While NMDC's track record, vast resources and growth prospects are enviable, the government will need to ensure that the FPO is attractively priced.

The iron ore mining major, NMDC’s follow-on public offer (FPO) will be one of its kind in the recent history of public issues considering that the price discovery for the offer could prove to be a difficult task for the lead managers and the government.

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However, even at these levels, the market believes that the stock is expensive as it is trading at a price-to-earnings (P/E) multiple of about 52 times based on its annualised earnings (for nine months of current fiscal) of 2009-10, or about 19 times its net sales of 2008-09. Even on the basis of enterprise value (EV) to EBIDTA, it is available at 23 times, much higher than most of its peers which are trading at about 8 times.

Low float, high valuations

The market experts believe that in the case of NMDC, the anomaly exists because of its very low floating stock. Out of the current equity capital, 98.38 per cent is held by the government and another 1.39 per cent is owned by long-term institutional investors like LIC, LIC Mutual Fund, Oriental Insurance, National Insurance and GIC among others. This leaves a mere 0.23 per cent as floating stock, which means absence of sufficient supply of shares. The result of this low float is among the key reason for the higher prices.

Now, through the FPO, the government is aiming to dilute its stake by 8.38 per cent, which should help increase the floating stock (viz. supply of the share) in the market, and thereby bring valuations to more realistic levels.

However, the question is what price will the government fix for the FPO? While acknowledging this issue, NMDC’s management says that the government will take this situation into the consideration and decide the offer pricing in consultation with the book running lead managers.

For now, even as the FPO pricing is expected to be announced on Monday (March 8) evening, going by NMDC’s current stock price NMDC’s valuations are fairly expensive. While applying different valuation methods, the company is valued in the range of about Rs 50,000 crore to Rs 70,000 crore.

On the optimistic side, even if some premium is attached considering the company’s leadership position, growing iron ore reserves, high operating profit margins of almost 80 per cent, large opportunity in the sector, higher production (over next two years) and improving iron ore prices, valuations work out to about Rs 118,000 crore or Rs 300 per share.

Market experts, too, believe that a reasonable price could be in the range of Rs 250-280 per share; the additional five per cent discount to retail investors would make valuations more reasonable.

On solid ground

Meanwhile, while valuations and pricing some of the critical issues for now, there is less doubt about the company’s business prospects. NMDC is a debt-free company with a strong balance sheet including cash and cash equivalents of about Rs 12,000 crore as on end-December 2009.

In terms of business, it is the 6th largest iron ore mining company in the world and has the biggest iron ore mines in the country with proven reserves of about 1,360 million tonnes. These reserves are quite large and, considering the current annual production of 28-30 million tonnes will last for the next 27 years.

While these estimates are merely based on the proven reserves, NMDC claims that its reserves keep on increasing by about 20-30 million tonnes per annum as a result of continuous exploration activities undertaken by the company.
 

On the operational efficiency front as well, the company scores high considering its operating expenses per tonne of iron ore mined stands at just Rs 352, which is among the lowest globally. This is also a reason that the company earns high operating profit margins of 78-80 per cent. Higher margins are not only due to the lower production cost, but are helped by a large share of revenues coming from long-term contracts, high quality of output and firm iron ore prices both, globally and in the domestic market.
 

Flexible pricing

Although NMDC sells its iron ore at relatively cheaper rates as compared to the international prices, the price is revised on an annual basis for the duration of the contract.

However, there is a provision in all domestic long-term contracts for the adjustment of prices in case of a variation in the market price of more than 25 per cent during the course of the year. This allows company and its customers to align with the benchmark international prices.

Most of NMDC’s long-term agreements with domestic customers are due for renewal at the end of March 2010 and for exports from April 2011. For the nine months ending December 2009, export realisations were Rs 3,102 per tonne and domestic realisations at Rs 2,355 per tonne.

While the company claims that prices have already been revised upwards from January 2010, analysts expect the realisations to improve further once these contracts expire, considering that the international and domestic iron ore prices have moved up in the recent past. They estimate the NMDC’s realisations to go up by 30-40 per cent in 2010-11 as compared to the first nine months of 2009-10.

Mining new opportunities

The international iron ore prices, which act as a benchmark for arriving at the prices for the domestic companies, have been on the rise in the past on the back of higher demand from the steel sector. Most of the 90 per cent iron ore production of NMDC is sold to domestic companies on long term contract basis.

In India, most of the steel companies do not have their own captive iron ore mines as a result of which they have to depend on the spot market as well as enter into long-term contracts with major suppliers like NMDC. Due to the volatility and higher spot prices, most companies prefer to enter into long-term contracts. “The situation is such that many times customers seek contracts for 10 million tonnes of iron ore, but we are only able to give them about 5-6 million tonnes,” says a company official.
 

For NMDC, its fortunes are closely linked with the growth in India’s steel production and consumption, which in turn is linked with economic growth. India’s steel production, which was about 55 million tonnes in 2008-09, is expected to grow to 80.5 million tonnes by 2011-12 on the back of the increasing domestic demand. To meet this growing demand, NMDC has ramped up its iron ore production from 21 million tonnes in 2004-05 to 30 million tonnes in 2007-08. The company plans to increase its production further to 50 million tonnes by the end of 2013-14, which should lead to higher volumes. The gains would be bigger if iron ore prices improve from the current levels in the coming years.

Digging deeper

Besides, the company has also chalked out plans to integrate forward and horizontally for which, it would incur a capital expenditure of about Rs 26,500 crore over the next 3-4 years. This will be invested in developing its mines and for setting up an integrated steel manufacturing plant of 3 million tonne capacity, steel pelletisation plant of 3.2 million tonne and towards merger of Sponge Iron India with itself. Besides, NMDC also intend to get into the power generation business.

In addition to this, the company also intends to use its cash balances to acquire new mines for the potash, iron ore and coal in the domestic as well as international markets such as Australia and Brazil.

However, these plans are still at the initial stage; the company is yet to finalise on such mines, which might happen in the medium to long term. Hence, the benefits of these steps will only be seen in the long run.

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