Monday, February 23, 2009

Sesa Goa - Buy

Investors with a three-year horizon can consider accumulating the stock of Sesa Goa, trading at Rs 82.10. The company’s market leadership in iron ore mining and exports, signs that Chinese demand for Indian ore may resume on the back of the stimulus package and the attractive valuation for the stock make it a reasonable long-term investment in the commodities pack.

The stock of Sesa Goa trades at a price-earning multiple of 4.6 times its trailing earnings. In the domestic context, National Mineral Development Corporation (NMDC) and Minerals and Metals Trading Corporation of India (MMTC) (not strictly comparable due to a wider product basket) trade at a P/E of about 15 times.

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Global iron ore miners such as BHP Billiton, Rio Tinto and Vale currently trade at 9.7, 9.4 and 6.6 P/Es respectively.

Business Overview

The company’s revenues originate from three segments — iron ore, pig iron and metallurgical coke (Met coke).

The iron ore segment is the backbone for the business and its share in revenues has steady increased in the last four years, to contribute 84 per cent to sales in 2007-08.

Sesa Goa, with its mines in Goa, Karnataka and Orissa, produces lower and medium grade ore. Sixty-six per cent of the company’s iron ore production is exported to China and 20 per cent to other Asian countries such as Japan, Pakistan and South Korea and 7 per cent to Europe. Domestic sales are a miniscule 7 per cent.

Demand Outlook

By relying substantially on the export market, particularly on China, Sesa Goa’s earnings prospects hinge to a large extent on Chinese offtake of Indian iron ore. This being the case, post-Olympic stockpiles and the sharper-than-expected deceleration in the Chinese economy led to imports recording sharp year-on-year falls from October 2008.

Iron ore spot prices also corrected from $190 in May to $ 63 in October 2008. While China’s 4 trillion Yuan ($586 billion) bail-out package is expected to revive demand for steel and, thus, iron ore, the jury is still out on whether overall Chinese import volumes will be maintained at last year’s levels of about 400 million tonnes.

But the past two months have brought signs of a drawdown in Chinese stockpiles and better export offtake of iron ore, especially for Indian exporters. Export volumes of iron ore from India staged a sharp year-on-year increase of 38 per cent and 21 per cent respectively in December and January.

Expectations of higher Chinese demand have propped up spot prices for iron ore by about 30 per cent from $63 to $ 85 a tonne in recent months.

While Sesa Goa appears well-placed to benefit from the higher volumes and higher spot sales, ongoing negotiations on contract prices for 2009-10 between the large iron ore producers and Chinese steel mills, expected to be concluded by April, may be the deciding factor on the price outlook. Current expectations are for a 10-30 per cent cut in contract prices compared to last year.

Financial Overview

Offtake has not been a key problem for Sesa Goa in recent years, with the company managing a 25-30 per cent volume growth every year since 2004-05.

In the current fiscal, Sesa Goa witnessed a volume decline in the September quarter to the tune of 30 per cent on a complete cutback in Chinese demand, but volumes recovered, increasing by 37 per cent in the December quarter. Sales for the last quarter were up by 23 per cent on a Y-o-Y basis, despite the economic slowdown.

Volume growth from the iron ore segment was at 36 per cent year on year and 37 per cent . Sales are up by 76 per cent and net profits by 69 per cent in the nine months ended December 2008.

Steadily rising iron ore realisations have helped Sesa Goa steadily improve its operating profit margins over the years to nearly 48 per cent in the first nine months of 2008-09; though margins have moderated in the December quarter.

A low cost structure and zero financing costs, endows the company with a cost advantage amongst its competitors globally. Vedanta Resources Plc (the 51 per cent holding company) had earlier announced plans for an eight-fold increase in the iron ore production capacity at Sesa Goa.

While this expansion project will certainly add scale over the long term, whether it will be implemented in its entirety, given a softer demand scenario, needs to be seen. This plan has the potential to increase the debt on the balance-sheet. Strong operational performance in recent years has left Sesa Goa with high return ratios (return on capital employed of over a 100 per cent), a strong balance-sheet, with high free reserves and near zero debt. With commodity prices set to fall further, the company has hinted at more room for downsizing costs.

Recent export duty concessions extended by the Indian Government will also translate into better realisations in the coming quarters. The easing off of inflation may see lower policy intervention on ore exports; this has been a key source of risk to earnings last year.

Valuations

The key risks to Sesa Goa’s earnings arise from a sharper-than-expected cut in iron ore prices (contract as well as spot), slippage in Chinese demand and a spike in freight rates.

Volumes and defending its market share being the foremost priority, Sesa Goa may have to work with thinner margins than in the immediate past, for the near term.

A key trigger to the stock price would be the conclusion of iron ore negotiations with China, at the expected prices.