India Coal : Deficit Is Rising – but Not Alarmingly :: Morgan Stanley Research

India Coal
Asia Insight: Deficit Is Rising
– but Not Alarmingly
India’s coal imports will grow in F13-F17, but the
pace is likely to be slower than generally thought in
India and below F11-F13. That should be aided by
higher volumes from CIL and should boost prices in
India. CIL, NTPC and Adani Ports would benefit.
Most challenged: Adani Power, and Nalco.
India’s coal crunch – growing but at a falling pace:
Our mining, utilities, cement and infrastructure research
teams collaborate to put into proper perspective the key
debates around India’s coal market, as seen below.
Key Debate 1 – How will coal imports trend in India?
We project a 13.2% CAGR in thermal coal imports in
F13-F17, to 160mt. Our F17 forecast is 11% lower than
consensus in India. Demand growth in F13-F16 should
be lower than market expectations. We expect output to
be buoyed – by recent government initiatives and by
captive mining – to a CAGR of 20% in F13-F17 versus
1.1% in F10-F13.
Key Debate 2 – Will infrastructure emerge as a
constraint? We conclude that logistics present the
biggest challenge for improvement in coal supplies.
Railways may just be able to handle the coal quantities
that we are forecasting, but would have to do this by
shifting some capacity away from other cargoes.
Key Debate 3 – How will coal prices evolve from
here? India’s contract coal prices should post a CAGR
of 5.8% in F13-F17 vs. the market’s view of 3-4%. We
expect the price rise will be greater (CAGR of 7.9%) for
non-power sector consumers. Also, we do not see much
progress on privatization, coal price regulation, new
captive blocks, or a break-up of CIL until F17.
Prospects of improving coal output strengthen our OW
calls on CIL and NTPC; rising imports could help Adani
Ports. Rising domestic coal prices too would help CIL.
Increasing coal prices and coal shortage would likely
continue to trouble Adani Power and Nalco.

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Investment Debates Summary:
Coal Deficit to Grow – but Not Alarmingly
DEBATE MARKET’S VIEW OUR VIEW
Coal imports:
how will they
trend from here?
Thermal coal
imports will rise at a
CAGR of 30-35% in
F13-F15 and will hit
180mt in F17.
21% CAGR in F13-F15 reaching 160 mt by F17%. We forecast thermal coal demand
CAGR at 9% in F13-F15 versus 13-15% expected on the Street. Our production forecast
is at 7.4% versus Street expectations of 3-4%.
Trends to track: Growth in power demand, new coal mining project development by MCL
and by captive mines.
Where we could be wrong: Regulatory and logistics issues bog down growth plans of
CIL and captive miners. Coal demand jumps along with a surge in economic activity and
increased reliance on coal-based power.
Infrastructure:
will it emerge as
a constraint to
coal supply
growth?
Yes, meaningfully.
Indian railways
(IR) and ports
infrastructure
aren’t equipped to
handle
incremental coal.
Infrastructure may be stretched, but it will still be able to handle required coal
quantum until F16. In F17 it may cause supplies to be lowered by about 1.5%.
Trends to track: Wagon purchases by IR, improvement in turnaround time (capacity
utilization) progress on last mile connectivity of three new coal fields, and port capacity
creation.
Where we could be wrong: IR struggles to add new wagons owing to procedural issues,
new rail line projects are further delayed, while last mile logistics deteriorate.
Coal prices: how
will they evolve
from here?
Coal prices in the
contract market
should post a CAGR
of 3-4% in F13-F17.
We expect 5.8% CAGR in contract price of coal in F13-F17. For power the growth
rate should be about 5.2% and 7.9% for non-power.
Trends to track: Import parity prices, inflation, extent of differentiation between power
and non-power sector consumers, and progress on pricing reforms in power sector.
Where we could be wrong: High inflation, poor production growth and a thrust by the
government towards coal price control.


What’s New?
