Friday, April 6, 2012

>COAL INDIA: Price increases will be hard but still only upside likely

Initiate at 1-OW; a sleeping giant

We view Coal India (CIL) as a core long-term holding in the mining sector given its extremely favourable risk/reward profile. The fact that its adjusted selling price (c45% discount to the seaborne price) looks to have only upside alleviates the coal market concerns around the stock, in our view. We believe investors need confidence about the seven key issues surrounding the stock (highlighted in the report) and that the market is under-appreciating both a potential rebound in volume growth and CIL’s ability to control costs. A hastening of reforms and notified price increases would likely provide significant upside optionality. With a free cash
flow yield of about 7%, valuations look attractive, especially considering the low downside risk to profitability and large cash balance (c26% of market cap). We

 initiate at 1-OW with a 12-month PT of Rs411.
Higher-than-consensus volume growth feasible: Although the c2% CAGR drop in production over FY10-12E has dented investor confidence, we are optimistic that CIL’s volume growth can rebound to a 5% CAGR over FY12-17E (to 557mt). With only 14% of volume having to come from new mines and tangible measures being taken to address logistics bottlenecks, visibility on a volume rebound has improved dramatically. 

 Ability to control costs appears underappreciated: Wages are c53% of CIL’s costs and a shift in volume mix towards more efficient subsidiaries (wage/tonne of the most efficient subsidiary is 1/12 that of the most inefficient subsidiary and 1/3 of CIL’s average) and natural attrition of the ageing workforce (expect a c9% drop in employee base over FY11-14E) should offset the impact of rising wage rates, in our view.

■ Price increases will be hard but still only upside likely: We expect price increases for CIL to be less frequent and its sales mix to move away from higher-margin (e-auction and non-power) volumes. Our estimates build in a mere 5% price rise in notified prices in FY14, translating into a 1.5% CAGR in weighted average realisations over FY12-14E. 

■ Near-term issues reflected in price target: Our 12-month price target of Rs411 already factors in a negative Rs41/share for the proposed mining tax. Concerns the government may push CIL to use its cash balance to pay off state electricity board losses are overdone, in our view. Higher dividend payouts would be RoE accretive.

■ Key risks: Key risks to our investment thesis, in our view, include further delays in price
increases, drops in e-auction volumes and adverse regulatory changes.

To read full report: COAL INDIA