s Biggest Coal Producer with Largest Reserves
Coal India Limited is the largest producer of coal globally, with
output of 431mt in F2010. We believe that power demand is
poised for sustained strong growth as manufacturing
expansion takes off and urbanization increases. According to
the forecasts of our power and utilities analyst, Parag Gupta,
51GW of coal-based power capacity will be added in F10-14
and 93GW in F14-18 versus 104GW at end-F2010. We
estimate India’s total coal demand will expand at a CAGR of
9-9.5% in F10-14. CIL also holds the largest coal reserves
globally (Source: CIL RHP quoting Crisil Research) with a
proved and probable reserves base of 18,862mt and measured
reserves of 51,326mt, as certified per the JORC code.
Good Visibility on Potential for Price Increases
Coal India sells its coal at a substantial discount to global
prices, and we believe it can raise its average coal price at a
CAGR of 9.4% in F10-13 versus 4.9% for the past ten years.
Favorable Geographic and Geological Conditions …
CIL benefits from favorable geographic and geological
conditions in many of its coalfields, including relatively thick,
flat-lying coal seams located at shallow depths, stable ground
conditions, fairly simple geological structures and a low
stripping ratio, which enable it to bring large open-cast mines
into operation in a relatively short time and with quite low
investment levels. In addition, most of CIL’s raw coal
production is from open-cast mines (90% in F2010), where the
cost of production is significantly lower than in underground
mines due to the low stripping ratio and favorable
geo-economic conditions.
… Allow Low Production Costs
CIL enjoys relatively low production costs due to its low strip
ratio. Even on an average basis, production costs are quite
competitive (at US$17/t in F2010) because of the high
proportion of production – almost 90% – from open-cast mines.
Lack of Direct Competition
CIL is the dominant player in the Indian coal market. In F2010,
it accounted for 81.9% of India’s coal output, with the
remainder produced by Singareni Collieries Company (a JV
between the Andhra Pradesh Government and Union
Government of India) and captive mines of a few private
players. We do not think imports pose a competitive threat to
CIL. While in the past three years imports have increased,
especially from Indonesia, South Africa and Australia, it is
worth highlighting that imports are simply a function of CIL’s
inability to upgrade its supply in line with demand growth.
Strong Balance Sheet Allows Exploration of New Areas
At the end of September 2010, CIL was sitting on US$8.3bn in
net cash, representing 19% of its current market capitalization.
Accordingly, the company has stated that it is considering the
acquisition of coal assets abroad in addition to aiming to speed
up growth in its Indian operations. CIL is also exploring
opportunities in coal trading. At a later stage, we would not be
surprised if CIL were to enter the power generation business to
utilize a part of its cash pile in another business that allows
earnings stability. However, the company has not indicated an
interest in such a strategy at this time.
Focus on Sustainability and CSR Activity
CIL views seriously the implementation of safety policies and
environmental initiatives such as land reclamation, restoration
of open-cast mines, water harvesting, reforestation and
rehabilitation at its mines and sets high standards in this
respect. In addition, it is quite active in the development of
communities in areas where it operates. The goodwill that CIL
has generated as a result helps it to keep production
disruptions due to Naxalite issues at a much lower level as
compared with most other metals and mining companies in
India. This is especially important since CIL operates deeply
into the interior of some of the areas worst affected by
Naxalism. In addition, the company generally finds it relatively
easier to obtain mining clearances as a result of its strong
environmental and safety record.
Impressive Capability for Exploration, Mine Planning, R&D
CIL’s wholly owned subsidiary, Central Mine Planning and
Design Institute Ltd. (India), or CMPDIL, provides technical and
consultancy services to CIL, its subsidiaries and third parties
for coal exploration, mine planning and design, coal
beneficiation and utilization, allied engineering services, etc. In
F2010, CIL achieved approximately 0.47mn meters of drilling
operations under the supervision of CMPDIL and intends to
improve the drilling technology and equipment further to
achieve a higher targeted drilling capacity. In F2010, CIL
incurred Rs2,487 mn in exploration and drilling expenses
related to coal mining activities. It intends to increase
exploratory drilling targets substantially for existing mines to
assess the viability of its resources. It is currently conducting
exploration activities in 12 coalfields through CMPDIL and is in
the process of evaluating potential coal deposits in 28 coal
blocks for open-cast (14 blocks) and underground coal (14
blocks) deposits.