• India’s thermal coal imports are likely to be lower than the
expectations of policy makers and investors in India, but
will likely be higher than those expected by global coal
industry observers.
• Coal-based power industry is moving into a surplus state
beginning F16.
• Utilities should get an increasingly high share of domestic
coal. We expect the proportion of utilities in domestic coal
supply to inch up closer to 80% levels by F17, as was the
norm until 5-6 years ago, versus about 75% currently.
• We forecast captive mines to contribute 29% of India's
incremental coal output in F13-F17, versus a share of 9%
in F13 output.
Where do we differ from the market?
• We estimate meaningful improvement in the output growth
of CIL and captive mines. Demand from the utilities,
cement, DRI and steel industries will be less than policy
makers expect, in our view.
• We forecast CIL’s production CAGR in F13-F17 to be
6.8%, lower than CIL’s optimistic scenario target but
higher than consensus expectations at 3-4%.
• Power utilities will likely continue to suffer from coal
scarcity until F15; however, in F16 and F17 overcapacity in
power, and not a coal shortage, will become the overriding
issue for this industry.
• On total thermal coal imports, we are 11% lower than
consensus expectations in India for F17 and 25% lower
than consensus on thermal coal imports by Utilities for
F17.
• On infrastructure, last mile connectivity can be a bigger
problem than railway wagon availability.
• We estimate India will cross 15% share in the global
thermal coal sea-borne import market in CY2014 to
become the second largest coal importer.
Some Key Drivers for our Analysis
Coal production – We project production numbers by
analyzing coal field production trends and by looking at the mix
of depletion from existing mines, brownfield and greenfield in
the project basket.
Coal demand – We look at the power sector’s coal demand by
forecasting power generation based on the lower of power
capacity and power demand (the latter often gets overlooked
thus giving misleading conclusions).
Logistics – We assess railway capacities in terms of (a)
wagon availability, and (b) last mile rail connectivity. We also
estimate port capacities in this report.
We also analyze progress on and possible impact of other
relevant factors like washing, privatization, coal regulation,
break up of CIL, and new captive blocks.

Key Stocks to Highlight
CIL (OW): Enhanced visibility on medium-term
pricing and volumes
Our confidence in CIL's ability to meaningfully increase its
production and prices has increased after this study.
Accordingly, we are now more optimistic on CIL.
1) Accelerating volume growth – As the clearance process
for brownfield expansions becomes less time consuming,
we expect CIL to post a healthy production CAGR of 6.8%
from F13-F17, essentially reversing the trend of flattish
growth over the last 3 years (CAGR of 1.5% from F10-F13)
and in 1QF14.
2) Likely re-rating with demonstration of improving
pricing power – After the recent price hike announced for
the power and non-power sector, we expect investor
confidence in CIL's ability to increase prices going forward
to be enhanced. This should be strengthened further by
4QF14 when we expect another round of price rises – this
time just for non-power sector consumers. We expect
average realizations of CIL to rise by 5.3% and 6.4% in
F14-F15e.
3) Fast improving cash return – Also, with an F13 cash
balance of US$11.4bn (33% of market cap) and net cash
generation after capex of about US$4.3bn in F14e, we
expect CIL to raise its dividend per share of Rs10 in F2012
and Rs14 in F13 to Rs25.2 in F14e. An F2014e dividend
yield of 8.4% looks attractive for a stock with low
vulnerability to global coal prices.
At valuations of EV/EBITDA (Adj) of 3.9x based on F14e and a
39% discount to its global peer group, it seems the Street is
unduly pessimistic and ignoring CIL’s positives of a large cash
pile, sizeable mine reserves and low exposure to global coal
pricing and a potential EBITDA CAGR of 25% in F13-F16e.

Further price hikes, especially for the non-power sector (we
expect a 12% hike for the non-power sector in 4QF14), and
higher production growth trends in 2HF14 are the key catalysts
over the next 12 months.
Where we different from consensus:
1) We assume another 12% price hike for the non-power
sector in 4QF14 while we believe the Street is not building
in another hike. Overall the Street is more muted in its
realization growth expectations at 3-4% CAGR in
F13-F16.
