Subscribe to Coal India IPO: Motilal

Coal India IPO has been given a 'buy rating' by most trading agencies.

Written by Motilal Oswal | New Delhi | Published:October 18, 2010 11:41 am

We arrive at Coal India price target of Rs 325 per share,valuing it at Rs 2,055 billion based on DCF (discounted cash flow) methodology.

At this price target,the Coal India stock would trade at 17.6x (times) FY11E and 15.3x FY12E earnings. At the higher end of IPO price band of Rs 245 per share,the stock is valued at 11.6x PER (price-to-earnings ratio) and 3.6x P/B (price-to-book) on FY12E basis,at a meaningful discount to utilities like NTPC,PGCIL,etc. Given the ‘utility’ model in ‘commodity’ business,coupled with the characteristics of sellers’ market,we believe that CIL will largely have a linear earnings trajectory and impressive RoE (return on equity)/ free cash generation. Reported RoE for FY10 was 44%,despite a cash balance of Rs 390 billion (1.4x capital employed). We recommend Subscribe.

CIL’s profitability and earnings growth are more linear compared to a few of its peers globally,depicting the ‘utility nature’ of earnings in a ‘commodity business.’

Size and scale: Access to 64.3 billion tonnes of reserves,representing about 6% share of global proven reserves,and production (largest global reserves and production) Growth visibility and sustainability: Reserves to production (RP) ratio of 50 years (extractable reserves) and 122 years (proved reserves) provides further growth option,as about 40% of proved resources has not been considered for mining studies.

Competitive cost structure: Given the favourable geological conditions of many of its operational coalfields,it has a lower strip ratio at 1.6x.

Sellers’ market: Given the widening demand-supply gap,we expect that imported coal will contribute 45%+ of the incremental requirement till FY15 vs 6.8% currently,placing CIL favorably to capitalise on the characteristics of a sellers’ market.

Growth for CIL,we believe,is a function of three key variables: (i) initiatives to ramp up production,(ii) aligning the business model to reap further benefits from market prices,and (iii) cost savings plus efficiency improvements. Continued momentum on these levers,as in the past,provides possibilities to improve returns meaningfully. CIL is aligning its business model to gain from higher spot prices,with the FY10 contribution at 26% of production and 38% of sales revenues.

There are the possibilities to improve the ratio further as: (i) in the Integrated Energy Policy,the Planning Commission had envisaged increasing the share of e-auction to about 20% of production gradually from 10% currently,(ii) beneficiated coal capacity (4% of FY10 despatch) is underutilised given the lax environment regulations and CIL itself is planning capacity expansion to 7x of current utilisation till FY17.

We believe that the quantum of washed coal sales could increase meaningfully as the MOEF (ministry of environment and forests) is seriously thinking of imposing norms for using washed coal beyond a distance of 500 km,vs 1,000 km now; and 27% of the capacity to be commissioned in the Eleventh Plan is at a distance of 1,000+ kms.

CIL’s volume CAGR (compound annual growth rate) shows an increasing trend of 4.4% over the last 15 years,5.3% over the last 10,and 5.9% over the last five years. Revised FY12 target of 487 million tonnes of coal production suggests a two-year volume CAGR of 6.1%. Capex is likely to be up 42% in FY11. Efficient subsidiaries (SECL,NCL and MCL) contribute 65% of the production,with just 30% of the total employees. As the contribution from these subsidiaries improves further,we expect efficiency improvements. Employee cost accounted for 34% of CIL’s revenues and 46% of costs in FY10; employee strength has declined about 10% over FY07-10 (and nearly 30% since FY00).

CIL is well placed to benefit from its dominant position in the Indian coal mining sector. However,the challenges are many,and revolve around production ramp-up being impacted by Naxalite movements,stringent environment norms,feasibility of price increases given the extended implications; infrastructure bottlenecks,26% sharing of profit with locals under new mining Act,etc. While the challenges are many and could impact the growth in the medium term,we believe that they are surmountable over the longer term.

We expect CIL to report earnings CAGR of 14% till FY13,driven largely by 4.4% CAGR in average realisations,6.6% CAGR in dispatches and 297 basis points operating leverage,with Ebitda (earnings before interest,taxes,depreciation and amortisation) margins at 25.4% in FY13. A large part of the earnings growth is front-ended,with FY11 net profit estimated at Rs 117 billion (up 19%) given 5% despatch increase,7.1% realisation increase (as prices of raw coal were increased 11% w.e.f. October 2009) and 312 bp (basis points) operating leverage (with Ebitda margins at 25.6% in FY11) largely due to staff cost savings. We believe that there exist possibilities for upgrade in FY12/FY13 estimates,driven by improved product mix,higher realisations,operating efficiencies,etc.

The key risk to our earnings estimates include slower than expected ramp-up in production,inability to increase prices/control costs and regulatory/policy changes.

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