Deep Talent Pool
CIL’s senior management has extensive experience in the coal
industry. The team cumulatively brings vast and diverse
experience from different aspects of the mining business.
Several members of the team have been with the company for
more than 30 years. Overall, CIL has a large, skilled pool of
397,138 employees, including 15,092 executives (a large
number are mining engineers), 38,475 supervisors and
343,571 workers as at F10 end.
Open to Strategic Tie-ups
CIL intends to build reserves by identifying suitable investment
opportunities outside India, particularly in Africa, Indonesia and
other parts of Asia/Pacific. It has already acquired a
prospecting license for and intends to enter into a strategic
tie-up for the development of two coal blocks in Mozambique. It
has also established a strategic JV, ICVL, with four large Indian
public sector companies, namely SAIL, NTPC, NMDC and
RINL, for the identification and development of coal assets
outside India.
Investment Concerns
Regulatory Issues Impede Production Growth …
The approval process for starting mining operations in India is
tedious and complicated. In addition, the process has, in the
past three to four quarters, become even more cumbersome
with much stricter enforcement of environmental norms and
with the introduction of some new environmental guidelines. In
addition, escalation in the Naxalite issue has made land
acquisition more difficult. As a result, even at mines where it
has received mining and land leases, CIL is unable to start
mining because of the need for forest and environmental
clearance. In fact, the new environmental guidelines may have
a negative bearing also on some of CIL’s existing operations.
However, since these factors affect the entire metals and
mining industry, the government is looking to introduce a new
mining law to simplify and clarify the entire legal framework for
the industry and thus alleviate some of the problems faced by
mining companies, including CIL.
… and Can Hinder Profit Growth
The government is in the process of introducing a new mining
bill in parliament. Among the proposed changes is an attempt
to mandate companies to pay 26% of mining profits for
development of local communities and for compensation to
those displaced by the mining activity. While we think that the
proposed legislation in its current form may be somewhat
difficult to implement (please see our report, “New Draft Mining
Act: In the Right Direction; Practicability Remains a Question
Mark,” dated November 11, 2010), the impact on the sales of
pure mining companies that are based on market-driven prices
could be substantial. In cases where customers’ bargaining
power is strong enough to place all the burden on the mining
companies, the PAT impact could be as much as 26%.
With respect to CIL, we highlight the following: (i) Companies
like CIL and NMDC sell their output on a net price basis and
customers have to pay all tax, cess, etc, over the net notified
price. CIL can therefore pass the burden to its customers. (ii)
Given that CIL sells coal at a substantial discount to market
prices, customers would probably not be in a position to resist
the related price hikes. (iii) CIL’s annual expenditure on CSR
(corporate social response) activity is quite substantial and in
the event that it is restricted from passing on the burden to
customers, it should be able to recover a large portion of the
annual loss by curtailing CSR expenditure.
Volume Growth Likely to Remain Modest: We Expect
Sales Volume CAGR of 5.4% in F10-13
We expect Coal India to expand its production and sales
volumes at muted CAGR of 4.3% and 5.4%, respectively, in
F2010-13. Despite having large mine and land leases and
being equipped with a strong talent pool and capital, CIL has
difficulty accelerating production growth because of a
combination of several factors: (1) obstacles to obtaining final
forest and environmental clearances; (2) demographic
problems leading to delays in getting land cleared for mining;
and (3) logistical bottlenecks, causing coal to pile up at the pit
head or at railway sidings.
Low Pricing Power
Although coal pricing has been deregulated since 2000, CIL
sets its notified coal price in consultation with a standing
committee, which consists of representatives of various
ministries and departments of the Government of India, as per
the New Coal Distribution Policy (NCDP). The standing
committee recommends the benchmark prices to CIL after
taking into account coal cost inflation, inflation in the general
economy, the need to generate internal resources to ensure
sustainable growth and, to some extent, import parity prices.
Since deregulation of coal prices in 2000, CIL’s prices have
risen only 4.9% CAGR through March 2010. This could make
CIL a disappointing stock choice if consensus estimates were
overly bullish on coal prices.
However, in the past two to three years, the government has
tacitly allowed Coal India to extract better pricing for some
portion of its coal by allowing (and in some cases even
encouraging) a higher sales proportion via e-auctions or MOUs
with its customers for higher grade and washed coal, which
entail some element of market-driven pricing.