2) We expect CIL to post healthy production growth of 5.4%
YoY in F14, versus Street expectation of 2-3% growth.
3) We expect the mining tax to be linked to royalties and
hence expect CIL to be unaffected by this tax. However,
many market observers on the Street expect that CIL may
have to share the new tax burden.
Risks: 1) CIL is unable to raise FSA prices over the next 12-18
months. 2) Production growth slips in the next 6-8 quarters.
3) A mining tax is imposed at 26% of PAT.
NTPC (OW): Improving coal availability could aid
PLF and earnings
We continue to like NTPC (OW), more so after this study:
1) It gains the most from any improvement in domestic coal
availability, even if other power companies still have to
depend more on imports.
2) Even if overcapacity in coal-based power industry
surfaces beginning F16, NTPC won't have any problems
in selling its power due to firm PPAs in place.
3) NTPC's regulated business model helps it to pass through
any coal cost increase.
From a valuation perspective, 12-month forward P/B is 1.3x,
almost 2SD below the six-year mean. We believe meaningful
steps taken by the government to improve the coal supply
situation can help earnings, as they can boost availability and
load factors for NTPC. Key downside risks would include
further deterioration in availability and load factors, regulatory
changes and delayed payments from SEBs.


Power Grid (OW): No exposure to fuel
Given that generating companies will remain exposed to the
fuel supply scenario, we would advise investors to look at
transmission, where fuel has no role to play. In such a scenario,
Power Grid (OW) is our top pick:
1) it has a monopoly in central transmission and operates in a
fully regulated environment, thus lending significant
visibility to future earnings.
2) Earnings are likely to post a 13% CAGR between
F2013-17 given the structural demand for transmission
capacity in the country.
12-month forward P/B is 1.6x, more than 1SD below the
six-year mean. Continued delivery on capex and
commissioning are key triggers. Key downside risks would
include a slowdown in capex, regulatory changes and delayed
payments from SEBs.
Adaro (OW): A play on rising coal imports by India
We highlight Adaro as one of the Indonesian stocks that could
gain meaningfully from our forecast for increasing imports from
India. Despite having lower coal quality than its Indonesian
peers, Adaro continues to achieve one of the highest unit
margins in the current soft coal price environment. This is
helped by its strong reputation in the market and concerted
focus on cost control in 2013.
We also like Adaro’s longer term positioning in 1) low-rank coal
to tap the Indian market, and 2) the power business to add
some stability to earnings.
On most valuation metrics, Adaro looks reasonably attractive.
Its low, versus peer group, EV/EBITDA of 5.3x based on
CY13e highlights that its operating earnings are competitive
despite its lower coal quality. Its EV/Reserves is also at the low
end within the coal sector, indicating its strong reserves and
longer-term production outlook.
Key risks:
1) Over the years, Adaro has made a number of acquisitions.
With several new projects on hand, Adaro faces increased
execution risk.
2) In the near term, Adaro’s relatively lower coal quality could
affect its coal price realizations.
ACC (EW): Rising coal costs can be passed on
Our EW rating factors in near-term earnings concern given
muted demand, which limits recovery in cement prices too. The
stock currently trades around 9x C2013e EV/EBITDA.
Structurally, we remain positive given slowing capacity
additions for the industry, which we believe will drive utilization
higher as demand recovers.
What could make us turn positive? Demand increase with
recovery in GDP growth and improvement in cement prices.
Adani Power (UW): No relief in sight
The company faces several challenges:
• PPAs tied up on fixed tariffs are turning uneconomical due
to fuel and currency risks;
• With operational cash flows diminishing, leverage has
increased to 10:1 in F2013;
• Dependence on CIL is increasing, which will pose a
challenge given the likelihood of a continued domestic
deficit.
