The Hindu Business Line : Sesa Goa: Hold

The demand-supply mismatch in the global market, expanding domestic demand and the prospect of volume growth driven by expansion, may ensure moderate earnings growth for the company.

Mr Anil Agarwal, Executive Chairman, Vedanta Resources.

C. N. M. Lavanya

The stock of iron ore producer, Sesa Goa, has witnessed a sharp fall in the recent market meltdown, tracking falling commodity prices. But given the sharp contraction in the stock valuation (PE multiple down from 21 to six since January), investors can hold the stock at the current price (Rs 108).

The company’s earnings growth may slow down as increases in iron ore prices may be tempered from here on. But the persisting demand-supply mismatch in the global market, expanding domestic demand and the prospect of volume growth driven by expansion, may ensure moderate earnings growth for the company.

The stock’s price-earnings multiple of six times the FY-08 earnings, is at a significant discount to its global peers such as BHP Billiton and Rio Tinto, which have P/E ratios of about 8-9 times.

Business overview

Sesa Goa, a 51 per cent subsidiary of Vedanta Resources, is engaged in the mining and export of iron ore. The company has three segments — iron ore (84 per cent of FY08 revenues), pig iron (13 per cent) and metallurgical coke (3 per cent).

Sesa Goa has the current capacity to produce 12 million tonnes per annum (MTPA) of iron ore, which it plans to increase to 25 MTPA by 2010 through an investment of $700 million. The company has sufficient internal resources to fund this expansion. To augment its existing capacity, Sesa Goa has been aggressively exploring acquisition of new mines in Goa and Karnataka.

The relatively lower and medium grade iron ore from Sesa Goa has been in high demand over the past few years, as the Chinese steel mills imported larger quantities of low grades ores.

This and the freight cost advantages that Indian exporters have over the Brazilian counterparts, had contributed to rising Chinese offtake of Indian ore.

With net sales registering a Compounded Annual Growth Rate (CAGR) of 55 per cent and net profit growing by 159 per cent, Sesa Goa’s earnings and cash flows have expanded at a rapid pace over the past five years. This period has also seen operating profit margins improve from 25.6 per cent to 63.3 per cent, superior to global peers as BHP Billiton and Vale. Strong cash flows have resulted in a zero-debt status for the company.

Scorching historic growth

In 2007-08, with contract prices of iron ore continuing to rise, Sesa Goa reported a 14 per cent growth in iron ore sales volume and a 70 per cent growth in topline. The company has also opportunistically changed its sales mix in favour of the spot market to improve realisations.

The proportion of sales in spot market to long-term contracts rose from 26:74 in the first quarter of 2007-08 to 65:35 in the June quarter of this year.

This strategy, coupled with its ability to generate a quality-based premium in the market, may allow the company greater flexibility to take advantage of price swings in the market. The company also makes foundry grade pig iron, which sells at a premium to basic grade pig iron. Pig iron prices across different markets have increased and the division has started contributing significantly to the bottomline.

Historically, the year-on-year growth rates in steel prices in different markets across the world have lagged the price escalation in iron ore. In June 2008, Rio Tinto and BHP Billiton negotiated an upward revision of prices of up to 85 per cent (iron ore fines) and 96.5 per cent (lump iron ore) with Baosteel as a representative of the Chinese steel industry.

Pricing risks

Going forward, however, the risks to Sesa Goa’s earnings arise from the inability to obtain similar increases in its contract prices and a possible slackening of Chinese demand, resulting from the economic slowdown.

About 65 per cent of the company’s revenues are derived from China, but shipments to China have been waning because of a shift in demand towards high quality iron ore compared to low quality iron ore, which requires more coke while processing.

The piling up of inventories in Chinese ports, increased supplies from other countries, moderation in Chinese pig iron production, lower freight rates (thereby reducing the advantage that India had over Brazil) have together resulted in a slowdown in demand for Sesa Goa in the immediate term.

The August shipments of Sesa Goa were down 53 per cent on a year-on-year basis to 2.5 million tonnes.

On the pricing front, iron ore prices have corrected by 35 per cent from January this year and by about 27 per cent in the last three months, after China pared purchases. Further, correction in prices cannot be ruled out in the near term.

Recent reports of Chinese buyers refusing to lift Indian ore until discounts are offered, also do not bode well for pricing on long-term contracts.

All this suggests that annual price increases in iron ore may moderate to 10-15 per cent levels in the year ahead. For Indian exporters, there is also the risk of increases in export tax or restrictions on iron ore exports.

Any increase in export duty on iron ore from the present 15 per cent may impact prospects for Sesa Goa, as about 90 per cent of the revenues, directly or otherwise, are derived through exports. But slower global demand and declining ore prices may reduce this threat for the time being.

However, over the medium-long term, the global demand for steel and the corresponding demand for iron ore are likely to remain robust, helped by Asian growth, notwithstanding moderation in growth rates of developed economies.

For Sesa Goa, the ambitious capex plans of both Tata Steel and SAIL and steady demand for steel from the infrastructure and construction sectors, suggest good domestic prospects.

China’s outlook for steel demand is generally positive, underpinned by urbanisation and the construction sector. The demand for lower and medium grade iron ore may pick up if the international metallurgical coke prices soften.

Increase in mining output from Sesa Goa is likely to ensure higher sales volume in the coming few years, even as the demand-supply mismatch in iron ore appears set to continue.