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NMDC FPO review and analysis by Angel Broking

By Angel Broking

 

National Mineral Development Corporation (NMDC) is India's leading iron ore producer and enjoys the benefits of huge iron ore reserves, high grade ore and lower costs. Nonetheless, we recommend an Avoid on the FPO, as at the lower price band the stock will trade at EV/EBITDA of 12.6x and 9.6x FY2011E and FY2012E, which is at a significant premium to its peers.

Increasing production - source of opportunity: NMDC plans to increase its production capacity to 50mn tonnes by FY2014E through increased exploration of its existing mines and development of new mines, ie. Deposit 11B and Deposit 13 in Bailadila and Kumaraswany in Karnataka.

Positioned at the lower end of cost curve: NMDC's operating cost (excluding freight) of US $7.2/tonne is at the lower end of the global iron ore cost curve. NMDC enjoys the benefit of low costs on account of its mines’ close proximity to ports and railways. The company also plans to invest Rs3,500cr in building a 10mn tonne slurry pipeline from Bacheli to the Vizag port, which would help it maintain Margins.

Re-negotiation of five-year pricing contracts and changing pricing mechanism: NMDC's five-year pricing contracts with its domestic players are ending in March'10, while the export contracts are due for revision in April'11. Given the changing business environment globally , the company has appointed a consultant to evaluate various options for pricing of its iron ore contracts. In our view, any change in the pricing mechanism would help to capture the short-term fluctuation in prices, which is likely to benefit the company in fetching higher realisations.

Seeking to diversify into steel making and acquisition of mines abroad: NMDC intends to diversify its operations by moving downstream through the establishment of steel plants and pellet plants. Accordingly, the company has lined up capex of Rs26,500cr for the next five years. In addition, management has indicated that it plans to acquire mines in Australia, Brazil and South Africa.

 

 

 

 

Investment Rationale

Increasing production - source of opportunity

NMDC produces and sells iron ore in the form of lumps, calibrated lump ore (CLO) and fines. In FY2009, NMDC constituted 13% of India's total iron ore production and produced 28.5mn tonnes of iron ore. The lump ore and fines constituted 11.4mn tonnes and 17.2mn tonnes, respectively. While the production in Chhattisgarh has increased at a CAGR of 8.9% over FY2005-09 to 22.2mn tonnes, production in Karnataka has increased at a CAGR of 5.3% to 6.4mn tonnes in the mentioned perio

 

 

 

 

The company plans to ramp up its production capacity to 50mn tonnes by FY2014E through increased exploration of its existing mines and development of new mines, ie. Deposit 11B and Deposit 13 in Bailadila and Kumaraswany in Karnataka. The targeted cost for the development of the three mines is Rs2,400cr.

- Deposit 11B is likely to start operations by October'10 and targeted production is 7mn tonnes.

- Kumaraswamy mine is expected to be operational by FY2012E and targeted production is 7mn tonnes.

- Deposit 13 is currently non-operational as the forest clearance is still pending. On receipt of the forest clearance, the company's share is expected to be 5mn tonnes out of the total planned production of 10mn tonnes; expected to come on-stream after FY2012E.

 

Positioned at the lower end of cost curve

NMDC's operating cost (excluding freight) of US $7.2/tonne is at the lower end of the global iron ore cost curve. NMDC enjoys the benefit of low costs due to close proximity of its mines to ports and railways. The company plans to invest Rs3,500cr in building a 10mn tonne slurry pipeline from Bacheli to the Vizag port, which would help maintain Margins, taking into account the additional capacity coming on stream.

 

 

 

 

Well-developed logistic infrastructure

Bailadila mines

- The company transports its iron ore production to the Kirandul and Bacheli Complexes via the Kirandul-Kottavalasa railway line (the "KK Line"), which is 475km long. The company has three loading plants at the mines that can load approximately 70,000 tonnes of iron ore per day onto the KK Line for transport to Vizag. Iron ore transported to the Vizag Port is mainly for exports, primarily to Japan, South Korea and China.