Our F2014 earnings are 69% lower than consensus; we expect
consensus earnings outlook to fall and so believe the stock will
remain pressured. Given significant earnings volatility, we think
earnings-based valuation multiples are not meaningful.
On a P/B basis, F2014e P/B is 1.6x – expensive relative to
ROE, which we expect to be negligible. Key upside risks for the
company include a significant improvement in low cost coal
supplies (from Bunyu and CIL), improvement in operational
efficiencies and possible tariff renegotiation.


Impact by Industry
India – Coal
We are now more positive on Indian coal miners than before.
We expect a CIL volume CAGR of 6.8% in F13-F17 (versus
5.8% earlier) based our detailed work on production and
logistics systems. Similarly we now expect a CIL contract price
CAGR of 5.8% versus 4.5% earlier.
Other important areas where our stance has changed are:
1. E-auction volumes – With this report we are assuming
lower sales volumes in the e-auction market as CIL strives to
enhance supplies in the FSA market. However we are still
assuming some increase in CIL’s e-auction tonnages in F16.
This is a negative for CIL but the impact is quite small.
2. New minerals tax – We push forward the roll out of a new
minerals tax to September 2014 now. Also, we now assume
that this tax will be linked to royalties as opposed to PAT, as
had been proposed earlier. This can be passed through to
customers by CIL and boosts our EPS forecasts for CIL – F14
by 3% and F15 by 8%.
India – Power
Our cautious stance on the power sector remains unchanged.
Power generators have been facing two key issues: a) lower
plant load factor (PLF) due to lower domestic coal availability;
and b) lower demand of power from SEBs due to
non-availability of debt funding which also leads to their inability
to buy expensive power (generated using imported coal). Our
analysis on the coal sector throws up the following implications:
1. Domestic coal supplies – While our fresh assessment on
production and infrastructure makes us more optimistic on
India’s coal volume growth from F15 onwards, it does little to
change the fortunes of Indian power generators.
(A) F13-F15 – Coal availability remains the key issue:
The private sector has significant capacity under
construction and a large part of this is slated for
commissioning in F2014/15. We estimate almost 40 GW of
coal-based capacity is due for commissioning in these
years. Hence, even amid an improved CAGR of 7.4% in
domestic coal availability in F13-F15, power sector
demand for coal is likely grow at 10.5% in the same period.
As a result power plant developers may delay construction
activities or synchronize capacity and not declare it
commercial, to prevent fixed costs from affecting the P&L.
Hence, we are assuming that only 29 GW of coal-based
capacity is synchronized/ commercialized in F2014/15
thus leading to almost 11 GW of capacity being pushed
into future years. Some of the key listed companies that
are expected to add large capacities in F2014/15 are
NTPC (4.9 GW), Adani Power (4 GW), Lanco (3.3 GW),
Indiabulls Power (2.4 GW), JSPL (2.4 GW) and Reliance
Power (3.3 GW). Out of the above some capacities
belonging to Lanco, Indiabulls Power and JSPL could be
pushed into later years, in our view.
(B) F15-F17– Coal issues are overshadowed by
overcapacity in power industry: We believe that from
F16 onwards lower demand for power (relative to available
power capacity) is likely to be a bigger and more
fundamental issue compared to coal availability. This
could be attributed to weak planning, but we expect power
capacities to remain under-utilized/idle due to excess
capacity. This will further hurt PLFs (especially for IPPs)
and hence, profitability.
2. Coal Pricing – For domestic coal, we expect FSA prices for
the power sector to increase at a CAGR of 5.2% in F13-F17
versus 4.5% earlier. This should be negative for the IPPs as we
were assuming 3-4% annual increases earlier. In addition to
this, our estimate of a US$15 increase in F16 over F15 in
imported coal prices could hurt IPPs again, more so for those
that either have fixed tariff PPAs or merchant capacities (such
as Adani Power and JSW Energy). We continue to prefer
NTPC in such a situation – its regulated business model should
provide a cushion against such price increases.
3. Logistics – This is now showing some promise as rail
infrastructure, availability of railway rakes and port connectivity
may not be as big a challenge as we have been expecting.
