Dig deeper for value in mining companies

A recent deal saw domestic iron ore miner NMDC and Russian steel producer Severstal come together to build a steel plant. The deal will see NMDC provide land and iron ore while Severstal will provide the know-how and coking coal. . The runaway investor response to the IPOs of Coal India and MOIL also indicate a rather buoyant outlook for Indian mining companies. Why are these companies attractive, and can they weather the various challenges being thrown their way?

Arcelor Mittal is currently engaged in a fight against a private equity group for Baffinland's iron ore assets in the Canadian Arctic. These yet-to-be-commissioned mines are vital to Arcelor Mittal's strategy to guard margins against raw material hikes. Indian steel producers have used this strategy for several decades.

Indian metal producers such as Tata Steel (domestic operations), SAIL, JSW Steel and Hindalco (domestic aluminium) enjoy operating margins in excess of 20 per cent, beating their global peers, mainly due to lower reliance on external raw material sources.

Their advantages stem from the lower cost of operating captive mines relative to the cost of purchasing raw materials from external sources.

COMPETITIVE EDGE

Indian miners as a class enjoy several advantages over their global peers. Their operating profit margins are in the 50-85 per cent range, owing to many cost savings. First is the low expense on setting up and maintaining mines, in the form of land-lease cost, dead rent and royalties paid to the government.

This system bestows domestic miners with a significant edge over their global counterparts, who have over the last decade either acquired mining companies with established operations at a significant valuation premium or have had to invest at current prices to develop new assets. Another advantage is that Indian miners such as NMDC, MOIL and NALCO rely on public infrastructure for logistics and their spend on the same is only a fraction of the costs incurred by international producers, who often have to build extensive rail-lines or ports. Domestic miners can tap a relatively low-cost yet massive labour force to compensate for the lack of automation. All these factors have enabled Indian miners enjoy among the lowest conversion and mining costs globally.

An added edge is the limited competition, as each segment of mining is dominated by a large government owned miner. NMDC, MOIL and Vedanta-operated Hindustan Zinc control 20, 50 and 80 per cent of their respective segments. Several domestic miners have seen very little borrowing towards capacity expansions or increasing output. The limited capital they have employed has come from the rich cash-flows the companies have generated.

BOOSTED BY PRICES

Indian miners have also been aided by soaring commodity prices over the last five years, with China emerging a major importer of raw materials. The last decade has also seen rising global concentration in several mining segments, such as Rio Tinto, Rusal, BHP Billiton, Vale and Norsk Hydro.

In contrast, metal producers, who may dominate their respective domestic markets, may account for a blip in the global setting. This setting has resulted in miners wielding far greater pricing power than their clients — the metal producers.

The pricing power of the miners eventually led to the advent of the quarterly pricing contract that allows quicker revisions of negotiated prices with the user industries. On the downside, however, any global weakness would serve as a stick for the metal producers to negotiate lower prices half-way through the year.

RACE for raw materials

The current scramble for raw materials across the globe by metal producers is an effort to counter the strength of a consolidated mining sector. Despite significant levels of integration, Indian steel, aluminium and copper producers also face significant challenges on the raw material front.

The doubling of steel capacities, addition of substantial hot and cold rolling capacities (which requires zinc coating) and the substantial addition of aluminium smelters are likely to result in a growing demand for substances such as iron ore, coking coal, thermal coal, bauxite clay, zinc, copper (India imports copper concentrate), manganese and chromium.

Though Indian miners have been in a sweet spot for several years, there are looming challenges. India is currently the world's fourth largest producer of iron ore, with more than 50 per cent of output being exported.

This export figure is expected to decline sharply this year as a result of government efforts to clamp down on illegal mining in Orissa and Karnataka. India has all the resources to keep its metal producers running for a few decades, if they are able to overcome the many challenges facing them.

First, obtaining mining concessions from State governments. The three-pronged process, which involves scoping, prospecting and mining an area, has proven to be a highly long drawn out one, with most miners, both captive or otherwise, mired in political or environmental problems and unable to monetise large deposits over the last few years. This dilemma has been compounded by conflicts relating to land acquisition.

The key challenge arises from the lack of economic incentives for traditional stakeholders, which has led to passive support for violent movements such as the Maoist insurgency. The process of providing a fair deal to those displaced is compounded by a laborious and highly inefficient land acquisition process that short-changes the traditional stakeholders.

Operations of several miners such as NALCO and NMDC have been disrupted due to violence targeted at state infrastructure, such as the railways and mines these companies operate. The arduous route to getting licenses has also led to illegal mining and companies overshooting the permitted levels, often using primitive methods. An additional challenge is the lack of proper infrastructure such as roads, sufficient rail-lines and ports in close proximity — a major challenge to ramping up or opening new mines. Investments in improving reserves at existing mines and setting up new mines capable of optimising output are likely to entail heavy capital expenditure. This could dent current margins and cash-flows because of the requisite spending for maintaining, depreciating and servicing additional debt.

ECONOMIC COUNTER-PUNCH

The government's move to counter the threat posed by the Maoist insurgency is contained in a new draft Mining and Minerals Development and Regulations Bill, expected to be passed this year. The Bill has extensive provisions on labour and operational conditions in the mining sector.

The Bill is also expected to contain a clause that would require miners to share 26 per cent of their profits with the local population. The ability to pass on the possible 26 per cent cost to consumers will be strong in segments such as iron ore and coal, which have supply-side constraints.

Segments with narrow consumer bases such as manganese and zinc are likely to witness partial hikes to pass on costs. However, the efficacy of a sharing clause will be questioned, considering the lack of an effective mechanism to disburse the proceeds.

In favour of Indian miners are their cash-rich balance-sheets, which will enable them to ramp up output through increasing existing reserves or obtain new concessions (an aspect the new mining Bill may simplify). They could tap into rich untapped reserves with local experience which several interested international miners lack. They can do so without incurring the debt which had threatened to derail global attempts of this kind.

Miners with high levels of government ownership are likely to be well served. The government with its ownership of several mining and metal entities is strongly incentivised to make mining easier for its companies. This, coupled with the readiness the Ministry of Mines and the Steel Ministry have exhibited in lobbying for their constituents such as SAIL, MOIL and Coal India, bodes well for the sector.

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