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Coal India (COAL)
Initiate N(V): A monopoly with supply-side constraints
State-owned monopoly set to benefit from spiralling demand,
which should double by FY17
But supply constraints and limited flexibility on pricing could
cramp earnings growth
Stock up c60% since IPO, so valuation stretched. Initiate with a
Neutral (V) and a TP of INR425
A good way to play India’s rising coal deficit. Coal India (COAL), which has a
domestic production monopoly, perhaps the lowest coal operating costs in the world as
well as the largest reserves, is set to benefit from a surge in demand in India. We estimate
demand will double by FY17, driven by domestic coal-fired power capacity which should
rise from 93GW in FY11 to 136GW in FY14; coal production will not be able to keep
pace with demand. Despite modest volume growth, we expect 23% EPS CAGR over
FY11-14e on the back of price hikes and 600bp margin expansion.
Growth limitations. COAL faces supply constraints and logistical challenges, which may
limit volume growth. Mining clearances in India take a long time and rail and road
infrastructure are poor, cramping coal movement. As a government-owned company it
sells coal at 20% of international rates, giving it the flexibility to adjust for inflation, but it
doesn’t have complete freedom on pricing, especially for sales to the power sector.
Share price up c60% since IPO in November 2010 (Sensex down 14% over the same
period). The stock needs fresh catalysts – such as a higher-than-expected price rise in
FY12, improved logistics, or higher prices at e-auctions – but given the lack of visibility
these have not been factored into our earnings estimates.
Initiate Neutral (V). We value COAL at INR425/share based on a combination of DCF
and earnings-multiple based valuation. At our target price, COAL will trade at 15x FY13e
EPS (current PE of 16x) and 9.2x FY13e EV/EBITDA, a c19% premium to global peers,
which we believe is justified given its relative insulation to pricing pressure.
Investment summary
Indian coal market to stay in deficit driven by surging demand
Growth in earnings limited by supply constraints, logistic
challenges and limited flexibility on pricing
Stock up c60% since IPO, so valuation stretched. Initiate with a
Neutral (V) and a TP of INR425
What we like about COAL …
Proxy on India’s growth story; India’s
largest coal company to benefit
We expect strong growth in Indian coal-fired
power capacity to drive domestic demand for
coal. COAL is a good way to play the rising
coal deficit.
Low cost assets, but coal quality not high
With a high percentage of opencast mines and
favourable geographic conditions, COAL has
the lowest operating costs of any major coal
company in the world. However, the quality of
the coal is not high.
In many respects low pricing risk makes it
a utility play
With its substantial selling price discount to
landed costs, COAL is a utility-like play.
However, its return on assets is materially
better than peers in the utilities segment.
Selling price can rise with richer mix
We believe COAL can increase prices over the
next few years as a result of (1) higher pricing
from ABC grade coal, (2) continued sales of
higher-priced washed coal, and (3) higher
prices from sales through e-auctions. We do
not build in the entire upside from these
factors. Our analysis suggests that, at current
estimates, a 1% increase in blended selling
price would result in a 2.4% rise in FY13 EPS
and a 3% increase in our target price.
New capacity to aid volume growth
We expect COAL to increase production by
127mt over FY11-17e (30%), mostly in the E
and F coal grades, through capacity expansion,
the development of new projects and an
increase in productivity at underground mines.
We note that several projects are behind
schedule and this could affect our forecasts. In
the event of lower-than-expected production,
we expect the company to sell part of its large
inventory (c60-70MT).
Our concerns …
Monopoly in India, but selling prices are low
We believe COAL cannot increase prices
dramatically over the next few years despite
the steep discount to landed cost because:
Higher prices would result in steep losses
for State Electricity Boards if they are not
passed on to the end customers, which are
already making large losses.
If passed on to the end consumer it would
result in 10-20% increase in tariffs,
increasing inflation.
Logistics may limit volume growth
Poor rail and road infrastructure is likely to
limit volume growth for COAL.
Unionised workforce increases cost inflation
risk
We believe the large number of non-executive
employees and a unionised workforce poses a
risk of high cost inflation for COAL. However,
the large selling price discount to landed costs
offers a buffer for product price increases.
Mining approvals can take a long time;
impact on volume forecast
Mining approvals and clearances can take a
long time (almost 10 years in the worst cases),
which could delay expansion plans. Some
forest areas have been declared “no go” areas
for mining companies.
Other risks
Implementation of the new legislation in
its current form could see 26% of profits
being shared with people moved off their
land by mining.
