Coal India - Book Profits :: Business Line

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Investors can consider booking profits in the Coal India (CIL) stock. At the current market price of Rs 360, the stock’s valuations seem expensive compared with global peers.

It trades at an EV/EBITDA of 10.3 times as against 6-8 times of global peers such as Peabody Energy, China Coal Energy, China Shenhua Energy and Yanzhou Coal. On price-to-earnings basis, CIL trades at 15.4 times compared to 6 to 10.5 times for global peers.

A possible impact on Coal India’s profitability due to new fuel supply agreements (FSAs), regulatory uncertainties surrounding its business and declining global coal prices may make current valuations unsustainable.

BUSINESS OVERVIEW

Coal India is one of the largest coal-producing companies in the world. It has 11 direct and indirect subsidiaries, of which nine are involved in coal production. It has proven reserves of 52 billion tonnes (47 per cent of India’s proved reserves) and extractable reserves of 22 billion tonnes. 72 per cent of CIL’s output is absorbed by power producers, with the rest being used by steel makers, cement makers and others.

Coal India sells its output at contracted prices that are at a substantial discount to global prices.

On a consolidated basis, CIL registered 24 per cent growth in sales in FY12 to Rs 62,415 crore compared with growth of 12 per cent in FY11 and 15 per cent in FY10. Its net profit grew 36 per cent in FY 12 to Rs 14,788 crore compared to 12 per cent growth in FY11.

FSA OVERHANG

CIL’s total dispatches for FY 12 were 433 million tonnes of coal, of which 83 per cent was sold under fuel supply agreements with power producers and other user industries. Under the existing FSAs, CIL has to supply 80 per cent of the assured contracted quantity to power plants that have entered into long-term power purchase agreements with distribution companies.

 In the event of supply falling short of 80 per cent, CIL has to pay a penalty at 0.01 per cent of the value of the unsupplied quantity. This penalty clause is applicable only after three years of signing the contract. Essentially, for the first three years, CIL is not obliged to supply the contracted quantity.

If CIL is not able to meet demand, it can meet the shortfall through imported coal. If the buyer agrees to accept it, CIL will import coal and supply it at the port on a cost-plus basis, including service charges.

Thus, transportation of imported coal from the port to the project site would be the buyer’s responsibility. If a customer does not accept imported coal, CIL would not be liable to pay any penalties.

However, these FSAs were seen as one-sided and power producers have been clamouring for higher penalties, without which their tariffs would become unviable. To resolve this issue, the Government has suggested revising the existing FSAs.

The proposals being considered include increasing the penalty from 0.01 per cent to 20-40 per cent range and setting a lower threshold of 65 per cent from domestic sources for levy of penalties. Supplies have to subsequently increase to 72 per cent in the fourth year and 80 per cent in the fifth year. Besides, the three-year moratorium period for penalties may also be removed.

If these proposals come through, CIL will have to ensure a larger volume of supplies for the first few years. This may be difficult. The management has indicated that it is targeting 470 million tonnes (mt) of dispatch for FY 13, an 8.7 per cent growth in volumes over FY 12.

This seems optimistic, considering that the company has often fallen short of its projected targets. For instance, in FY-12, it managed to despatch around 433 mt against its target of 448 mt. Also, in the September quarter FY-13, CIL’s despatch was 101.7 mt against the projected 107 mt. Any diversion from the e-auction route to meet these commitments may result in lower realisations.

Also, CIL receives incentive payments (Rs 1,100 crore and Rs 650 crore in FY11 and FY12 respectively) if it is able to supply more than 90 per cent of the quantity in the existing FSA; this could also come under threat.

DECLINING GLOBAL COAL PRICES

Regulatory pressures on pricing and weakness in the global coal prices may impact the company’s pricing power too. In FY12, sales through e-auction contributed 21 per cent of CIL’s revenues despite only 11 per cent share in sales mix, as they command an 80-100 per cent premium over notified prices.

Softening global prices may prompt buyers to switch to imports. CIL’s realisations from the sale of coal through e-auction route have already been impacted.

For Q2 FY13, CIL’s e-auction realisations were at Rs 2,300 per tonne compared with Rs 2,550 in Q1 FY13 and Rs 2,800 in Q4 FY 12. Also there is a high chance of an increase in rail freight rates (53 per cent of dispatched coal is through Railways) due to the Railways’ worsening finances. Recent dispatches growth was impressive as it increased by 8.1 per cent on quarter-on-quarter basis due to improved rake availability (180 rakes/day) because of weak economic activity. Sustaining higher dispatches growth may prove difficult, with an uptick in economic activity. Costs are also a major concern, with the company’s largest cost item — wages — moving up sharply on recently renegotiated hikes.

REGULATORY ISSUES

Due to monopolistic nature of CIL’s business and given the concerns over power shortages, CIL will continue to be in the regulatory spotlight. Recently, the Ministry of Coal has invited proposals from consultants for suggestions to restructure CIL. The purpose appears to induce greater competition among coal mining companies and to improve production and marketing.

There have also been suggestions that CIL reduce its e-auction quantity and divert this coal to the power sector, which will curtail realisations. Uncertainty over the new Mining Bill regarding sharing of profits with locals could also turn out to be a negative. CIL being a cash-rich company, other income, which contributes 36 per cent of profit before tax (PBT), for FY12 will come under pressure if interest rates decline sharply.