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Coal India::
Hampered by ‘national service’ and tax overhang
We initiate coverage on Coal India (CIL) with an IN-LINE
rating and target price of Rs.338, implying modest 6%
potential upside
CIL’s current share price looks fairly valued, in our view,
given its risk-reward profile
CIL has limited downside risk to coal prices, a dominant
market share and is the only listed coal play in India
‘National service’ likely to stand in the way of passing on the
full impact of the proposed mining tax and higher wages,
preventing it from taking full advantage of the global coal
shortage
Limited downside price risk, but offers little exposure to
seaborne prices: CIL is the largest thermal coal producer
in the world, with a large reserves base and low-cost
operation. The company currently sells its coal at a deep
discount to the international seaborne price (55% on an
import-parity basis). This discount limits downside price risk,
but offers little exposure to the potentially bullish Indian
supply-demand gap in coal.
‘National service’ to cap price increases? As CIL is 90%
government-owned, it has to balance the conflicting aims of
providing a national service, while simultaneously creating
value for shareholders. Since January 2000, the company
has increased its coal prices by a 4.4% CAGR, well below
India’s inflation rate of 6.8% p.a. and the 14.6% p.a. increase
in seaborne benchmark thermal coal during the same period.
Tax overhang could be a drag: The government is
proposing a mining tax of 26% to fund compensation for
local populations affected by mining. While the proposed tax
may undergo several changes before its possible
implementation, we think CIL may not be able to pass on
the full impact of this tax to its customers given inflation
concerns. Prima facie, the tax in its current form would
reduce our PT by 26% if the company absorbs the full
impact, but only by 2% if it is able to net off the royalties.
Looks fully valued: We think the current share price fairly
reflects CIL’s risk-reward profile. We derive our 12-month
price target of Rs.338 based on a DCF methodology,
implying modest 6% potential upside. CIL currently trades at
a 24% premium on FY12E PER, which we think will narrow
going forward, given low exposure to the bullish supplydemand gap and potential tax increases. We prefer cheaper
Indonesian coal producers as the way to play the coal
shortage in India.
Investment thesis
We initiate coverage on Coal India (COAL IN) with an IN-LINE rating and a price target of
Rs.338/share, implying 6% potential upside from the current price.
Low cost, large reserves; low price risk and margin expansion on increased eAuction and
beneficiated volumes
Low exposure to the tight seaborne coal market
Project delays likely on environmental issues, infrastructure constraints, land acquisition
issues
On inflation grounds, CIL not likely to pass on full impact of wage revisions and higher taxes
We believe the share price captures warranted premium for low-risk earnings outlook and
dominant market share; we prefer cheap Indonesian coal producers
Coal India (CIL), the world’s largest coal company by production, accounts for over 80% of India’s
coal production. The company made an impressive stock exchange debut in India on 4
November 2010 and ended the week up 43% at Rs.349.65, from an issue price of Rs.245/share.
CIL is the only listed coal company in the country. We see CIL as an Indian coal-cum-utility play,
with upside value potential from improving product mix (increasing beneficiated coal production),
efficiency gains and steady volume growth; we believe the company has limited downside risk
given its deeply discounted pricing to import parity price. However, we believe the share price
rally in its first week of listing re-rated the stock to cover this warranted premium.
The company is trading at 24% premium to the global peers on FY12E earnings. Given CIL’s low
exposure to seaborne prices in a potentially bullish coal market, the overhanging risk of potential
tax increases and its inability to fully pass on the increasing cash costs due to the Government’s
inflation concerns, we believe CIL’s premium to the peer group is likely to narrow. We prefer
cheaper Indonesian coal players to play the Indian coal shortage and very tight international coal
market. Driven by infrastructure constraints and environmental issues in India, domestic
production growth could be restricted, resulting in coal imports potentially doubling in five years.
The Indonesian coal producers, which are among the biggest exporters of coal to India, are
trading at an average PER of 10.0x for 2012E, i.e. a 27% discount to CIL’s.
Coal India offers the potential for steady value growth in the next five years, primarily from
increased eAuction & beneficiated volumes and efficiency improvements. Given our bullish coal
outlook, we believe Indonesian producers, such as Adaro (ADRO IJ, O/P, IDR2,475, PT
IDR2,904) and Bumi (BUMI IJ O/P, IDR3,075, PT IDR2,963), will be more rewarding.
Investment thesis
We initiate coverage on Coal India (COAL IN) with an IN-LINE rating and a price target of
Rs.338/share, implying 6% potential upside from the current price.