“No Go” from Environmental Ministry Can Put Significant
Amount of CIL’s Reserves Out of Reach
The Ministry of the Environment recently proposed that mining
be prohibited in sensitive areas (“No Go” areas), to be
identified based on forest cover in the areas. Interestingly, the
“No Go” areas include a few coal blocks that were previously
allocated to CIL and where mining is currently in progress.
While in the past three to four months, there has been some
scaling down in the proportion of coal-bearing areas termed as
“No Go”, the issue is yet to be resolved fully. The ministries of
coal, power, steel and mining have tried to raise the issue at
appropriate levels but we cannot be sure that resolution of the
issue will be favorable for Coal India. In the event that CIL is
unable to mine in any such designated areas, our reserve and
production estimates would be cut back significantly.
Some mitigating factors for CIL could be the following: (i) the
‘”No Go” area concept is still not formalized, in our view, and
the debate is ongoing. Already, there has been a substantial
scaling down in the “No Go” area from 60% when the idea was
first mooted to about 25% currently; (ii) CIL has such large
reserves that even if some of its coal-bearing areas were to fall
into the “No Go “ category, it could still comfortably produce
coal for next 30-35 years simply from mines in the “Go” areas,
we estimate; (c) in the longer term, when India’s coal crunch
becomes more severe, permission will most likely be granted
for mining in parts of the “No Go” areas.
Increasingly Stretched Logistics Hamper CIL’s Ability to
Produce and Sell
As volumes of materials (coal, iron ore, cement among the
bulkiest) handled by India’s railway system multiply, logistics
are becoming significant bottlenecks for India’s mining industry.
With considerable volumes to transport, CIL is highly
dependent on the upgrading of logistics in India. If the coal
evacuation process from the mine site is not smooth, inventory
builds up at mines and production is curtailed. CIL uses rail,
road and MGR (merry-go-rounds) to evacuate coal, with rail
transportation accounting for about 49% of dispatches in
F2010. Including MGR, rail constituted about 68% of
dispatches in F2010. Any logistical bottlenecks, like low
availability of rail wagons, can lead to an inventory build-up at
the mining site. In the event of low wagon availability, over
which CIL has little control, the company depends on road
transport, which is inefficient, slow, and costlier than rail.
Law and Order
Law and order problems grip most Indian metals and mining
companies, especially in the mining belt of eastern and central
India, hard hit by Naxalite-Maoist violence. Attacks, or the
threat of such attacks, whether or not successful, may disrupt
CIL operations and/or delivery of goods, resulting in increased
costs for security and insurance. The company has
experienced interruptions in production and exploration due to
such attacks in the past. Furthermore, as a result of these
disruptions, state-owned railway lines in these areas are
restricted from time to time. In addition, increased security
concerns limit CIL’s ability to attract and retain talent.
Two factors may mitigate the impact on CIL: (1) Most of its 471
mines are deep in Naxalite-stricken areas, which are often
some of the least developed parts of India. Having worked in
those areas for so long with an especially strong focus on CSR
activity, CIL has considerable goodwill in those areas; and (2)
CIL’s large workforce ( about 343,571 workmen, 38,475
supervisors and 15,092 executives) consists mostly of local
people whose support for CIL is quite high.
Illegal Mining and Pilferage
Unauthorized extraction and pilferage of coal from the
company’s mines have increased significantly in recent years
due primarily to higher market prices for coal and increased
black-market demand. CIL’s losses from illegal mining include
reserve losses, additional rehabilitation costs associated with
illegally mined areas and greater security risk to its employees.
The company is also adversely affected by the unauthorized
removal of coal from mines or stockpiles, particularly from
coalfields in politically unstable areas.
Low Productivity
Coal India had a large base of 397,138 employees as of
September 30, 2010, implying per person output of 4.47mt a
year. This is significantly lower than that for other coal
companies. The higher employee base leads to increased
administrative issues, high statutory liability, and greater threat
of industrial action. A large part of overstaffing is due to the
large number of small, and mostly unprofitable, underground
mines that CIL runs. Due to the difficult geology of these mines,
we think it is unlikely that mechanization levels can increase at
these mines even in the longer term. However, as employees
retire in next three to seven years, some of the mines may be
closed, pushing up CIL’s average productivity.
Valuation
Valuation
CIL stock trades at EV/EBITDA of 7.6 based on our F2012
forecasts, which we think indicates a reasonable entry point.
The F2012 multiple is at discount to our global coal coverage
universe and at a discount of 26% to NTPC. The stock’s target
P/E multiples based on our F2011 and F2012 forecasts are
16.1 and 13.1, respectively.
