NMDC

Investors should consider bidding in the follow-on public offering from National Minerals Development Corporation (NMDC) only if it is priced at a steep discount to the current market price.

NMDC has a good exposure to the iron ore mining sector with large reserves of high-grade ore, assured demand from the expanding Indian steel industry, production costs that are far below the global average and large cash in its coffers to pump into diversification and expansion projects.

The company's impressive operating profit margins of 70-80 per cent, its zero debt status and cash of over Rs 12,000 crore on its books (as of December 2009), make the stock a preferred exposure in the listed mining space.

However, it is the stiff valuation that the stock is trading at which is a cause for concern for investors. At the current market price of Rs 416, the stock discounts its trailing 12-month earnings by about 48 times. While NMDC's Indian peer Sesa Goa trades at 19 times, much larger global competitors such as Rio Tinto, Vale and BHP Billion trade at 18-23 times.

Even if one looks at other relevant valuation metrics such as Enterprise Value (EV)/EBITDA, NMDC's stock appears very expensive. While its EV/EBITDA stands at over 40 times, that of diversified global mining majors (much larger in size) such as Rio Tinto, Vale and BHP Billion are around 13-16 times.

Apart from the one-off factors which depressed NMDC's earnings in the latest nine months, the valuations for the stock have run up to unrealistic levels due to the buzz surrounding divestment and the limited floating stock that has been available for trading. Given this backdrop, in our view, the FPO would be worth considering if priced at Rs 300 per share or lower. That would capture a price-earnings multiple of about 32 times on its normalised earnings (average of three years to current fiscal) and an EV/EBIDTA multiple of about 19 times on the same basis.

The company's cash balances of about Rs 12,077 crore (as of December 2009) alone translate into a value of about Rs 30 per share.

Domestic strength

NMDC enjoys a near monopoly status in the Indian iron ore mining sector, with iron ore making up nearly all of its revenues.

The company has a wide customer profile. Supplies to domestic steel companies which are on an expansion spree assure it volume growth. Operating mainly through long-term contracts lends it high revenue visibility.

It has a total proven reserves of 977.5 million tonnes, with an average mine life of about 30 years. More than half of this is currently put to use. Spread across Chhattisgarh and Karnataka, the reserves are predominantly of high quality (64 per cent and greater iron ore content).

The company produced 28.8 million tonnes of iron ore in FY09, of which, about 22.6 tonnes was sold in the domestic markets while the rest was exported to Japan, South Korea and China. Exports are done through MMTC and the company shares foreign currency risk with the former.

NMDC's Indian market focus lends high stability to its revenue, given the strong steel demand in the domestic market and the expansion plans of domestic steel majors.

Key customers in the domestic market are Rashtriya Ispat Nigam (Vizag Steel Plant), Essar Steel, Ispat Industries, JSW Steel and Welspun Maxsteel. These clients account for over 60 per cent of its total sales. A good portion of sales is done through long-term contracts.

Though contracts are usually long term, NMDC has traditionally enjoyed strong pricing power even during the tenure of the contracts.

In this context, global iron ore prices which were depressed through last year, appear to be showing signs of resuming their uptrend, with recent forecasts indicating that prices may trend up by 50-60 per cent over the next one year as global contracts get renegotiated in a stronger economic environment.

Global spot prices of high grade iron ore are up by over 40 per cent since September 2009.

At present, NMDC charges around Rs 2,600 per tonne of iron ore. If its clients resort to importing the same quality ore from Australia or Brazil, costs may range between Rs 3,200 and Rs 4,000 a tonne.

With the ongoing expansion in the steel industry and a bulk of customer contracts soon due for renewal, NMDC may witness strong revenue growth of 25-30 per cent in the next couple of years.

Revenue growth may go directly to bolster the operating profit margins, given that NMDC's costs of production are among the lowest in the peer group. That could mean operating profit margins reverting to the historical range of over 80 per cent.

Diversification bid

To keep pace with the growth in the steel industry, NMDC plans to expand its iron ore production capacities to 50 million tonnes by 2014-15.

Additionally, to move up the value chain, NMDC, in collaboration with the Government of Chhattisgarh, will develop a steel plant at a cost of Rs 14,000 crore and a capacity of 3 mtpa in Jagdalpur. It also plans to set up a steel plant in Karnataka.

The steel projects may improve its revenues but can also expose it to debt and steel price cycles. NMDC also proposes to diversify as a mineral producer.

The company's diamond mine at Panna is one of the largest diamond mines in Asia. That apart, it has exposure to other minerals such as limestone, dolomite and manganese which are captively used to produce iron ore.

Sound financials

NMDC has seen a compounded annual production and sales growth of 20-25 per cent between FY05 and FY09.

Operating profit margins have improved from 57 per cent to 88 per cent between 2004-05 and 2008-09, as costs remained steady even as realisations shot up. NMDC's performance however suffered a setback in the recently concluded nine months ended December 2009 as its operations were disrupted by Naxalite attacks.

Sales revenues declined by 32 per cent year-on-year in the December 2009 quarter and by 25 per cent for the nine-month period. Operating margins fell from 80 per cent in December 2008 to 60 per cent in December 2009.

Nevertheless, these margins are still above the industry average of 40-50 per cent. Net profits for the December 2009 quarter also fell to Rs 859.99 crore from Rs 1,424.95 crore in December 2008.

Though the situation is now under control, NMDC is still vulnerable to such attacks. Normalised production, an improvement in sales off-take and a revision in selling prices will boost NMDC's earnings in the coming quarters.

Issue details: NMDC plans to offer for sale 33.2 crore shares of face value of Re 1, at a price band to be announced a day prior to the offer opening. This represents 8.38 per cent of the outstanding shares of the company.

via BL