Low cost, large reserves; low price risk and margin expansion on increased eAuction and
beneficiated volumes
Low exposure to the tight seaborne coal market
Project delays likely on environmental issues, infrastructure constraints, land acquisition
issues
On inflation grounds, CIL not likely to pass on full impact of wage revisions and higher taxes
We believe the share price captures warranted premium for low-risk earnings outlook and
dominant market share; we prefer cheap Indonesian coal producers
Coal India (CIL), the world’s largest coal company by production, accounts for over 80% of India’s
coal production. The company made an impressive stock exchange debut in India on 4
November 2010 and ended the week up 43% at Rs.349.65, from an issue price of Rs.245/share.
CIL is the only listed coal company in the country. We see CIL as an Indian coal-cum-utility play,
with upside value potential from improving product mix (increasing beneficiated coal production),
efficiency gains and steady volume growth; we believe the company has limited downside risk
given its deeply discounted pricing to import parity price. However, we believe the share price
rally in its first week of listing re-rated the stock to cover this warranted premium.
The company is trading at 24% premium to the global peers on FY12E earnings. Given CIL’s low
exposure to seaborne prices in a potentially bullish coal market, the overhanging risk of potential
tax increases and its inability to fully pass on the increasing cash costs due to the Government’s
inflation concerns, we believe CIL’s premium to the peer group is likely to narrow. We prefer
cheaper Indonesian coal players to play the Indian coal shortage and very tight international coal
market. Driven by infrastructure constraints and environmental issues in India, domestic
production growth could be restricted, resulting in coal imports potentially doubling in five years.
The Indonesian coal producers, which are among the biggest exporters of coal to India, are
trading at an average PER of 10.0x for 2012E, i.e. a 27% discount to CIL’s.
Coal India offers the potential for steady value growth in the next five years, primarily from
increased eAuction & beneficiated volumes and efficiency improvements. Given our bullish coal
outlook, we believe Indonesian producers, such as Adaro (ADRO IJ, O/P, IDR2,475, PT
IDR2,904) and Bumi (BUMI IJ O/P, IDR3,075, PT IDR2,963), will be more rewarding.
National service to stand in the way of a rising coal price?
CIL, now 90% owned by the Government of India (GOI), is the largest coal supplier to stateowned thermal plants. CIL produces 82% of India’s thermal coal and is thus a vital player in the
electricity supply chain. With the GOI trying to woo investors for developing new power plants, it
is in the government’s interest to maintain low coal prices both to attract investment and to control
inflation. We estimate a 10% increase in coal price could lead to a direct 0.175% increase in
inflation. We think the indirect effect could be multi-fold. Since January 2000, CIL’s raw coal price
increased only by 4.9% pa, while Indian inflation increased by 6.8% pa and Newcastle
benchmark thermal coal prices increased by 14.6% pa, as illustrated in the figures below. We
believe that the company’s coal prices will continue to lag inflation and international seaborne
prices as CIL will continue to operate in “national service” mode. Going forward, raw coal prices
sold to thermal power plants under Fuel Supply Agreements (FSAs) will also be more cost driven
rather than supply-demand driven. We forecast the next price increase for CIL’s coal by Q3 2011,
driven by its wage revision, which is due in July 2011.
Historically, the company has been happy to maintain PBT margins of c.25-30%. We believe that
the net profit margins will improve to 30-33% going forward, as the company increases its
beneficiated coal production and with limited fallout from the increasing international coal prices
through eAuction and sales under MoUs. We think the company will control the price increases to
maintain margins.
Good production track record and solid outlook
CIL has a strong track record of increasing production and delivered a production CAGR of 5.1%
in the last decade. Going forward, we estimate the company will deliver production growth of
4.6% CAGR in the next 6 years. CIL currently has 25 projects at various stages of
implementation, which could add 47.51 million tonnes of annual capacity by end FY12. The
company has approved Rs.33.86 billion (US$752mn) of capex for development of these projects.
Additionally, CIL also has 20 growth projects that it aims to bring into production between FY13-
17, for which it has allocated Rs.25.76 billion (US$572mn) capex. We believe, however, that
there could be significant challenges in achieving these targets from factors such as
environmental permits, infrastructure constraints, land acquisitions and Naxalism (Maoist
terrorists). We discuss these challenges in detail in our Risk section.
Good production track record and solid outlook
CIL has a strong track record of increasing production and delivered a production CAGR of 5.1%
in the last decade. Going forward, we estimate the company will deliver production growth of
4.6% CAGR in the next 6 years. CIL currently has 25 projects at various stages of
implementation, which could add 47.51 million tonnes of annual capacity by end FY12. The
company has approved Rs.33.86 billion (US$752mn) of capex for development of these projects.
Additionally, CIL also has 20 growth projects that it aims to bring into production between FY13-
17, for which it has allocated Rs.25.76 billion (US$572mn) capex. We believe, however, that
there could be significant challenges in achieving these targets from factors such as
environmental permits, infrastructure constraints, land acquisitions and Naxalism (Maoist
terrorists). We discuss these challenges in detail in our Risk section.
