Saurabh Mukherjea

I like companies that have overwhelming sustainable competitive advantages — so strong that you can almost reach out and feel them — and yet are underappreciated by the market. While there is always a risk that such competitive advantages will forever be undervalued by investors, I believe that in situations like these, the odds are loaded in my favour, as borne out in my pick of the year — Coal India (CIL).

CIL was incorporated in 1973 as a wholly-owned state undertaking, following the government’s drive to nationalise coal mines to expedite growth in the sector. The government effectively took over the ownership of all coal assets in the country and gave CIL the right to develop and mine various coal blocks. Hence, the government is the sole owner of all coal assets, while CIL is a deemed lessee of mines that it explores and operates.

Not surprising, then, that the entity today accounts for over 80% of the country’s coal production and is the world’s largest coal producer. Its reserve base is one of the largest among global peers — 18.9 billion tonne of proven and probable reserves and 22.3 billion tonne of extractable reserves. That implies a reserve life of 35-40 years, significantly higher than the 15-20 years in case of its global peers.

By law, only government-owned companies are allowed to extract coal and sell in the open market and CIL accounts for over 90% of the total coal sold commercially. While this might change as the government might amend the law to allow private sector operators to mine coal, it is unlikely that the private sector will be able to rival CIL’s annual production of around 500 million tonne in the coming decade.

As a result, CIL’s competitive advantages are among the strongest for any large-cap Indian company. The question is whether the company can leverage these advantages to improve its profitability. There are three reasons I believe it can do so.

Volume growth 

We expect a two-phased revival in production growth for Coal India — 5% over FY14-17 and 8% thereafter. Based on Ambit’s analysis of key mines that are likely to drive 70% of the production growth from now till FY17, analysts Parita Ashar and Dayanand Mittal expect production to ramp up in the first phase to 534 metric tonne (MT) in FY17, not very far off from its target of 555 MT in FY17 under the business-as-usual scenario. This would also imply FY14-17 production CAGR of 5.1%, significantly better than 1.7% CAGR over the past four years (FY10-14).

With a strong government at the Centre that intends to increase domestic coal output, the construction of three key railway lines (potential to increase domestic coal output by 300 MT) has been expedited. We expect partial completion of these lines in the second phase over the next three to four years, which is likely to increase production growth to 8% per annum. We expect the new railway lines to boost CIL’s output by 140 MT over FY18-20; the incremental 300 MT production is more of an eight- to ten-year story rather than a four- to five-year story.

No price constraint

Coal India currently sells its produce at a 50% discount to the international free on board (FoB) coal prices. However, in order to offset cost escalation (mainly wage costs) and maintain margins, CIL hikes prices regularly. In this context, it is worth noting that rising private participation is unlikely to negatively impact CIL’s pricing power, given that it sells coal at significant discount to market price and, hence, there is significant room for price hikes before its notified price reaches closer to the market price.

Also, private players would have to bid in coal auctions to get access to mines and this acquisition cost — compared with nil acquisition cost for CIL — implies that private players are at a natural disadvantage. Further, drawing an inference from the gas price hike push by Reliance Industries (with ONGC becoming the natural beneficiary of the same), we wish to point out that with rising private participation and its push to deregulate prices, Coal India is likely to benefit from an improving pricing scenario.

Mining reserves

Given that CIL has a cash balance of ₹590 billion as of September 2015 and it generates cash of ₹200 billion annually, utilisation of cash remains important. Going forward, I expect CIL to invest cash in:
 Purchase of wagons to reduce dependence on wagon availability from railways  Construction of railway lines to improve coal evacuation potential from east Indian states
 Pit head power plant construction with the benefits of rising domestic coal production from all the regions that have evacuation constraints in place

Further, higher dividend to shareholders (similar to the ₹29 a share — around 10% of the-then CMP — paid in FY14) would be a positive. Unlike the country’s oil and gas sector, which is currently struggling for want of resources, India has rich coal reserves and, hence, we don’t expect Coal India to make aggressive or expensive international acquisitions.

Importantly, none of these competitive advantages or profitability improvements are adequately built into CIL’s current share price of ₹377 at the time of writing this article. We believe that fair value for CIL is ₹436 (implying a 25% upside) based on discounted cash flow methodology. We value the future operations of the company (reserves depleted over FY15-34) at ₹361 per share, 83% of the target price; we factor in net cash of ₹742 billion in September 2015 and, hence, derive an additional ₹118 a share and a negative contribution of ₹42 a share, as well as adjust for overburden removal and employee provisions at 0.5 times the current book value.

One may ask, won’t CIL suffer the same fate as ONGC, BHEL, State Bank of India (SBI), Air India and others that were neglected by the government and overtaken by more enterprising private sector counterparts? There are two reasons CIL won’t suffer a similar fate.

First, our discussions with the powers that be suggest that CIL will be allowed to raise prices not just to offset cost inflation but also to reduce the gap between its price and prevalent market prices. Reducing this gap is critical to keep some sort of lid on the black market in coal and attract private sector investment.

Second, the production growth imperative is stronger for Coal India than any other public sector behemoth. The PSU’s production growth is likely to revive to around 5% CAGR over FY14-17 versus 1.6% CAGR over the past four years and rise further to 8% CAGR over FY18-24 as volume benefits from the phased completion of the railway lines accrue. 

Without such production growth, given India’s 130 GW of thermal installed power capacity, the coal shortfall will widen in the years to come. Politically, that will create more problems for the government than rotting loans on SBI’s balance sheet or the red ink on Air India’s P&L. 

The writer is also the author of Gurus of Chaos: Modern India’s Money Masters. The views expressed here are personal.

This is Saurabh Mukherjea's best pick for 2015, you might be interested in what he recommended for 2014