April 7, 2012

PSU mining stocks: More than meets the eye!

At first blush, mining stocks are a value investor’s dream. A company with a mandated monopoly, earning around 50%+ net margins and almost 400%+ return on capital should be an ideal opportunity. On top of that if this business sells for 7-8 times cash flow, it is like hitting the jackpot!
Is the stock market nuts to ignore such companies?
Let’s look at the numbers
Let’s look at some of the Government owned mining companies. I will look at two examples in this post – NMDC limited and GMDC (Gujarat mineral development corporation).
NMDC is the largest iron ore producer in India, with an annual production of around 26MMT per annum. The company earned around 12680 Crs in 2011, mainly through the production and sale of iron ore. The company made a net profit of around 50% and earned a return on capital of around 400 % (after excluding the excess cash).
The net profit has grown from around 2300 Crs to almost 6500 crs in the last five years, mainly due to the rise in iron ore prices (as volumes have grown only by around 10% during the same period). The company has around 17000 Crs of excess cash and can easily meet capex requirement from the interest income alone.
The company is also selling at around 6-7 times free cash flow (excluding the cash)
GMDC is one of the largest lignite producer based in Gujarat. The company earned around 375 Crs on a topline of around 1400 crs in 2011. The company made around 25% net margins and around 25% return on capital (excluding excess cash). The company has grown the topline and profits at around 18% p.a in the last 10 years.
As you can see, the numbers look good and are likely to be maintained as iron and Lignite/coal continues to be in high demand (With imports being far more expensive)
Why is the market discounting these companies?
There is more to these companies than meets the eye. The numbers look good for a specific reason – These are government mandated quasi monopolies, which have preferential access to these mineral resources. A private company cannot get license to a mine (other than for captive purposes).
In addition, even if a company were to get a license, it would take a lot of effort and money for the company to get all the clearances to operate the mine. These factors add up to a meaningful competitive advantage.
The flip side of this advantage is that these companies are run by the government as it sees fit and not necessarily for the benefit of the shareholder (or maybe the general public too – which is a different issue completely)
The impact of government control
There are several obvious and non obvious impacts of government ownership . For starters, these companies are not in the business of maximizing shareholder value. These companies exist to serve a specific objective, as decided by the government.
For example, NMDC’s objective seems to be to expand the mining operations to meet domestic and international demand. It has managed to make a lot of money in the process, but the excess capital has not been returned to shareholders. You may argue that this is true in case of a lot of companies. However in all such cases, where the management (private or public) uses the capital inefficiently, the stock market takes a dim view and does not give the company a high valuation
In case of NMDC, the company has now decided to invest in a 3 MTPA steel plant at the cost of around 15000 Crs. You can call this as forward integration, but I see this as a high return business investing in low to average return business – not exactly a value enhancing decision.
In case of GMDC, the company is now expanding into power generation. Power generation in India, is a very tough business with poor free cash flow. In case of the GMDC, look at page 56 of the annual report -  The mining segment made almost 570 Crs on 60 Crs of asset (1000% !),  whereas the power segment made around 57 crs on 1300 (less than 5%).
I hope you can see the pattern here – We have a very profitable business in mining (due to the government policies) and the big profits from this business are being invested into some very mediocre businesses (again due to the government)
Isolated cases ?
The above example may be seem to be a case of related diversification. The problem with such related diversification is that the bureaucrat making these decisions, is doing it with some non financial objective in mind (nation building !!) and does not care about the return on capital
In addition to all these lofty goals, there are smaller cases of waste of capital too. NMDC recently acquired sponge iron limited for around 80 Crs. This is a  30000 TPA producer  of sponge iron with a sale of around 65 Crs and loss of around 10-15 Crs per annum. In comparison , Tata sponge iron has a capacity of 300000 TPA , made a profit of around 100 Crs and sells for around 300 Crs (net of excess cash).
GMDC has several such cases of cross holdings in other PSUs, guest houses and what not!
The above cases are small, but indicative of the way these companies are being run.
Should one avoid these companies?
I am not indicating that these companies are to be avoided at all costs just because they are controlled by the government. On the contrary, there are several PSUs which are run much better , where economics and not politics is the driving factor.
In the case of mining companies one should not get infatuated by the huge cash profits being made by the company, but also look how these cash flows will be utilized. One can expect  to receive decent dividends over time in case of some of these companies, but the intrinsic value of these companies is unlikely to grow rapidly (more likely at around 10% per annum).
The bladder theory is very much at work in these companies – When  management  and more so the government has too much cash, there is a high tendency to piss it away.
What do you guys think? please share your thoughts in the comments
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of blog.

14 comments:

Nelson Christian said...

Hello,

Some excellent analysis there. I too had a look at the company's financials when the price had reached around 150 for NMDC but due to the company being a PSU dropped the idea in spite of its excellent numbers.

Just a question. Would not NMDC get better realizations if it were to sell Steel instead of selling iron ore. I had read some time back that India exports Iron ore to countries like China and then imports steel from such countries. NMDC's fortunes are anyways linked to the steel sector so this way the company is ensuring that when the times are good it will perform better than it used to. But cyclicality is the problem and timing it is never an easy task.

