Within a week of completion of offer for sale (OFS), NMDC announced the board’s approval to demerge its yet-to-be-commissioned steel plant at Nagarnar in Chattishgarh state. The demerger plan is not something new. The Cabinet Committee on Economic Affairs, in October 2020, already had given its approval to the demerger of steel plant, as well as, strategic divestment by the government of its stake in the steel business.

The board’s approval begins the formal demerger process, which is considered a value unlocking move for NMDC. The capex already spent by NMDC on the steel plant is about ₹18,500 crore, with the total capex plan at ₹21,300 crore.

Currently, NMDC’s 3-million tonne capacity steel plant is a part of NMDC and would now need further approvals from the NCLT and the exchanges for the demerger. Post demerger, NMDC Steel would be separately listed on the exchanges.

Since our ‘accumulate’ call on NMDC in December 2020, the stock has gone up by 54 per cent to ₹178 per share. Value unlocking from demerged steel business could provide some margin of safety to NMDC’s current price in case of a reversal in the commodity cycle and thus, existing investors with long term perspective can continue holding the stock.

Demerger process

As part of the demerger process, NMDC will issue to its shareholders (as of the record date of demerger - yet to be determined) 1 share of NMDC Steel for each share held by them in NMDC.

Thus, NMDC Steel's shareholding pattern will mirror the shareholding pattern of NMDC once the demerger scheme becomes effective and NMDC inevestors will own shares seperately in the mining business (NMDC) and the steel business (NMDC Steel) in lieu of their holding in combined NMDC (mining and steel).

Meanwhile, investments held by NMDC in NMDC Steel will be cancelled. Note that there will be no change in the shareholding pattern of NMDC as a consequence of the scheme.

Impact on NMDC

NMDC, in 2001, announced its plans to construct the steel plant with a view to expand into forward integration. Now, the company believes, and rightly so, that the demerger will add more value to its shareholders. NMDC thus far has funded the steel plant capex through internal accruals shifting the focus to an extent towards steel plant.

Further, the ramp up process of a steel plant can take at least a year, and there could be material costs and losses initially, which may impact the profits of the iron ore business.

Also, NMDC doesn’t have any experience in running a steel business which may hinder realisations and profitability.

Hence, merger gives an opportunity for NMDC to focus back on the organic, high returns-iron ore business. The success of the steel business depends on the new independent managment/board and the prospects of the industry going ahead.

Any supply of iron ore to the steel plant, in the future, would be at arm’s length pricing and provides some business to NMDC.

Valuations

The steel plant would have a flat steel production capacity of 3 mtpa and its product mix comprises of HRC, HR plates, pipes, cylinders, and auto grade sheets. Based on the capital work-in-progress of about ₹18,500 crore for steel business, the book value of the NMDC Steel comes to almost ₹60 per share . Considering the P/B valuation of about 0.25-0.8 (based on P/B valuations of steel PSU, SAIL in the last decade) , the share price of NMDC Steel would be in the range of ₹16 to almost ₹50 per share.

The value of steel business improves with commissioning, and when the government finds a suitable partner for the steel business. The management believes the steel plant demerger process is likely to be completed FY22 end. Delay in commissioning can create valuation overhang.

At the current market price, on the basis of forward estimates of earnings for the current fiscal, NMDC trades at about 5 times versus a three-year average of 7.6 times. While the current valuations look cheap compared to its historical average and the decent outlook in the current industry environment, risks in case of any downturn in the commodities cycle needs to be factored. Also after factoring additional premium to be paid by NMDC on iron ore sales from this year and some uncertainty on the timing of steel plant commissioning, the risk reward appears balanced with the value of to-be demerged steel business providing some margin of safety.

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