- A slurry pipeline (267km long) at the Kirandul and Bacheli Complexes owned and operated by Essar Steel, can transport 8mn tonnes of iron ore fines slimes to Vizag. The pipeline was heavily damaged in May 2009 following an attack by Naxalite rebels and is not operational currently.

 

 

 

 

Donimalai mines

- The company has a mechanised loading plant at Ranjitpura that loads onto South-Western Railway's (SWR) rakes for transport to the Chennai Port for export to China, Japan and South Korea. The plant is capable of loading 24,000tonnes of iron ore per day.

 

 

 

 

Dependency on long-term contracts reflects business visibility

NMDC currently sells around 92% of its volumes on long-term contract basis, while around 8% is sold on spot basis. In case of the spot sales, China is the main export destination. The domestic long-term contracts account for nearly 91% of the total long-term off-take quantity, while the balance 9% is sold to Japanese and Korean steel mills on a long term basis. In FY2009, about 85% of the total iron ore volume of 26.5mn tonnes was sold in the domestic markets, while exports comprised 15% of the total sales volume. For the nine-month period ending December 31, 2009, total iron ore sales volume were 17.2mn tonnes compared to 19.1mn tonnes in the corresponding period of the previous year.

 

 

 

 

Re-negotiation of 5-year pricing contracts and changing pricing mechanism

NMDC's five-year pricing contracts with its domestic players are ending in March'10 and expected to be renegotiated depending on the new benchmark iron ore prices and pricing mechanism. The export contracts are due for revision in April'11E. Till date, the company has been following the policy of revising the contract prices based on the annual benchmark iron prices accepted globally. As 92% of its sales are on long term contracts, the company is not reaping the benefits of spot appreciation in iron ore prices. Given the changing business environment globally and the global miners seeking a change in the pricing mechanism, the company has appointed a consultant to evaluate various options for the pricing of its iron ore contracts. In our view, any change in the pricing mechanism to capture the short-term fluctuation in prices is likely to aid the company in fetching higher realisation.

 

 

Gap in realisations due to different terms with regard to domestic and export sales

The domestic contracts are generally for a 5-year period and are typically priced on "Free on Rail" or "Free on Truck" basis where royalty and transportation cost is borne by the domestic customers. Contract prices are based on the Fe content supplied and are adjusted based on the variation of the Japanese benchmark prices and the exchange rate fluctuations. However, the company has the right to revise the prices in case the market prices fluctuate significantly by more than 25%. In the last 3 years, the company revised its prices 5 times (thrice upwards and twice downwards).

 

 

 

 

The exports contracts are adjusted every year based on the benchmark prices and the exports sales are Free-on-Board basis where the company is required to pay the royalty costs, railway freight, port charges and export duty. Thus, due to the different pricing mechanism for exports and domestic agreement, the company has lower domestic realisation vis-?-vis its export realisation. In FY2009, domestic iron ore realisations were US $56.3/tonne (FOR/FOT basis), while export realisations were US $96/tonne (FOB basis).

 

Adherence to export policy

As per the export policy of GoI, export iron ore with a Fe content of more than 64% should be canalised only through MMTC. The policy also imposes a cap on the quantum of exports from specific areas like Bailadila. The company cannot export more than 3mn tonnes of Bailadila lumps or more than 3.8mn tonnes of Bailadila fines.

 

International prices of fines are determined based on the price at which MMTC concludes its contracts with the international buyers. In the event MMTC does not remain a canalising agency, then the prices agreed between the Japanese steel mills and the global miners serves as the benchmark. The agreement entered into with MMTC is due to expire in March'11.

 

Seeking to diversify into steel making and acquisition of mines abroad

NMDC intends to diversify its operations by moving downstream with the establishment of steel plants, pellet plants and beneficiation plants in Chhattisgarh and Karnataka. Steel making venture in process

- The company plans to develop an integrated steel plant project in Jagdalpur (Chhattisgarh) with a capacity of 3mtpa. The iron ore required for the production of steel would be supplied by the company's existing mines. The company is in possession of 995 acres of land and has submitted an application for additional land of 777.2 acres. The company has obtained necessary clearances like environmental, rail transport, power and water connectivity.