Given the low labour costs, low strip ratio and shallow deposits at open cast mines, CIL is one of
the lowest cost coal producers in the industry, as illustrated in the figure below. CIL has an
average strip ratio of 1.97, compared with an average of 9-10 for Indonesian mines. However,
67% of CIL’s coal production is high ash and low calorific Grades E & F coal, which are priced at
a discount to international benchmark prices. Newcastle thermal coal (Australia) has a calorific
value of 6,600kcal/kg, Richards Bay (South Africa) is 6,200kcal/kg and Indonesia coal is
5,200kcal/kg. CIL, on average, produces coal at 4,704kcal/kg calorific value.
Better price realisation potential on beneficiation and E-auction coal
CIL’s exposure to the spot coal market is driven primarily by sales under eAuction and MoUs.
The company sold 11.6% of its raw coal production under eAuction in FY10. The realised coal
price via this channel was 68% higher than the raw coal price under the FSAs with the stateowned thermal plants. The company also sells some of its high grade (Grades A-C) coal and
beneficiated coal through specific MoUs with customers, where realised prices were
approximately 92-96% higher than the selling price of equivalent coal under FSAs. Prices under
MoUs are generally fixed at a 15% discount to the import parity price.
CIL derived only 23% of its revenue from beneficiated and eAuction sales in FY10. We forecast
the contribution of beneficiated and eAuction sales to increase to 35% by FY15E, given the coal
shortage in India and the fallout from the potential increase in international seaborne prices. For
every 10% increase in the Newcastle benchmark price, we estimate CIL’s earnings increase by
7% in FY11E, but by 10% in FY15E. If the Newcastle benchmark prices reached our target of
US$150/t in the next year, CIL’s run-rate earnings for FY12E could be Rs.24.4, 22% higher than
our base-case estimate.
CIL has 17 Coal beneficiation facilities with an aggregate capacity of 39.4mt pa, but produces
only 15mt because of the inefficiencies attributable to the age of these plants. The company
intends to add 20 more coal beneficiation facilities, with a total feedstock capacity of 111mt in the
next eight years, which will lead to increasing margins and better realisations, in our view.
Management also intends that all new open cast mines with coal production capacities in excess
of 2.5mt per annum, which are not linked to pit head customers, will be equipped with dedicated
coal beneficiation facilities. In FY10, the company’s realised beneficiated coal price of Rs.2,134/t
was more than double the average raw coal price of Rs.1,045/t. We estimate CIL’s beneficiated
coal volume will rise to 15mt in FY11 and to 55mt by FY15.
Efficiency improvement likely to offset cost inflation
CIL has managed to decrease its wage bill from as much as 75% of its total cost in FY01 to 43%
in FY10, driven primarily by natural attrition and technological upgrades. The number of
employees at CIL decreased from 552k in FY01 to 404k by FY10, more than doubling coal
productivity from 486 tonnes to 1,086 tonnes per employee in the last 10 years. We believe the
number of employees will continue to decrease going forward from natural attrition, with likely
improvements in productivity likely to offset potential wage inflation.
Coal Videsh – Taking CIL to new horizons
CIL has established the Coal Videsh division to acquire or enter into joint ventures with respect to
assets outside India to bridge the supply-demand gap within the country. The company is
presently looking at possible opportunities in Australia, South Africa, Indonesia and the United
States. It has allocated Rs.60 billion (US$1.3billion) for acquisitions in FY11, which represents
16% of its Rs.370 billion (US$8.2bn) cash balance as at March 2010. The company also obtained
two coal blocks in Mozambique in 2009 and has five years to explore the licence area to establish
resources. Mozambique remains one of highest-potential undeveloped coal basins in the world
and we think CIL’s venture into the country provides an exciting opportunity for future growth,
especially in coking coal. We believe, however, that new production from Mozambique could be
at least five years away given lack of rail capacity available to transport coal from the Tete basin
to the Beira port, the only access to the international seaborne market. We believe that the
company has to get more aggressive in its acquisitions to increase its exposure to seaborne coal
prices.
Risks
New Mines and Minerals (Development and Regulation) Act could knock the wind out of CIL
The government is contemplating an additional profits tax on mining operations, which will be
used for local social development. The new tax was proposed under The Mines and Minerals
(Development and Regulation) Bill. If approved, the bill would have severe repercussions in the
mining industry, in our view. Though currently at a very early stage, the government proposes a
26% tax on the miners’ profits after tax (PAT). We think there is a good probability that this bill will
come into force, albeit in a modified form, as the miners have found it increasingly difficult to
appease locals, with a burgeoning list of delayed/cancelled projects in India due to protests.
