Global Outlook

Investors must read the financials well before taking an investment decision

Contributed by Nirmal Bang

By Nirmal Bang

The government’s plan to divest its stake in different Public Sector Undertakings (PSUs) is slowly taking shape. Recent media reports state that the government has cleared the decks to reduce its share in Hindustan Copper Ltd (HCL) and go in for a new initial public offering (IPO) in case of Coal India Ltd (CIL).

Both HCL and CIL are uniquely placed in their respective industries as they are among the largest in their sectors with strong financials. However, investors must be cautious about these companies when it comes to their public issues – both secondary and primary.

Owing to their high valuation, the stock prices of these public sector undertakings may fall steeply after the issue, as seen in the case of National Mineral Development Corporation (NMDC) last time. As a precautionary measure, it is advisable to go through the business and financials of these companies so as to take a right investment decision.

HINDUSTAN COPPER LTD (HCL)

HCL is India’s only vertically integrated copper company. Unlike Hindalco and Sterlite Industries, HCL has its own copper mines and is involved in mining, beneficiation, smelting, refining and casting of refined copper metal. The company has limited floating shares as more than 99% shares of the company are with the government of India.

BUSINESS

The company manufactures downstream copper products like cathode, bar and wire rods among others. During the manufacturing process, it also generates by-products like copper sulphate and sulphuric acid. In simple terms, the company mines ores, converts them into copper concentrates, which are then converted into copper cathodes and finally into copper wire bars. HCL’s plants are located across states like Rajasthan, Madhya Pradesh, Jharkhand and Maharashtra.

The company has a refined copper production capacity of roughly 50,00,000 tonnes. To fulfil its requirements, the company has to mine nearly 3.2 million tonnes of copper ore every year from its different mines located across the country. However, its captive mines are not enough to meet the copper concentrate requirement and hence it imports around 40% of copper concentrate from outside.

FINANCIALS

The company’s operating revenue has grown only by half to Rs 1,300 crore in FY10 in the last four years. The net profit of the company grew at a slightly faster pace during the same period. The lower growth is mainly on account of the recent slowdown in the global economy and these figures are expected to improve significantly in the coming period.

During a normal economic environment, the company has an operating margin of around 20-25%. The company is totally debt-free and has had a strong operating cash flow trend in the past. It had a cash balance of around Rs 400 crore at the end of FY10. Its return on capital employed (ROCE) is very volatile and ranges from -9% to 20%.

FUTURE GROWTH PLANS

Looking at the infrastructure growth in India, the company is slated to quadruple its mining capacity to around 12 million tonnes in the next 5 years. This will also help in increasing the capacity utilisation level of around 50%, which is relatively lower.

All these factors will help to increase its concentrator capacity going forward. Another positive for the company will come from reduced manpower. It has already managed to reduce its employee head count by half to around 5,000 in the last eight years. However, there doesn’t seem to be any big expansion plan in the near future.

VALUATION

HCL has 0.4% floating shares out of the total shares outstanding and this often results in market manipulation. Hence, the stock price on exchange does not reflect the fair value most of the time. Like NMDC, the valuation looks far stretched.

For instance, its market cap (so also Enterprise Value) is more than 200 times its annual operating profit in FY10. Although the profitability figure in FY07, the best in recent past, the current market cap is even more than 100 times the operating profit.

There is neither going to be any drastic change in the business model nor any great expansion plan in the future to justify such mind-boggling valuation. Its trailing price-earning (P/E) ratio, another popular valuation measure, for FY10 is close to 300.

Most mining and metal stocks demand no more than 20 times their earnings even during their best times. During the offer, the stock is likely to be priced far lower than the current market price. Whatever be the case, investors should maintain extreme caution when the stock will come for the Follow on Public Offer (FPO).

COAL INDIA (CIL)

CIL is the world’s largest coal producer and has the highest number of employees – over four lakh - in the Indian corporate world. It has also been conferred with the ‘Navaratna’ status by the government of India two years back. It is not listed and the government is planning the IPO sometime this year.

BUSINESS

The company is in the business of coal mining and production of related products. The company produces different types of coal like coking coal, semi-coking coal, hard coal and thermal coal among others. The company produces little more than 400 million tonnes of coal every year.

It operates through eight subsidiaries spread across different parts of the country. It has around 471 mines which are the backbone of the company. Along with coal, the company also produces coke, coke fines and tar among others.

The raw coal production and the associated despatches have increased by one-third in the last five years. Though the company has the highest number of employees, it has made sure to utilise it as its strength.

For instance, its average productivity per man per year has a northward trend and has increased by roughly half in the last four years. This is a positive point for the company even as several other PSUs are struggling to cut their manpower owing to lower utilisation rate.

FINANCIALS

The company is slowly but steadily increasing its topline. For instance, its operating revenue at Rs 38,800 crore in FY09 has risen by one-third over the past three years.

The financial information for the company is available only up to FY09 since the company is not listed. However, the profitability in FY09 has come down compared to the previous years. This is mainly on account of higher salary and wages (expenses) following the Sixth Pay Commission recommendation. This is likely to continue going forward as well.

The company’s operating profit margin (after depreciation) is close to 15%. Unlike other PSUs, Coal India is not a completely zero-debt company. It has a small amount of unsecured loan of around Rs 2,000 crore. The debt-to-equity ratio for the company by the end of FY09 was around 0.3.

The coal producing company has a strong operating cash flow record to cover its debt burden. Even though the profitability has come down, the company still has a high return-on-capital employed (ROCE). Its FY09 ROCE stands at a whopping 35%, which is very good in a capital-intensive industry.

VALUATION

There is no strict peer comparison for CIL in India and hence it’s not easy to make a quick relative valuation. However, since the company is the biggest coal producer in the world, it makes more sense to compare it with global mining majors like Rio Tinto, BHP Billiton and CVRDE among others.

One of the important valuation parameters for mining companies is EV/ EBITDA (Enterprise Value/ Earning before Interest Tax Depreciation and Amortization). The two mining majors, Rio Tinto and BHP Billiton, trade at an EV/EBITDA of around 11-13. If we assume a conservative EV/ EBITDA multiple of 12 for CIL, the enterprise value based on FY09 EBITDA works out to be around Rs 90,000 crore. This definitely will be higher if the calculation is based on FY11 numbers.

The company has a strong net cash and bank balance (excluding long-term debt) of Rs 28,000 crore. If we adjust for all these, the market capitalization of the company should at least be Rs 1,20,000 crore. These estimates are indicative of only FY09 figures and will change once the company makes public its latest numbers during the IPO issue.

RISKS AND CONCERNS

The company, like many other commodity companies, faces the risk of volatility in coal prices owing to international economic environment. Being governmentowned, the company also has to succumb to government pressure to supply coal at a discounted price to other government companies.

Finally, the future mining expansion plan will largely depend on the company’s strategy for rehabilitation of local people and land acquisition among others.