NMDC FPO Analysis

A pricey commodity stock

The company's high P/E already captures substantial rise in iron ore prices over the next few years and EV /tonne of iron ore reserves is at significant premium to global peers

NMDC (National Mineral Development Corporation), incorporated in 1958, is a public sector company controlled by the Government of India (GoI). The company has been conferred "Navaratna" status. It has access to significant reserves of high grade iron ore, predominantly greater than 64% Fe content and iron ore production accounted for approximately 13% of India's total iron ore production (according to the Indian Bureau of Mines). The company is also one of the lowest cost producers of iron ore, resulting in strong margins.

NMDC was the largest iron ore producer by volume in India during the last three fiscals (according to a certificate of the Federation of Indian Mineral Industries, dated February 8, 2010) and produced 28.5 million tonnes of iron ore in FY 2009. The company's principal operations include its three iron ore mining complexes at Kirandul and Bacheli in Chhattisgarh and Donimalai in Karnataka, each of which consists of several iron ore mines. Core operation is iron ore mining and iron ore sales, representing approximately 99% of its consolidated income from operations for FY 2009 and for the nine months ended December 31, 2009.

As on 1 January 2010, as per the assessment of Behre Dolbear (in accordance with the Joint Ore Reserves Committee (JORC) code), total reserve stood at 1360.6 million tonnes (proven reserve 977.5 million tonnes, probable reserve 182.2 million tonnes and mineral resources 201.0 million tonnes), predominantly greater than 64% Fe content. The company's producing mines are open cast and primarily fully mechanized. It is planning a number of projects to meet demand by enhancing the production capabilities of its existing mines and also by opening new mines.

Going forward, NMDC has guided for a volume guidance of around 50 million tonnes p. a. by 2014. However, most of the volume growth will be back-ended. The management also expects the actual reserves to be higher than the reported reserves. The company also has a healthy balance sheet with cash of Rs 12078.25 crore and is actively exploring options of acquiring iron mines in countries like Brazil, Australia and Senegal.

NMDC sells most of its high-grade iron ore production to the Indian domestic steel market on long-term sales contracts. In FY 2009, exports constituted approximately 15% of consolidated total sales volume, primarily to Japan and South Korea. The company sells its core products, iron ore fines, lump and slimes, through the sales and marketing function. In FY 2009, approximately 92% of the iron ore domestic and export sales volumes were on long-term contracts. The remaining 8% was sold in the spot market at negotiated prices.

Most long-term contracts are for five years. Around 96% of the current agreements for domestic sales are due to expire in 2010 and all current agreements for exports are due to expire in 2011 Till now, NMDC was varying the price in line with changes in global benchmark rates. In view of the crumbling benchmark system, it has appointed a consultant to re-look its pricing structure on long-term contracts and develop a new pricing mechanism. NMDC expects to receive the report soon.

As NMDC is one of the lowest cost producers of iron ore globally, it enjoys very high OPM, which has been consistently above 75% from FY 2007 to FY 2009). As per the company, domestic margins are higher than export margins. For exports, the company has to bear additional costs of export duties, royalty rates, and transportation cost from mine to the port (export sales are on a FOB basis). For domestic sales, royalty charges and transportation costs are borne by customers.

In addition to iron ore operations, NMDC also operates a diamond mine at Panna in Madhya Pradesh, one of the largest diamond mines in Asia, and owns a wind power facility with seven towers with a total capacity of 10.5 MW in Karnataka. The company has the clearance for producing 1,00,000 carats of gem and industrial diamonds per annum. Further more, it expects to complete its acquisition of Sponge Iron India, a company primarily involved in the production of sponge iron, early 2010.

NMDC's key expansion plans include development of steel mill, beneficiation pellet plants, etc. Over the next five years, the company has chalked out a capex plan of Rs 26500 crore. A major part of the capex is to be back ended. Of this, a bulk of the capex (around Rs 15500 crore) would be for steel expansion. The rest would be spent on the pellet plant, development of mines, etc. The company plans to start value-added projects such as steel production and has signed an MOU with the government of Chhattisgarh to develop a steel plant with a capacity of three mtpa at Jagdalpur. It also has plans to develop a steel plant in Karnataka. MMDC is planning to diversify and has been allotted two coal blocks. It is also looking overseas to acquire rock phosphate/potash mines and has secured a prospecting license for gold in Tanzania

NMDC is coming out with a follow-on issue, which is an offer for sale of 332243200 equity shares by the GoI, representing 8.38% of the outstanding equity share capital of the company as part of the decision of GoI to divest part of its shareholding in the company. Being an offer for sale, the company will not receive any proceeds of this offer. All the proceeds will be received by the seller of shares.