Unrest in some areas could affect current
and future mine projects.
Coal pilferage is a concern.
EBITDA: 20% CAGR over
FY11-14e
We expect COAL to report a 20% CAGR in
EBITDA over FY11-14e following a 4% increase
in off-take (sales volume), a 9% increase in
selling price, despite a 10% increase in costs
following our expectations of 30% rise in wages
from 2Q FY12.
COAL raised prices at the end of February 2011,
only the fourth increase in the last nine years. We
expect another hike in 3Q FY12 for DEFG grade
coal. Combined, we expect this to drive 46% EPS
growth in FY12 but it should then moderate, as
we do not expect any further price hikes in the
next two to three years.
We believe that adjustment for overburden removal
(OBR – the amount of surplus material moved to
mine the coal) is more likely to be lower in the
short term since the company is expected to align
its policy to IFRS accounting standards. This
could have a positive impact on the margins in the
short term but should even out in the long term.
Value COAL at INR425/share
We use a combination of DCF and earnings
multiple-based valuations to arrive at our target
price of INR425. At our target, COAL will trade
at a PE of 15x on FY13 EPS.
We believe a reserve-based metric is not best suited
to COAL as its coal prices are much lower (and
probably will stay much lower) than regional peers.
Initiate with a Neutral (V)
The stock has risen more than 60% since the IPO
in November 2010, driven by a number of
positive triggers. Valuations are now stretched so
we will have to wait for new catalysts, such as a
higher-than-expected price rise in FY12,
improved logistics or more e-auction sales. Given
the lack of visibility, these have not been
considered in our earnings estimates.
We classify COAL as a volatile stock (see
disclosure appendix for HSBC’s definition).
Under our research model, for stocks with a
volatility indicator (V), the Neutral rating band is
10ppt above and below the hurdle rate for Indian
stocks of 11%. This translates into a 1-21%
potential return on the current share price. As the
9% potential return for COAL shares (including
prospective dividend yield) falls within the
Neutral band, we initiate coverage of the name
with a Neutral (V) rating.
COAL’s earnings could be impacted by factors
not considered by us. The table below (Exhibit 1)
lists some of the possible areas not considered in
our valuation but which could act as triggers.
Exhibit 1A shows the price behaviour since its
listing in November 2010.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Coal India (COAL)
Initiate N(V): A monopoly with supply-side constraints
State-owned monopoly set to benefit from spiralling demand,
which should double by FY17
But supply constraints and limited flexibility on pricing could
cramp earnings growth
Stock up c60% since IPO, so valuation stretched. Initiate with a
Neutral (V) and a TP of INR425
A good way to play India’s rising coal deficit. Coal India (COAL), which has a
domestic production monopoly, perhaps the lowest coal operating costs in the world as
well as the largest reserves, is set to benefit from a surge in demand in India. We estimate
demand will double by FY17, driven by domestic coal-fired power capacity which should
rise from 93GW in FY11 to 136GW in FY14; coal production will not be able to keep
pace with demand. Despite modest volume growth, we expect 23% EPS CAGR over
FY11-14e on the back of price hikes and 600bp margin expansion.
Growth limitations. COAL faces supply constraints and logistical challenges, which may
limit volume growth. Mining clearances in India take a long time and rail and road
infrastructure are poor, cramping coal movement. As a government-owned company it
sells coal at 20% of international rates, giving it the flexibility to adjust for inflation, but it
doesn’t have complete freedom on pricing, especially for sales to the power sector.
Share price up c60% since IPO in November 2010 (Sensex down 14% over the same
period). The stock needs fresh catalysts – such as a higher-than-expected price rise in
FY12, improved logistics, or higher prices at e-auctions – but given the lack of visibility
these have not been factored into our earnings estimates.
Initiate Neutral (V). We value COAL at INR425/share based on a combination of DCF
and earnings-multiple based valuation. At our target price, COAL will trade at 15x FY13e
EPS (current PE of 16x) and 9.2x FY13e EV/EBITDA, a c19% premium to global peers,
which we believe is justified given its relative insulation to pricing pressure.
Investment summary
Indian coal market to stay in deficit driven by surging demand
Growth in earnings limited by supply constraints, logistic
challenges and limited flexibility on pricing
Stock up c60% since IPO, so valuation stretched. Initiate with a
Neutral (V) and a TP of INR425
What we like about COAL …
Proxy on India’s growth story; India’s
largest coal company to benefit
We expect strong growth in Indian coal-fired
power capacity to drive domestic demand for
coal. COAL is a good way to play the rising
coal deficit.
