Coal India Limited is poised to do well, given the various intrinsic and extrinsic factors in its favour
09-Jan-2015 •Saurabh Mukherjea
I like the companies which have overwhelming sustainable competitive advantages - advantages so strong that you can almost reach out and feel them - and yet are underappreciated by the market. Whilst there is always a risk that such companies' competitive advantages will forever be undervalued by investors, I believe that in such situations the odds are loaded in my favour. One such company is Coal India Limited (CIL).
CIL was incorporated in 1973 as a 100 per cent government-owned entity as part of the government's drive to nationalise coal mines to expedite growth in the coal sector. Under the coal nationalisation drive, the government effectively took over the ownership of all the coal assets in India and in turn gave CIL the right to develop and mine various coal blocks in India. Hence, the government has sole ownership of all the coal assets in India, whilst CIL is a deemed lessee of the mines that it explores and operates.
CIL accounts for over 80 per cent of India's coal production and is the world's largest coal producer. CIL's coal reserve base is one of the largest amongst its global peers--18.9 bn tonnes of proven and probable reserves and 22.3 bn tonnes of extractable coal reserves. CIL's reserve size implies a reserve life of ~35-40 years, significantly higher than its global peers' reserve life of ~15-20 years.
By law, only government-owned companies are allowed to extract coal and sell it in the open market, and CIL accounts for ~90 per cent of total coal sold commercially. Whilst this might change going forward (as the government might amend the law to allow private sector operators to mine coal), it is unlikely that at any stage in the coming decade, the private sector will be able to rival Coal India's current production of ~500 mn tonnes.
As a result, CIL's competitive advantages are amongst the strongest of any large-cap Indian company. The question is whether CIL can leverage these competitive advantages to improve its profitability going forward. There are three reasons to believe that it can do so:
Volume growth likely to improve: We expect a two-phased revival in production growth for CIL: 5 per cent over FY14-17 and 8 per cent thereafter.
Prices likely to rise: CIL currently sells coal at ~50 per cent discount to the international free on board (FoB) coal prices. However, in order to offset cost escalation (mainly wage costs) and maintain margins, CIL takes regular price hikes. In this context, it is worth noting that rising private participation is unlikely to negatively impact CIL's pricing power, given: (a) CIL sells coal at ~50 per cent discount to the market price and hence there is a significant room for price hikes before its notified price reaches closer to the market price; and (b) private players will have to bid in coal auctions to get access to mines while CIL has a NIL acquisition cost (implying that private players are at a natural disadvantage as compared to CIL). Further, drawing an inference from the gas price hike push by RIL (with ONGC ending up becoming natural beneficiary of the same), we highlight that with rising private participation and push to deregulate prices, CIL will also benefit from an improving pricing scenario.
Surplus cash likely to be utilised more efficiently: Given that CIL has a cash balance of ₹590 bn (~$10 bn) as of September 2014 and given that CIL generates cash of ~₹200 bn annually, utilisation of this cash remains important. Going forward, we expect CIL to invest cash in: (a) purchase of wagons to reduce dependence on wagon availability from railways; (b) construction of railway lines to improve coal evacuation potential from the East Indian states; and (c) construction of pit head power plants which will have benefits of increasing domestic coal production from regions with evacuation constraints. Further, higher dividend to shareholders (similar to the ₹29/share, ~10 per cent of the then CMP, paid in FY14) would be a positive. Unlike India's oil and gas sector, which is struggling for resources, India has rich coal reserves and hence we do not expect CIL to make aggressive/expensive international acquisitions.
Just as importantly, none of these competitive advantages nor the profitability improvements are adequately baked into CIL's current share price (₹245 at the time of writing). Ambit's mining analysts believe that the fair value for CIL is ₹436 (implying a 25 per cent upside) based on the DCF methodology. (a) We value the future operations of the company (reserves depleted over FY15-FY34) at Rs 361/share, 83 per cent of the target price; (b) we build in net cash of Rs 742 bn in September 2015 and hence derive an additional ₹118/share; and (c) we adjust negative contribution of ₹42/share as well for overburden removal and employee provisions at 0.5 times book value.
Saurabh Mukherjea is CEO of institutional equities at Ambit Capital. The views expressed here are personal.