Strengths

Iron ore is a key input required in steel making. During the recent global financial market turmoil, India and China were the only two bright spots. In calendar year 2009, among the major steel producers in the world, India and China experienced a growth in steel output, while most others reported a fall. This indicates that the demand for iron ore has remained relatively firm. Furthermore, NMDC caters mainly to the domestic market, which augurs well. The National Steel Policy (NSP) has set a steel production goal of 110 million tonnes by 2019-20. This requires an availability of 190 million tonnes of iron ore for domestic consumption. Currently, domestic iron ore consumption is estimated at around 90 million tones in FY 2009.

NMDC is one of the lowest cost producers of iron ore across the globe and has been able to keep the operating expenses in check, giving the company a competitive edge. While the EBIDTA has increased sharply from US$ 13.4 per tonne in FY 2005 to around US$ 51.3 per tonne in FY 2009, the operating expenses (based on consolidated audited financial statements excluding selling expenses) have increased from US$ 6.1 per tonne in FY 2005 to around US$ 7.6 per tonne in FY 2009.

NMDC's 92% of iron-ore sales are on long-term contract and the balance 8% on spot basis. As a result, the current performance is reflective of the long-term contractual iron ore pricing, which is at a steep discount to spot price. However, going forward, there are proposals to move the contract prices near to the spot rates next year. This would have a positive impact on its iron ore realization. Strong spot prices coupled with indication by global majors to seek settlement close to the spot rates augur well for the company. NMDC has appointed a consultant to look at various possible pricing mechanisms available to realise higher iron ore price once the benchmark system is changed.

Weaknesses

Most major domestic steel companies have applied for captive iron ore mines and their application is in different stages of approval. Allocation of mines to steel companies may affect the demand prospects of NMDC over a longer time frame.

The mining operations are located in geographically remote areas, some of which are at risk of attacks by rebel groups. Such attacks have had and may continue to have a material adverse effect on NMDC's operations. For example, the slurry pipeline owned and operated by Essar Steel, used to transport NMDC's iron ore from the Kirandul complex to Essar's facility in Vizag, was damaged by Naxalite rebels in May 2009, adversely impacting the revenue and profitability of NMDC. In addition to disruptions in state-owned railway lines, the company's supplies through rail (KK Line) from the Kirandul and Bacheli complexes to the Vizag port have been restricted from time to time due to security concerns of terrorist activities of Naxalite rebels operating in the area. Further more, time overruns have been experienced at the Bailadila Iron Ore Project Deposit 11B due to Naxalite activity in Chhattisgarh.

NMDC generates a significant portion of its revenue from certain key customers. Rashtriya Ispat Nigam and Essar Steel together accounted for 37% and 37% of iron ore sales revenue in FY 2009 and in the nine months ended December 2009, respectively.

For the next few years, the primary driver of NMDC's earnings will be the increase in iron prices as no significant volume growth is expected (except for the recovery from the temporary dip in the current year).

The company's capacity to execute and operate large steel projects planned is untested.

Valuation

Operationally as well financially, NMDC is on a strong footing. However, its FPO represents an exceptional case whose current share price does not give a true picture of its value because the pre-issue floating stock is just 1.62% (64054620 equity shares). Total Institutional holding is 1.38%, leaving very little float for public holding. The stock also has been very volatile. After recently hitting a closing high of Rs 556.05 (closing price as on 19 January 2010), it has corrected by 28% (closing price of Rs 400.60 as on 8 March 2010). Due to low floating stock, the scrip was enjoying high valuation. But with the increase in floating stock after the current issue, valuation will come down.

In FY 2008, NMDC's total iron ore production stood at 30 million tonnes, while in FY 2009, it was around 28.5 million tonnes. In the nine months ended December 2009, iron ore production stood at 17.2 million tonnes. The nine months ended December 2009 were relatively lower partly due to damage to the Essar Steel slurry pipeline, which was not operational since May 2009 and was restored recently.

The stock is offered at a price band of Rs 300 – Rs 350 (without considering the 5% discount being offered to retail individual bidders and eligible employees), which is in a range of 13%-25% discount to the closing price of Rs 400.60 on 08 March 2010. P/E at the offer price band is at 27.3x- 31.9x times consolidated FY 2009 EPS of Rs 11.0 and 37.3x - 43.6x times the consolidated annualised nine months ended December 2009 EPS of Rs 8.0. So even the lower price band already factors in the substantial rise in iron ore prices in the near term as only the rise in iron ore prices will be the key earnings driver over the next few years,

At the price band of Rs 300 – Rs 350, the EV (Enterprise Value) per tonne of iron ore reserve works out to be in the range of US$ 20.2 per tonne to US$ 23.9 per tonne. The EV/tonne of iron ore reserve of comparable player in the sector, Sesa Goa, is around US$ 22.7 per tonne (based on the closing price on 8 March 2010). Notably in last one month, the Sesa Goa scrip is up 23%. However, on the basis of EV/tonne of iron ore reserves both the Indian players are trading at significant premium to the global peers.

Commodity stocks like NMDC track actual and expected changes in commodity (iron ore for NMDC) prices, which are very sensitive to global economic and liquidity factors and are likely to continue to be highly volatile.