Given that CIL is selling coal at deeply discounted prices, it has the option to pass on this tax to
customers. The government, however, would not be inclined to increase coal prices on an
inflation perspective.
We do not see this new mining bill as entirely negative as the payout to locals could potentially
open up new projects that have been delayed due to land acquisition and social issues. Since the
draft mining bill is still at very early stage, it eventual impact is unclear. The chart below illustrates
the impact of the new mining bill under two scenarios, namely a 26% mining tax levied on profit
after tax which could reduce our DCF value by 26%, or if royalties and other statutory charges
are allowed to be fully netted off against the mining tax, which would reduce our DCF by only 2%
Tightening environmental permits
There appears to be a bottleneck in obtaining environmental permits from the Ministry of
Environment and Forests for development of new coal projects. Earlier, the environment ministry
designated 44% of CIL’s licence areas as no-go zones, which essentially prevents any mining in
those regions. Prior to CIL’s IPO, the prime minister intervened and reduced the no-go zones to
some 10% of CIL’s licence area. We think there remains significant risk of overhanging
environmental issues for developing CIL’s coal projects. Moreover, the company needs to obtain
50 approvals from the Ministry of Environment and Forests, which could take anywhere between
3-5 years to come through, before it could start developing any new mines. We understand that
there are a total of 59 coal projects pending environmental approval.
Infrastructure bottlenecks
We think the biggest challenge to CIL increasing production is infrastructure. Coal is produced
only in nine Indian states, but consumed in all 29 states, making transportation vital. With very
little investment in a dedicated freight corridor in India to date, however, coal transportation has
become one of the biggest challenges in expansion of production. CIL transports nearly 46% of
its coal production to customers by rail. The company requires some 180 rakes/day to transport
its coal; however, given the transportation bottlenecks and availability of rakes, the company is
currently able to load only 153 rakes/day, leading to build up in pithead stockpiles from 42 million
tonnes in FY07 to 63 million tonnes by FY10.
Naxalite influences
Most of CIL’s coalfields fall within the Naxal affected regions of India. Frequent strike action
called by the Naxals has impacted both coal production and transportation in these regions. The
three richest coal states in India, Jharkhand, Orissa and Chhattisgarh, which together host 67%
of total coal reserves in India, contribute only 6.1% to the country’s GDP, with a per capita of only
20% of the country’s average.
Land acquisitions
CIL needs to acquire more than 67,000 hectares of land for commissioning its new projects. As of
September 2010, CIL has 11 projects that have been delayed due to land acquisition issues for
an average of four years. Going forward, we believe land acquisitions will continue hamper the
development of new projects, given growing unrest among locals against miners.
Near-term catalysts
We list following near-term catalysts for the stock:
Potential price hike: We forecast a coal price hike of c.10% by mid-2011 following wage
revisions, given that labour constitutes nearly 45% of total cash costs for the company. Going
forward, we assume price increases of 4% pa on average.
Potential acquisitions: CIL is on the lookout for value accretive acquisitions that will underpin
its medium- to long-term committed overseas coal volume of 20-30mt per annum, for which
we believe CIL has the option of leveraging its balance sheet. In addition, CIL has already
identified three potential ready to operate asset acquisitions from Australia, Indonesia and the
US, with a potential capacity of 8-9mt. If the deals go through, we believe there is a further
earnings upside on account of increased volumes.
Valuation
We arrive at our PT of Rs.338/share based on a DCF methodology. We summarise our DCF
computation for CIL below. Our PT implies modest potential share price upside of 6%. We
believe that stock is currently fairly valued, given the company’s low pricing risk, dominant market
share and only listed coal play in India.
We derive a WACC of 12.8% based on our cost of equity assumption of 14.7% and cost of debt
of 7.5%. We assume a terminal growth rate of 3.0% from FY20, which we think is reasonable,
given our production growth rate estimate of 4% pa in the next 10 years and more than 100 years
of mine life based on resources.
DCF sensitivities
We detail sensitivities to our DCF value on various WACC and terminal growth assumptions in
the following figures. If we assume a terminal growth rate of 4%, in line with the estimated
production growth rate for FY11-15E, we get a further 5% upside to our price target. Every 10%
increase in the long-term Newcastle benchmark prices adds 9% to our DCF value.
Trades at warranted premium, but likely to narrow
CIL currently trades at 20% and 42% premiums on its FY12E P/E and EV/EBITDA, respectively.
We think CIL warrants a premium to the peer group, given its low risk price exposure, stable
margins and a strong balance sheet. We believe, however, that the premium is likely to narrow,
as inflation in India is likely to limit CIL’s ability to fully pass on the cost increases, coupled with
the overhanging risk of increased taxes under the proposed new mining bill.
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