Coal India: Buy

Fresh investments with a three-year horizon can be considered in the Coal India stock, the world's largest coal mining company in terms of coal reserves. The stock has lost close to 29 per cent in the last seven months and valuations are 46 per cent below the peak.

Under-performance of the stock can be attributed mainly to the company missing production targets due to inclement weather, concerns of higher wage bill and laws proposing profit-sharing with the locals. News of the government eyeing Coal India's cash for meeting its disinvestment targets also took its toll on the stock.

These concerns seem to be priced in limiting the downside for the stock and providing good potential for gains. Being a near-monopoly in the Indian coal mining sector, the company can take advantage of chronic shortage of coal.

The company's lower selling price for a chunk of its coal output also gives it the pricing power to pass on rise in costs, and shields it from earnings volatility. Also, high cash balances with strong operating cash flows augurs well for its medium-to-long term investment needs. Cash and cash balances (Rs 55,000 crore in the consolidated book, as on September 2011), amount to Rs 87 per share in Coal India.

Premium valuations warranted

At the current price of Rs 300, the stock is trading at an EV/ EBITDA (earnings before interest, depreciation and taxes) of 8.6 times as against 5.5-8 times of global peers such as Peabody Energy, China Coal Energy, Bumi Resources and Yanzhou Coal. A higher valuation, though, seems warranted.

Apart from being a near-monopoly in the sector, strong profitability, low cost of mining production and high reliance on open-cast mines are the key positives.

The average selling price of Coal India is at more than 50 per cent discount to the global prices of similar grade coal. Going forward, the company is looking at improving quality of its coal output which would aid realisations.

Long-term advantages remain

The extractable reserves of Coal India would last at least for the next 50 years at current production rate. Environmental clearances, which have been the biggest hindrances, are expected to be expedited as Ministry of Coal and Ministry of Power realise the importance of widening demand-supply gap for coal and would want to keep it in check.

The demand of coal in the 12th Plan is estimated to rise at 8 per cent annually and is expected to outpace estimated supply growth of 6.2 per cent.

Coal India is expected to ramp up its production from 440 million tonnes in 2012 to 615 million tonnes by 2017. For meeting its production target, Coal India is expected to incur Rs 25,400 crore of capital outlay during the 12th plan. This is less than half the current cash balances of Coal India.

The company, which missed its production target in the September quarter, has liquidated a portion of its inventory to maintain supply target for this fiscal.

With the production stagnating at 430-440 million tonnes over the past three years, a 6.9 per cent rate of compounded annual growth in the next five years may seem like a tall order.

However, delayed commissioning of ongoing projects and improved regulatory environment with quicker clearances and building of logistics, may help achieve output targets.

As the company is scouting for mines abroad to augment its production capacity and is in discussion for long-term coal linkages with international players at lower than market rates, it may be able to meet its coal supply targets.

Coal India's production fell by 5 per cent year-on-year in the first half of the year due to heavy rains in the eastern part of India.

Yet, Coal India managed to supply more than 90 per cent of the coal target to its long-term customers up to October 2011, and may have avoided penalty.

Going forward, Coal India may manage to achieve the year's off-take target (454 million tonnes), subject to train rake availability.

Also, on a positive note, there were few takers for the Ministry of Coal's plans to divert e-auction coal to power projects, due to lack of infrastructure.

The company already sells more than 10 per cent of its coal through e-auction which fetches double the price of long-term contracts. Over the long-term, e-auctioning of coal sales may go up to 20 per cent of the total.

Concerns

Wage bill negotiations and profit-sharing are the other major concerns. While Coal India is provisioning for Rs 3,000 crore per year or a 17 per cent hike to meet the wage bill of non-executives, the Bill may go over the budgeted amount.

During the last wage negotiations, a 24 per cent hike in wages was given to its employees. At this level, the company may have to shell out close to Rs 4500 crore per year.

This coupled with sharing of 26 per cent of net profit with the locals proposed in the Mining Bill may reduce margins, if cost hikes are not passed on.

In the worst case scenario, Coal India may have to hike its coal prices by around 10 to 12 per cent across-the-board to compensate for the rise in costs.

In any case, the steep discount in its sales price, relative to import prices, for the chunk of its produce gives it enough room to pass on costs of wages and profit-sharing.

The last concern is demands from the government for a share of Coal India's cash balances to meet its deficit target. In this context, measures such as special dividend or buybacks that comply with SEBI norms, will benefit all shareholders equally, given that the company has far higher cash balances than it requires for its capital expenditure.

However, proposals for acquisition of cross-holdings in other PSUs may not be viewed positively by the market.

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