BTW I have emailed a report which compares CIL, NMDC and MOIL on various factors. Do have a look and if possible do answer my questions.

Kindly also have a look at Gujarat NRE Coke and let me know your opinion whether you see value in the company. I Know value like beauty lies in the eyes of the beholder. I had sent you an email regarding this but maybe you did not get a chance to read it.

Regards,
Nelson

Rohit Chauhan said...

Hi nelson
can you send me an email again ..i somehow never got the earlier ...dont know if it went to the spam folder. my email is rohitc99@indiatimes.com

you are right that company will get better realizations via steel, but it is important to do the next steps of the analysis - what is the incremental capital to get this incremental profit. My point is that it is not too good ..the best of steel companies dont make more than 12-15% ROC over a biz cycle

tata is steel is an exception as it has its own iron ore mines. so i think it is not a great deal for the shareholder if the company expands into steel making

I havent looked at CIL and MOIL , i have written earlier which is a play on mangense / steel demand

rgds
rohit

nirav678 said...

Good data for mining PSU stock analysis.

I point out one NOS-PSU minig compnay ashapura minchem- leader in bentonite mining & processing. I am tracking this scrip since last two year. And learn good biz model & market but why not value creating stock? share with us if have data.

Dhwanil said...

Hi Rohit,

I can not agee with you more! Mining companies have very strong business economics and hence if one lloks at the financial ratios/balancsheet/ FCF, it will always look tempting. However the worrisome part is the management (i.e. government) which runs these companies not for the best interests of minority shareholders to achieve its other objectives as you pointed out. Government's hold on these companies is so strong and management of capital is so shoddy that one would find hard to even rationalize any of their decisions. Take the case of CIL and TCF imbroglio. CIL board has been lambasted by TCIF but to no avail. Prof. Bakshi brings out a great point that CIL in its red herring has mentioned that "company may not act in the best interest of shareholders" as key risk.
http://fundooprofessor.wordpress.com/2012/03/29/why-coal-india-is-not-a-childs-play/

Best Regards
Dhwanil Desai

Anonymous said...

Rohit,

The way I look at it is, it is better for NMDC to earn 12 to 15% on its capital by investing in steel mine than hold that as cash and earn meagre 8% before tax. I understand that it would be better for them to return the cash to us shareholders who can then invest in the best steel company to get better return. But that is the way these PSUs are and I think that is the reason they are available at a discount.
Regards
Ravi

Ankur Jain said...

Hi Rohit,

Nice analysis. You have hit the nail on the head.

Poor capital allocation is one reason why the markets never discount the earnings of these companies fully.

Guest houses and other wastages are only a rounding error but the capital intensive projects like the steel plants etc which really suck up the cash generated by these companies.

Anonymous said...

One advantage with PSUs is that they never can really face competition especially in areas like mining.Even if they grow at 10%p.a because of compounding,their share value is bound to increase over a period of time.However private companies can face stiff competition and even if they grow at 30% ,over the years can slow down like L&T and may average out.

Rohit Chauhan said...

hi nirav
i have not looked at pvt mining companies other than sesa goa.

considering the mess in terms of regulation, it is not easy to invest in pvt mining companies

rgds
rohit

Rohit Chauhan said...

Hi dhwanil
right on target ..you are right. these companies are classic value traps. you can see the cash , but you will never touch it.

most psu's are being managed by the government for all kinds of reasons. with high deficiet, we will see more gouging now from companies which are profitable

rgds
rohit

Rohit Chauhan said...

Hi ravi
thats a reasonable explaination for what is happening. i agree with you, but i will not invest based on this.

as an investor, i need to choose 15-20 companies from 4000+ companies. why choose these kind of companies, where your majority partner tries to hurt you at any opportunity

this may sound harsh - but the government considers the investors as a cow to be milked whenever they need money to fund the deficiet.

rgds
rohit

Rohit Chauhan said...

Hi ankur
you are right ..the guest house etc is just rounding error, but shows the way these enterprises are run

in the end, they seem to be run for the babus alone , because the money they give back to the government is anyway wasted

rgds

rohit

Rohit Chauhan said...

Hi anon
i disagree ...these companies have monopoly due to the goverment and any excess value created will be sucked out by the government.

the government makes the rules and can do whatever it like. for ex: mining tax, buybacks ..and what not

look at the recent directive on gas pricing !!

companies like L&T may face more competition and they may slow down over a business cycle, but all such companies over the long term create more wealth for the shareholders than any of the PSUs

rgds
rohit

Sachin Purohit said...

Interesting case studies. I would say that even from the point of view of nation-building, the best that they can do is pay back to the shareholders in the form of dividend if they don't find any more ores to be mined. This way, at least government, which is the majority shareholder in these companies will be able to get rid of some of its deficits.

Balaji said...

Interesting article. Investors, especially small investors, should not buy shares of Govt owned or controlled companies.