RBS: Coal India – More reforms needed

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Coal India is the world's largest coal producer, with FY10 output of 431mt. We see major
hurdles ahead to Coal India achieving volume growth of more than 4%, even as pricing
continues to be largely independent of international prices. We initiate coverage with a Sell
recommendation and Rs265 target price.

 

Volume growth guidance may not be met
Coal India has witnessed volume CAGRs of 5.9% and 5.2% over the past five and ten years,
respectively. We expect a volume CAGR of 3.6% over the next five years, below historical
growth rates due to a combination of factors: 1) the lack of timely environmental and forest
clearances; 2) overemphasis on open cast mining, requiring continuous land acquisition; and
3) a moratorium on expansion of select clusters by the Ministry of Environment and Forests
(MoEF). Management recently stated it may not be able to meet earlier volume guidance of
461mt and 487mt for FY11 and FY12, respectively. We have assumed 441mt/461mt for
FY11/FY12 in our forecasts.
Coal pricing continues to be 'guided'; prices should see a modest CAGR of 5.5%
Coal prices in India were deregulated in January 2000, but prices continue to be guided by
the Ministry of Coal. Historically, Coal India has revised prices biennially and raised them at a
CAGR of 4.9% over the past decade. Pricing is based on the cost of mining plus a
reasonable profit margin. This approach has very low volatility and no connection to
international prices. About 10% of India’s coal is sold on open auction, at which prices are
based on demand/supply and have fetched a premium of 50-60% to notified prices.

Valuations remain rich; we initiate coverage at Sell; Rs265 target price
We initiate coverage of Coal India with a Sell rating and a DCF-based target price of Rs265. We
believe Coal India lacks the necessary catalyst for volume growth and future price increases
might just offset wage increases, for which we expect a CAGR of 14% over the next three years.
We see several headwinds: 1) the new mining act could have a negative impact of up to 17% of
FY12F earnings; 2) the weak financial health of State Electricity Boards, which account for 55%
of India’s power generation; and 3) high reliance on contractors, which now account for 40-50%
of output. We note that our earnings for FY11 and FY12 are 11% and 18% below Bloomberg
consensus, respectively.