Five Reasons Why Coal India Is Likely To Do Better In The Future

by Sourav Datta - Aug 13, 2021 01:23 PM +05:30 IST
Five Reasons Why Coal India Is Likely To Do Better In The FutureA Coal India mine.
Snapshot
  • The Coal India business does face issues of inefficiency, environmental concerns and babudom.

    However, the company's healthy financial profile and its low valuation can make it a potentially good investment.

Coal India Limited (CIL) is among the largest coal producing companies in the world. It accounted for an estimated 85 per cent of domestic coal production in the financial year 2020. CIL forms a critical part of India’s economy as the largest coal supplier to India’s power sector.

Nearly 80 per cent of its coal production serves the power sector, with the remaining supporting the steel, fertiliser and other sectors. Despite its near-monopoly status, the company’s stock has declined by around 58 per cent from its listing price on an absolute basis, making it one of India’s worst-performing large-cap stocks. Despite, the dismal performance, the stock might prove to be a good cyclical play.

Here are some reasons why:

Coal Is Here To Stay: Regardless of the focus on renewable energy and generating cleaner electricity, the thermal power industry has continued growing consistently. Phasing out coal plants is no easy task, especially when India doesn’t have another source of cheap fuel.

The US, which phased out coal plants, could do so because it had large shale gas reserves. With the easy availability of cheap shale, phasing out thermal plants made economic sense. However, for countries like India and China, coal remains an integral part of the energy mix.

Though Indian companies have tried setting up gas-based power plants, the non-availability of domestic gas, combined with expensive imported gas has caused almost half of India’s gas-based power capacity to become non-operational.

In addition, fossil-fuel based power can be depended upon, unlike renewable resources whose production is dependent on the vagaries of the weather. Unless efficient, large-scale energy storage mechanisms come into the picture, coal-based power will continue dominating the country’s energy mix.

Increasing Coal Prices: Like other commodities, international coal prices have grown at a rapid pace over the past one year and currently command the highest rates in a decade. Australian coal prices have increased by around 56 per cent, while European coal prices have gone up by 64 per cent in 2021.

The increase in coal prices has outpaced the increase in other commodities like crude oil and copper. Indonesia set its coal price benchmark at $115 per tonne in July, which is the highest since $117 per tonne in May, 2011. Domestic coal prices have remained lower than international prices, which could result in greater demand for CIL’s coal. CIL sells its product through fuel supply agreements (FSA) and e-auctions.

While FSAs are relatively longer term agreements, with lesser provisions for price changes, e-auctions are likely to reflect the increasing global prices much quicker. As inventory levels at power generators and CIL’s mines decline, e-auction realisations might see an upward push.

Increasing Production And Demand: Over the years, the demand for coal has seen a secular increase. For the year 2015-16, CIL had produced 536 million tonnes of coal, which has increased to 600 million tonnes of coal during FY20. A bet on CIL is a bet on India’s growth story.

While short-term issues like Covid put the economy off-track, over the long term, India’s economy is bound to do well. Power demand has been increasing, which bodes well for CIL’s future prospects. Given the higher prices of coal in the international markets, CIL can be instrumental in lowering the fuel import bill as India is one of the largest importers of coal.

The Indian government has commercialised the coal sector by ending CIL’s monopoly and allowing private players to take part in coal-mining activities without any restrictions on the end use of the coal. However, it will take time for these players to set themselves up and stabilise operations. Therefore, CIL will continue to dominate India’s coal production ecosystem for some time.

Financial Strength: Before the Covid crisis, CIL had been growing its revenue at a compounded annual growth rate of around 7 per cent per year. The company’s operating margins have also remained stable at between 21 and 25 per cent, except during the 2016 to 2018 period, when the company was battling a drop in sales due to shortage of coal while expenses kept growing. However, CIL has managed to overcome these roadblocks and scale production.

Despite the capital-intensive nature of the business, CIL has a low debt gearing of around 0.15, implying that 85 per cent of CIL’s capital comes from its internal accruals. However, short term working capital loans might increase as the company is struggling to collect its dues from power generation companies.

The economic slowdown has affected the liquidity position of power generation companies. Even then, CIL has managed to bring down receivables to Rs 17,000 crore from around Rs 25,000 crore in the beginning of the fiscal 2021.

CIL has been cash flow positive for years. Though the business requires a high level of investment, the company has funded its capital expenditure through a mix of operating cash flows, interest income and accrued cash. So far, the company has maintained positive cash flows from both operating and investing activities. The prudent financial management has helped it remain virtually debt-free and allowed it to pay hefty dividends to shareholders.

Valuations: The company is currently valued at five times enterprise value (EV) to earnings before interest, depreciation, taxes and amortisation (EBIDTA).The price-to-earnings ratio stands at around 7. The company has consistently paid a high dividend that has resulted in a dividend yield of 11 per cent. To put this into perspective, if you invest in a savings account, you would receive interest of 4 per cent per annum, while CIL’s stock offers three times the return. The stock has been battered with negative investor sentiment for years.

However, despite its pre-Covid growth rates, the market does not expect it to grow at a high rate. Most investors would call it a value-trap, but its financial and physical performance has shown otherwise.

Given the negative investor sentiment around the stock, most negatives have been priced-in and weaker hands have moved out; therefore, the stock is unlikely to go down any further. The stock can also serve as a good substitute for cash, and allow investors to earn higher returns on the money with the upside optionality.

In conclusion, the business does face issues of inefficiency, environmental concerns and babudom. However, the extremely low valuation in a frothy market indicates the pessimism around the stock, which limits the downside. The favourable macroeconomic scenario, CIL’s healthy financial profile and its low valuation can make it a potentially good investment.

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