- The company has been allocated 2,500 acres of land in Karnataka for construction of a 2mtpa steel plant and has obtained power connectivity and water connectivity in the Bellary/Hospet areas.

 

Pellet Plant

- The company is developing a 1.2mtpa pellet plant at Donimalai (Karnataka) at an investment of Rs572cr and has received the environmental clearances for the same.

- The second pellet plant of 2mtpa is being developed at Bailadila (Chhattisgarh). The total investment outlay is Rs807cr and the company is awaiting the forest clearance.

- The company has identified land for both these plants and a due diligence report has been received for the plants.

Accordingly, the company has lined up capex of Rs26,500cr for the next five years. Of the total amount, the company plans to invest Rs15,500cr in setting up an integrated steel plant, while Rs1,400cr would be incurred towards setting up two pellet plants. The company has indicated that majority of the cash outflow will start from FY2013E onwards. In addition, management has indicated that it plans to acquire mines in Australia, Brazil and South Africa.

 

 

 

 

Financial Analysis

EBITDA Margins to remain stable

In FY2009, the company's EBITDA Margins stood at 77.2%. We expect Margins to remain at 77% in FY2010E, but expand to 81.5% in FY2011E due to the revision in contract pricing. Thereafter, we expect Margins to stablise.

 

 

 

Net Income Margins to remain stable till FY2012E

While Net Income is expected to decline by 10.7% in FY2010E to Rs3,903cr due to lower volumes and realisation, we expect FY2011E and FY2012E Net Income to increase by 56.2% yoy and 25.6% yoy respectively, primarily driven by strong operating performance.

 

 

 

 

Strong cash flows to fund the expansion plans...

The company has drawn up huge capex plans of Rs26,500cr over the next five years to diversify its operations by setting up steel plants, pellet plants and beneficiation plants in Chhattisgarh and Karnataka. We believe that

the company is well placed to fund its expansion plans through internal accruals, without resorting to external debt.

 

 

 

 

…Net Debt to Equity to remain comfortable

Despite the company's huge expansion plans, its Net Debt to Equity is expected to remain comfortable. The company had cash and cash equivalents of Rs12,000cr at the end of December'09, which is expected to increase to Rs14,189cr by FY2015E.

 

 

 

 

 

 

 

Industry Outlook

Iron ore industry - fundamentals are looking strong into 2010E

There has been a significant rise in iron ore spot prices since December'09, up 32% to US $138.3/tonne. The key reasons for the recent rally in spot prices are: a) expected improvement in the world economic growth leading to a more bullish tone in the general commodity space, b) significant restarts of idle blast furnaces, which led to higher steel production. General consensus regards an increase in FY2011E contract prices are above 40% and as per media reports, Chinese mills have provisionally accepted a 40% hike in contract prices.

 

 

 

 

Global steel production to grow by 9.8% in 2010E

According to estimates, global steel output in 2010E is expected to reach 1,351mn tonnes (an increase of 9.8% yoy). While the crude steel production in China is expected to moderate in 2010E, up 8.1% yoy to 617mn tonnes, the ex-China regions are likely to grow by 11.4% yoy to 734mn tonnes. The capacity utilisation levels in many of the developed countries has started to improve with utilisation rates rising to ~70%, significantly higher than the 30-50% levels experienced during the financial crisis. Thus, the rising steel production is expected to translate into higher demand for iron ore.

 

 

 

 

Strong steel production to support iron ore demand

In 2010E, demand for iron ore is expected to increase on the back of higher crude steel production. Global iron trade is expected to increase by 8.1% to 987mn tonnes in 2010, compared to the rise of 2% in 2009. Iron ore imports of Japan, European Union and China are expected to increase by 13.8%, 8.5% and 8.0%, respectively.

 

 

 

 

Investment Concerns

Disruption at the key mining complexes

NMDC's two principal mining complexes, Kirandul and Bacheli, Chhattisgarh produced 78% of the total iron ore production in FY2009. These complexes constituted approximately 87% of the total reserves of the operating mines as on January'10. Any interruption in the operations would impact the company operations and our estimates

 

Delay in the development of new mines

Any delay in the development of the new mines (Deposit 11B in Bailadila and Kumaraswamy mine) could adversely impact the company target of achieving 50mn tonnes by FY2014E.