As indicated in Exhibit 9, even though CIL has a stronger
earnings growth profile and greater visibility than that for the
Sensex basket of companies for F12E , the stock is trading at
an 8% discount to the average Sensex P/E multiple. We
believe this is due to the market’s skepticism about CIL’s ability
to enhance its earnings or the lack of volatility in its earnings.
We think these doubts should ease in the next three to four
quarters as CIL demonstrates its ability to improve its market
mix.
Why We Expect Some Stock Rerating
(1) In the coming three to four quarters, the low volatility that we
expect for CIL’s earnings should increasingly expand its
valuation multiples.
(2) We expect the Street to gain confidence in CIL’s ability to
show EBITDA CAGR approaching 31% in F11-13. This would
underpin the EV/EBITDA multiple of 7.6 on our F2012
estimate.
(3) As investors become aware that in the next three to four
quarters CIL may not be able to use much of its cash balance,
they are likely to start factoring in some cash return. This would
bring down their WACC expectations, pushing up the stock’s
fair value from this perspective.
Price Target Methodology
Our price target of Rs387 implies upside of 22% from current
levels and target F2012 multiples of 15.4 P/E and 7.6
EV/EBITDA, which we think are reasonable when compared
with the respective multiples of 14.8 and 8.3 for the global peer
group.
To set our price target, we use a two-phase DCF model with an
explicit phase of six years and a terminal growth rate of 3%. We
assume an average realization of Rs1,132/ton for F2011,
increasing at a CAGR of 6.5% for the explicit phase and
production of 453mt for F2011 with a CAGR of 5.4% for the
explicit phase.
Our price target is driven by (1) increasing realizations due to a
higher focus on the e-auction pricing mechanism and a rising
share of value-added products in the product mix; and (2)
strong production growth. Our realization assumptions are
supported by our forecasts for (i) an increase in market-linked
volumes from 22% of the total in F2010 to 34% in F2013, and
(ii) a CAGR of 6.3% in notified prices in F2010-13.
We believe these assumptions fairly reflect (a) a balance
between the tightening demand-supply situation in the country
as demand from the thermal power, steel and cement
industries grows rapidly on the one hand, and the need to keep
coal prices affordable for end-consumers on the other, and (b)
CIL’s ability to ramp up its production at a pace that is heavily
dependent on the regulatory environment and logistical set-up.
We derive a WACC of 13.0% for the company with a risk-free
rate of 7.9% (10-year government bond yield) and a
market-risk premium of 6.5%, in line with the recommendations
of our regional strategy team. We derive CIL’s beta as follows.
We assume that, in the utility-commodity beta scale, the two
extremes are occupied by NTPC and typical mining companies
in India. Adani Power and NMDC are two other companies with
utility and commodity characteristics although they are slightly
away from the extremes, in our view.
We think CIL’s earnings have low volatility aided by
government support for CIL’s efforts to increase its prices to
offset cost inflation. In this sense, CIL looks close to being a
utility company. However, CIL does not have any implicit
guarantee embedded in its pricing formula supported by the
government as a typical utility such as NTPC enjoys. On
occasions, there is a lag between CIL’s cost increase and the
offsetting coal price rise (as happened in F2009). Thus, CIL
has some characteristics of a utility company but it cannot be
considered a utility company.
On the other hand, CIL deals in a commodity like coal but with
a high element of fixed and notified prices. Unlike a typical
commodity market situation where pricing power keeps shifting
between buyer and seller, in CIL’s case, pricing power is slowly
moving towards the seller (CIL), albeit off a low base.
Downside Risks to Price Target
Risks to our price target include slower than expected price
increase, a sudden dip in industrial and economic activity in
India and globally, and an unfavorable regulatory and law and
order environment.
We see the following key value drivers for CIL in the next few
years:
• Change in sales mix: As CIL shifts more of its volumes
towards the free market (i.e., through e-auction, ABC
grades of coal and washed coal sales), its earnings and
hence fair value will be enhanced because of the
substantial price difference between the free market and
notified-price market. In our view, this is the most crucial
value driver for the company and which probably is not
being captured appropriately in the stock price. This is
possibly due to the perception that the government may
not allow this sales shift because of concerns about
inflation. For every 500bps increase in the share of
market-linked sales volumes, we estimate CIL’s F12E
EPS would change by 8.8%.
