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.