Sesa Goa

Iron ore major Sesa Goa appears to be a risky play in the metals space considering the uncertain outlook on iron ore realisations and demand from the export market. The company's reliance on the Chinese market, where iron ore prices and volumes are showing fatigue after a 20-month period of buoyant demand, makes its near-term prospects uncertain. While the company's generous profit margins and financial strength are attractive, its consumers led by the Chinese are likely to make the company's realisations quite volatile. The company, which trades at Rs.364 or 8.6 times trailing 12-month earnings, is at a discount to domestic peer NMDC, which trades at 29 times FY10 earnings and international peers such as Rio Tinto, BHP Billton and Vale, which trade between 16 and 20 times. With the base effect wearing off and China cutting back on stimulus efforts, the company has a difficult 2010-11 to contend with.



Sesa Goa owns iron ore mines and permits in Goa, Karnataka and Orissa. In addition, it produces metallurgical coal and pig iron. The company's stated reserves stand at 343 million tonnes, 70 million contributed by the acquisition of Dempo during the first quarter of 2009-10. The company sold 21.4 million tonnes of iron ore in 2009-10, a 34 per cent increase from the year before. Dempo contributed to 3.6 million tonnes of sales and accounted for 22 per cent of the increased volumes of 2009-10.

Sales performance

Sesa Goa's sales between FY06 and FY10 have grown at a compounded rate of 31 per cent as the company has ramped up capacity more than twofold during this period. Profits during the same period have grown at a compounded rate of 46 per cent and net profit margins have averaged 37 per cent. The margins spiked to 45 per cent in 2009-10, thanks to higher realisations.

The company exports 93 per cent of its production, with China accounting for 83 per cent followed by South Korea, Japan and Europe. The company has roughly a 80:20 mix of spot:contract sales.

The company's higher grade Karnataka and Orissa mines contributed to 3.96 and 1.88 million tonnes of 2009-10 sales volumes. Sesa Goa's proximity to ports and minimal processing cost rewarded it during the China fuelled commodity run over the last three years.

A low debt balance-sheet (0.15:1, debt:equity ratio) and the low cost of scaling up existing operations has led to Rs 8,000 crore of cash and equivalents on the company's books. This leaves the company well poised to pick up quality domestic iron-ore assets.

The companies expansion plans include doubling of pig iron and metallurgical coke which accounted for 5 percent of FY10 profits. Possible additions include a steel plant and mines in Jharkhand.

Growth avenues

While a forward integration into steel may protect Sesa Goa from policy risks such as a ban on iron ore exports, the execution of this project may take three-four years at a minimum. The company has two avenues for growth in its core iron ore business: volumes and realisations. The company is hoping to double volumes to 50 million tonnes by 2014.

Challenges to this doubling include obtaining government clearances to upgrade the output from Orissa and logistical ‘bottlenecks'. The bottlenecks include inadequate loading facilities, port and rail infrastructure to support massive expansion. Karnataka locations. Over the last few months, several political and sectoral players have called for a blanket ban on iron ore exports as well. However, the likely outcome is an increased tax on iron ore fines and lumps. While this will reduce Sesa Goa's margins, the company's operating margins of about 62 per cent in 2009-10 will ensure that a hike from the current 5 per cent excise on iron ore fines can be absorbed or even partially passed on to consumers.

Arguments against the ban include the inability of the domestic industry to absorb the massive quantity of iron ore fines which are exported. However with the anticipated doubling of steel capacity by 2015 and emerging sinter capacity, the company's local offtake may rise to cater to a larger domestic steel market which could account for a larger portion of revenues and counter to the lumpiness of Chinese demand. However, realisations will continue to be a roller-coaster ride.

Realisation pressures

The pressure on realisations is three-fold: China is the largest importer of iron ore in the world, consuming 600 million tonnes in 2009. With increasing tensions between international iron ore miners and China over price negotiations, no contract, regardless of duration, seems to provide stability to miner realisations.

Chinese government intervention to consolidate existing steel mills and shut down small mills is likely to make price negotiations even tougher. Chinese domestic ore reserves of over 200 billion tonnes of low-grade ore is another bargaining card whose significance remains to be seen. While Chinese demand for iron ore is expected to rebound in the first half of 2011, the lumpy nature of Chinese demand makes it a very volatile price maker in the iron ore market.

Prices of high grade Chinese iron ore have moved from the March 2009 lows of $60 a tonne to the current $127 a tonne. Prices are down 35 per cent from the peak of $186 a tonne in late April. With continued global uncertainty, Sesa's realisations are likely to remain under pressure for the next six months.