• Reduction in price discount: Interestingly, even in the
free market, CIL sells its product at a discount to import
parity prices. We expect this discount to be bridged in the
coming two years as customers attempt to avoid too much
of imports. For every 500 bps reduction in the price
discount, CIL’s F12E EPS would change by 7.1%.
• Increase in staff costs: Given that staff costs constitute a
big proportion of CIL’s overall costs, this is a key driver of
the stock’s fair value. Every 5% change in staff costs
would change our F12E EPS forecast by 5.0%.
Base-case Scenario (Rs387): Realizations should
rise faster than Street expectations
Our realization assumptions are supported by our forecasts for
(i) an increase in market-linked volumes from 22% of the total
in F2010 to 34% in F2013, and (ii) a CAGR of 6.3% in notified
prices in F2010-13. We believe these assumptions fairly reflect
(a) a balance between the tightening demand-supply situation
in the country as demand from the thermal power, steel and
cement industries grows rapidly on the one hand, and the need
to keep coal prices affordable for end-consumers on the other;
and (b) CIL’s ability to ramp up its production at a pace that is
heavily influenced by the regulatory environment and logistical
set-up.
Bull-case Scenario (Rs473): Rapid improvement in sales
mix
Surging coal demand and increased imports allow further
improvement in CIL’s prices. Coal India stock could move up
by 45% from current levels to Rs473 in the event the
government loosens controls over pricing and allows CIL to
shift more of its sales volumes to market-linked pricing.
In this scenario, we assume CIL sells about 50% of volumes in
the free market. This scenario emerges from a rapid
acceleration in coal demand with a consequent jump in
imported coal. Coal buyers will push for more coal sales on the
basis of MOUs, which have market-linked pricing. In this
scenario, we assume CIL will be able to increase the proportion
of its A,B,C grade coal sold via MOUs to 15% in F2013 from the
F2010 level of 1% and our base-case assumption of 9%.
Similarly, in our base case, we pencil in 20mt of washed coal
sales in F2013 (in F10 this was 14.6mt) and assume in our bull
case that the company will be able to accelerate the pace of
washery capacity creation in the next six quarters and hence
will be able to sell 35mt of washed coal in F2013. In this case,
the government may effectively agree to increase the size of
the free-price market to lower the average cost for buyers..
We also believe that under this scenario the government may
give some additional pricing power to CIL by allowing it to raise
notified prices at a CAGR of 8.5% in F10-13 versus our base
case of 6%.
We assume CIL is able to close loss-making underground
mines, reducing underground mine output by 2.5%. This
outlook can be realized if CIL is able to shift the remaining
employees at some of the smaller mines, proposed to be
closed, to nearby mines.
Out bull case scenario throws up EPS of Rs28.3 in F2012 and
Rs39.7 in F2013 versus our base-case estimates of Rs20 and
Rs27.
Bear-case Scenario (Rs225): Production shrinks;
price increases unable to compensate for cost
escalation.
Regulatory issues intensify, staff costs rise dramatically. Under
this scenario, the stock falls to a fair value of Rs225. Our bear
case is driven by the following: (a) Due to the tightening of
environmental, forest and land acquisition standards, coupled
with deterioration in Naxalite and logistical issues, CIL
witnesses a 5% decline in coal output between F10 and F13
versus our base-case assumption of a 13.3% increase. (b)
Inflation rises sharply and is sustained at these high levels for
three to four quarters, prompting the government to put
pressure on CIL to go slow on price increases. Thus, CIL is
able to raise its average realizations only at a CAGR of 4% in
F10-13 versus our base case of 9.4% CAGR. (c) Faced with
increased local law and order problems and threats of
industrial action, CIL increases non-executive wages by 70% in
July 2011 versus our base-case assumption of 45%. (d) The
new mining bill is implemented in its current form, and CIL is
able to pass on only 30% of the impact.
Earnings Drivers
A rising proportion of volumes sold on the free market and a
shrinking discount on volumes sold to import parity prices
should provide underlying support for earnings growth over the
next three to four years. Until F1Q12, we expect a diminishing
work force and a higher proportion of free market volumes to
be the main earnings drivers for CIL. Beginning in F2Q12, the
company could see gains from an increase in notified prices
over and above what is needed to compensate for a likely
simultaneous increase in wage costs.