However last mile connectivity of power plants may still be an
issue. As an example, railway connectivity is posing a
challenge for Indiabulls Power’s capacities in Amravati and
Nashik. Hence, we believe logistics will be a challenge on a
case-to-case basis rather than being a sectoral issue.
We continue to like NTPC (OW) and Power Grid (OW).
In our view, Adani Power (UW) and IndiaBulls Power (UW)
should still be avoided, and we would not add to positions in
Lanco (EW).

India – Cement
Rising cement production will drive coal demand higher. While
we estimate Coal India’s production to rise at a 6.8% CAGR
over F13-17, a higher proportion of the production will be
diverted to the power sector, in our view. We expect the cement
industry’s dependence on imported coal / pet coke to rise in the
medium term.
Imports: While our team’s assessment of Coal India’s
production and supplies is positive, we expect a larger share to
be diverted to the power sector. Based on our cement
production and domestic coal supplies forecast, we estimate
the share of imported coal in total coal consumption for the
industry to rise sharply from 61% in F13 to 71% in F15 and
further to 73% in F2017 (i.e., around 23mnt).
Pricing: Domestic coal prices for non-power sector consumers
are set to rise at a fast clip. We estimate that, currently,
international coal is around 80% more expensive than
domestically linked coal for cement. With the industry’s
dependence on imported coal expected to increase, coal /
energy cost for the industry will increase in the medium term.
Impact on Morgan Stanley’s coverage:
• ACC (EW) currently has highest exposure to linkage coal
at 50% of total requirement relative to 30-35% for Ambuja
(EW) and Ultratech (EW).
• The impact of increased exposure to imported coal (for the
industry) will vary across companies subjected to the
change in their respective coal mix over the period.
• Assuming that the incremental shift in domestic coal
supplies is similar for all the companies, the impact would
be similar.
• We also expect 7.9% CAGR increase in domestic coal
prices over F13-F17.
• Given ACC’s higher exposure to domestic coal coupled
with some potential shift to imported coal, we believe it that
would be relatively more affected. The overall impact for
the companies, however, is likely to be partly offset by shift
to alternate energy sources / waste materials, which is a
key focus for some companies (and not covered in our
analysis given limited clarity)..
India – Infrastructure
Rising coal demand will drive logistics demand higher – both
for rail (domestic and imports) and ports (imports). The rail side
of the story is a bit difficult to play other than through the small
listed wagon manufacturers. However, the upside in ports can
be played – given the capacity constraints at major ports, the
minor ports are likely to be the key beneficiaries of rising coal
demand, just like they have been the key beneficiaries of the
growth in India’s trade over the last decade.
Stock impact: Mundra (Adani Ports, OW) handled a total of
82.1mmt in F2013 (up 21% YoY vs. the 3% decline in the cargo
of the major ports), maintaining its no. 2 position in Indian ports
in terms of cargo handled. With its location on the West Coast
helping it serve both the Northern and Western hinterland, and
a planned dedicated coal capacity of 100 mn tons by F15e (vs.
a cargo of 27 mn tons in F13), the company is best placed to
benefit both from the 11% CAGR we expect in coal imports
over F13-17e.
India – Non-Ferrous Metals and Mining
Rising domestic coal prices and a decreasing proportion of
FSA coal would further push up production costs for aluminum
companies – Nalco (UW), Hindalco (EW) and Sterlite (OW).
Aluminum contributes less than 15% and 25% to Sterlite and
Hindalco’s EBITDA, respectively, and hence rising coal costs
impact them less. For Nalco this issue will continue to hurt in
the medium term.
Indonesia – Coal
The Indonesian coal industry could be one of the biggest
gainers from fast-rising thermal coal imports India. India’s
import requirements are growing faster for the lower quality and
lower priced coal and Indonesia is the largest supplier of such
coal. Also, due to the close proximity of the two countries Indian
consumers prefer importing from Indonesia.