Low cost assets, but coal quality not high
With a high percentage of opencast mines and
favourable geographic conditions, COAL has
the lowest operating costs of any major coal
company in the world. However, the quality of
the coal is not high.
In many respects low pricing risk makes it
a utility play
With its substantial selling price discount to
landed costs, COAL is a utility-like play.
However, its return on assets is materially
better than peers in the utilities segment.
Selling price can rise with richer mix
We believe COAL can increase prices over the
next few years as a result of (1) higher pricing
from ABC grade coal, (2) continued sales of
higher-priced washed coal, and (3) higher
prices from sales through e-auctions. We do
not build in the entire upside from these
factors. Our analysis suggests that, at current
estimates, a 1% increase in blended selling
price would result in a 2.4% rise in FY13 EPS
and a 3% increase in our target price.
New capacity to aid volume growth
We expect COAL to increase production by
127mt over FY11-17e (30%), mostly in the E
and F coal grades, through capacity expansion,
the development of new projects and an
increase in productivity at underground mines.
We note that several projects are behind
schedule and this could affect our forecasts. In
the event of lower-than-expected production,
we expect the company to sell part of its large
inventory (c60-70MT).
Our concerns …
Monopoly in India, but selling prices are low
We believe COAL cannot increase prices
dramatically over the next few years despite
the steep discount to landed cost because:
Higher prices would result in steep losses
for State Electricity Boards if they are not
passed on to the end customers, which are
already making large losses.
If passed on to the end consumer it would
result in 10-20% increase in tariffs,
increasing inflation.
Logistics may limit volume growth
Poor rail and road infrastructure is likely to
limit volume growth for COAL.
Unionised workforce increases cost inflation
risk
We believe the large number of non-executive
employees and a unionised workforce poses a
risk of high cost inflation for COAL. However,
the large selling price discount to landed costs
offers a buffer for product price increases.
Mining approvals can take a long time;
impact on volume forecast
Mining approvals and clearances can take a
long time (almost 10 years in the worst cases),
which could delay expansion plans. Some
forest areas have been declared “no go” areas
for mining companies.
Other risks
Implementation of the new legislation in
its current form could see 26% of profits
being shared with people moved off their
land by mining.
Unrest in some areas could affect current
and future mine projects.
Coal pilferage is a concern.
EBITDA: 20% CAGR over
FY11-14e
We expect COAL to report a 20% CAGR in
EBITDA over FY11-14e following a 4% increase
in off-take (sales volume), a 9% increase in
selling price, despite a 10% increase in costs
following our expectations of 30% rise in wages
from 2Q FY12.
COAL raised prices at the end of February 2011,
only the fourth increase in the last nine years. We
expect another hike in 3Q FY12 for DEFG grade
coal. Combined, we expect this to drive 46% EPS
growth in FY12 but it should then moderate, as
we do not expect any further price hikes in the
next two to three years.
We believe that adjustment for overburden removal
(OBR – the amount of surplus material moved to
mine the coal) is more likely to be lower in the
short term since the company is expected to align
its policy to IFRS accounting standards. This
could have a positive impact on the margins in the
short term but should even out in the long term.
Value COAL at INR425/share
We use a combination of DCF and earnings
multiple-based valuations to arrive at our target
price of INR425. At our target, COAL will trade
at a PE of 15x on FY13 EPS.
We believe a reserve-based metric is not best suited
to COAL as its coal prices are much lower (and
probably will stay much lower) than regional peers.
Initiate with a Neutral (V)
The stock has risen more than 60% since the IPO
in November 2010, driven by a number of
positive triggers. Valuations are now stretched so
we will have to wait for new catalysts, such as a
higher-than-expected price rise in FY12,
improved logistics or more e-auction sales. Given
the lack of visibility, these have not been
considered in our earnings estimates.
We classify COAL as a volatile stock (see
disclosure appendix for HSBC’s definition).
Under our research model, for stocks with a
volatility indicator (V), the Neutral rating band is
10ppt above and below the hurdle rate for Indian
stocks of 11%. This translates into a 1-21%
potential return on the current share price. As the
9% potential return for COAL shares (including
prospective dividend yield) falls within the
Neutral band, we initiate coverage of the name
with a Neutral (V) rating.
COAL’s earnings could be impacted by factors
not considered by us. The table below (Exhibit 1)
lists some of the possible areas not considered in
our valuation but which could act as triggers.
Exhibit 1A shows the price behaviour since its
listing in November 2010.
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