Coal India: FSA with a diluted penalty clause? : Kotak Securities PDF link

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FSA with a diluted penalty clause? As per media reports, a Presidential directive
asking Coal India (CIL) to sign fuel supply agreements (FSAs) has been issued. However,
the terms of the penalty clause for shortfall below the directed 80% assurance level will
be decided by CIL itself. In our view, CIL will likely be inclined to dilute the penalty
clauses for short-supply of assured quantities, thereby reducing the efficacy of the FSA.
Continued uncertainty over the terms of an FSA will likely weigh on stock performance.
Government invokes Presidential directive to CIL, leaves penalty clause at Board’s discretion
As per media flash, the Government has issued a Presidential directive to Coal India (under clause
37 of MOA of CIL) to sign FSAs with power utilities as directed by the PMO in February 2012.
However, the penalty clause for not meeting the assured quantity level of 80% has been left to
the discretion of CIL. This comes in the wake of recent standstill on signing of FSAs after
objections were raised by the independent directors. In our view, CIL will likely be inclined to dilute
the penalty clauses and even provide for meeting shortfalls through imports (as directed by the
PMO), thereby safeguarding its interest, and reduce the efficacy of an FSA given the current
demand-supply gap.
Imports inevitable in our view; ministry confident of ramping up domestic production
Import of coal to meet the ever-increasing energy requirements is inevitable at current production
levels of CIL, although the ministry remains confident of ramping up domestic coal production.
The moot question that still remains unanswered is—who will pay for potential coal imports, (1)
the procuring plant at the market price, (2) all power plants using a pooled mechanism, (3) Coal
India through some subsidization, or (4) a combination of all. A general consensus appears to have
evolved (and has been corroborated by CIL management) that CIL will be fully reimbursed for its
import bills.
In our view, the quantum of imports required to meet the 80% FSA levels will likely be to the tune
of 30-40 mtpa based on our production targets and assumed delays in commissioning of power
plants (see Exhibit 1), though achievement of planned targets can help plug the gap for meeting
FSA commitments.
Maintain ADD with a target price of Rs380
We maintain our ADD rating with a target price of Rs380/share, though concede that clarity on
terms and conditions of the proposed fuel supply agreement is key to stock performance. Our
target price is based on 11X FY2013E EPS adjusted for overburden removal and interest income
and implies an EV/EBITDA of 7.7X on FY2013E EBITDA (adjusted for overburden removal).