(1) Average Realizations – Expect growth of 6.8% in F11,
11.9% in F12, and 9.8% in F13
We expect CIL to make its next round of notified price
increases in F2Q12, and we are modeling for an 11% increase,
the impact of which should be spread over F12 and F13. We
base our price increase assumptions on (i) past instances – in
2006, 2008, and 2009, prices were raised by 16.2%, 10%, and
11.0%, respectively – and (ii) our view that some loss-making
mines, especially in Eastern Coalfields Limited (ECL) and
Bharat Coking Coal Ltd (BCCL), will increase their prices
occasionally. We note that CIL continues to adjust prices for
some of its mines depending on the situation.
How to Track This:
(i) Average realizations, as released in quarterly financials;
(ii) Progress in wage settlements since stipulated prices will be
raised once the wage increases are settled.
(2) Volume Growth – Expect sales growth of 5.3% in F12
and 6% in F13
Effective F2H12, we forecast increases of about 9% HoH and
28% YoY, which look achievable, especially given the high
overburden removal (OBR) realized by CIL in F1H11, as this
should accelerate the coal extraction process in F2H11.
According to the company, it focused more on OB removal and
less on coal extraction in F1H11 as coal inventories mounted at
pit heads as well as at CIL’s sidings, due to logistical
constraints. Thus, our production forecast of a 2% YoY
increase for F11 assumes low operational risk but is subject to
an improvement in railway rake availability in F2H11 over
F1H11, on which the company seems confident.
In terms of sales volumes, we forecast HoH growth of 8%,
which seems realistic, and with this quantum of coal
evacuation our production forecast also looks realistic.
For F12 and F13, we forecast sales volume increases of 5.3%
and 6%, respectively. This is slightly higher than the F2006-10
CAGR of 5%, which, in our view, reflected fewer new projects
planned four to five years ago (a typical new mining project in
India can have a gestation period of five to seven years even if
the mining lease is in place). This, in turn, was due to (i)
underestimation of demand growth and hence relatively few
serious attempts at new projects by CIL four to five years ago;
(ii) overestimation of the pace of approval of new mines, as a
result of which the company did not attempt to seek clearance
for more projects than it perceived to be necessary; and (iii)
CIL’s relatively weaker balance sheet in F05-07.
Some of the above factors may ease in the next four to five
years, we believe, and hence we expect the growth trajectory
to inch up above 7% in F15 and beyond.
How to Track This:
(i) Volumes are released by the company and the Ministry of
Coal on a monthly basis.
(ii) Progress in new mining projects can be tracked on the
websites of the Ministry of Coal and the Ministry of Power.
(3) Staff Cost – Expect total staff cost to rise 9.7% in F11,
24.8% in F12, and 5.6% in F13
In line with company guidance and the trend over the past two
to three years, we assume the number of CIL employees
declines at a 3.6% compound annual rate in F10-14. The next
wage revision for non-executive employees is due on July 1,
2011, and we model a 45% increase in per head salary for
non-executive staff. We assume the wage increase will be
effective immediately, since, in contrast to the previous
instance, the current negotiations have started in good time.
How to Track This:
(i) We expect CIL to issue updates on its headcount from time
to time.
(ii) Information is available from industry sources, the company,
the Ministry of Coal, and the Ministry of Labor Affairs
(4) OBR – Expect adjustments of Rs25.7bn in F11,
Rs29.6bn in F12, and Rs31.3bn in F13
The company has stated that once International Financial
Reporting Standards (IFRS) are implemented, it will do away
with the practice of OBR adjustment. While there are plans in
India to implement IFRS in F12, we assume this will happen
from F14.
Although we also present valuation metrics on the basis of
reported numbers (the way the company gives them, including
OBR adjustment), we believe that the valuation process should
exclude the impact of OBR adjustment, for three reasons: (1)
Consistency – when we compare valuation metrics with other
companies, in India and abroad, we prefer to apply the same
parameters to all, and, as we noted earlier, we know of no other
company that adjusts for OBR; (2) normal mining operations
incur costs that do not require any adjustment for OBR; and (3)
OBR adjustment is a non-cash item.
What Will Happen When OBR Adjustments Cease?
(i) CIL will start reporting actual EBITDA and PAT without
adjusting for the difference in strip ratio as per the mining plan
and strip ratio in a particular period. This should the company’s
reported EBITDA and PBT.
(ii) CIL will transfer the OBR adjustment amount from its
current liabilities (at end-F10, this amount was about Rs120bn)
to the reserves and surplus, thus improving the net worth of the
company. Its RoE will change as per the changes in PAT and
net worth.
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