 

Labour strikes and logistical hurdles may lead to production halts

Historically, strikes, work stoppages and industrial actions have occurred leading to business interruptions and halts in production. In addition to the industrial unrest, KK Lines operation has also been restricted from time to time due to possible terrorist activities of Naxalite rebels operating in the area. In future, any such events may affect the production and distribution process of the company.

 

Scouting for new mines amidst increasing competition

The company's future operations depend on its ability to obtain additional or new reserves. As the steel companies are focusing on increasing their integration levels, the company might face intense competition from other steel and iron ore companies.

 

 

Follow on Public Offer details

The FPO entails issue of 33.2cr equity shares priced in the band of Rs300-350. The issue of 33cr equity share by the GoI represents 8.38% of the total outstanding share capital of the company. Retail Investors and employees are entitled for a 5% discount of the issue price. Post the issue, the government holding will be around 90% of the total share capital. The company will not receive the offer proceeds as it is a part of the government's divestment plan.

 

 

 

 

Outlook and Valuation

NMDC is India's leading iron ore producer and enjoys the benefits of huge iron ore reserves, high grade ore and lower costs. Moreover, NMDC’s plans of diversifying its operations by moving downstream, expansion of mines and the upcoming contract negotiation augurs well for the company going ahead.

Fair Value lower at Rs225

To arrive at a fair value for the iron ore business, we have used an average of EV/EBITDA and Discounted Cash Flow (DCF) methodology. While EV/EBITDA captures the short-term strength in iron ore prices, DCF normalises the Earnings over the long term.

Methodology 1: Discounted Cash Flow

Based on the Discounted Cash Flow methodology, we get a price of Rs154 per share. We have assumed a discounting rate of 14.6% and perpetual growth of 5%.

 

 

 

 

 

Peer comparison

At the lower price band, NMDC will trade at 12.6x and 9.6x FY2011E and FY2012E EV/EBITDA, while at the upper band it will trade at 15.1x and 11.5x its FY2011E and FY2012E EV/EBITDA.

In comparison to its domestic peer, Sesa Goa (only listed domestic iron ore company), which is trading at 7.6x and 6.2x FY2011E and FY2012E EV/EBITDA, we feel that the FPO is overpriced.

Recent corporate acquisitions in the Indian iron ore space, viz. Sesa Goa acquiring Dempo in 2009 and Vedanta Resources acquiring controlling stake in Sesa Goa in 2007, were executed in the range of 5-10x EV/tonne. Thus, on the EV/tonne premises too, NMDC is trading expensive in the range of 19-22x at the given price band.

 

 

Even compared to global peers, the NMDC FPO is expensive at the given price range. While global miners like BHP Billiton, Rio Tinto and Vale are trading in the multiples of 7-10x FY2011E EV/EBITDA and 6-7x FY2012E EV/EBITDA respectively, pure iron ore players like Kumba and FMG are trading at 8-9x FY2011E EV/EBITDA and around 6x FY2012E EV/EBITDA, respectively.

 

 

 

 

Company Background

NMDC, India's largest iron ore producer, was incorporated on November 15, 1958. Later, in 2008, the company was conferred Navratna status by the Government of India (GoI). The company is involved in the exploration of minerals including iron ore, copper, rock phosphate, lime stone, dolomite, gypsum, bentonite, magnesite, diamond, tin, tungsten, graphite, beach sands, etc.

NMDC is currently producing about 30mn tonnes from three iron ore mining complexes at Kirandul and Bacheli (Chhattisgarh) and Donimalai (Karnataka). The company has total reserves and a resource base of 1360.6mn tonnes of high grade iron ore (>64% Fe content). The company plans to increase it reserves base by around 600mn tonnes over the next few years, taking the total reserves to 2,000mn tonnes. In addition, the company also operates one of Asia's largest diamond mines at Panna, Madhya Pradesh, which was reopened in August'09 and is currently operating at 60% capacity utilisation.