India’s leading iron ore producer, NMDC Ltd, enjoys the benefits of huge iron ore reserves, high grade ore and lower costs.

Nonetheless, we recommend an avoid on the follow-on public offer because at the lower price band, the stock will trade at enterprise value/earnings before interest, tax, amortization and depreciation (Ebitda) of 12.6 times and 9.6 times its FY11 and FY12 estimates, which is at a significant premium to its peers.

NMDC produces and sells iron ore in the form of lumps, calibrated lump ore (CLO) and fines. In FY09, NMDC constituted 13% of India’s total iron ore production and produced 28.5 million tonnes (mt) of iron ore. The lump ore and fines constituted 11.4 mt and 17.2 mt, respectively. While the production in Chhattisgarh has increased at a compounded annual growth rate (CAGR) of 8.9% over FY05-09 to 22.2 mt, production in Karnataka has increased at a CAGR of 5.3% to 6.4 mt in the mentioned period.

Also See In The Pipeline (Graphics)

NMDC plans to increase its production capacity to 50 mt by FY14 through increased exploration of its existing mines and development of new mines—deposit 11B and deposit 13 in Bailadila and Kumaraswamy in Karnataka. The targeted cost for the development of the three mines is Rs2,400 crore. Deposit 11B is likely to start operations by October and targeted production is 7 mt.

Kumaraswamy mine is expected to be operational by FY12 and targeted production is 7 mt. Deposit 13 is currently non-operational as forest clearance is still pending. On receipt of forest clearance, the company’s share is expected to be 5 mt out of the total planned production of 10 mt; expected to come on-stream after FY12.

NMDC’s operating cost (excluding freight) of $7.2 per tonne is at the lower end of the global iron ore cost curve. NMDC enjoys the benefit of low costs on account of its mines’ proximity to ports and railways.

The company also plans to invest Rs3,500 crore in building a 10 mt slurry pipeline from Bacheli to the Vizag port, which would help it maintain margins.

NMDC’s five-year pricing contracts with its domestic firms are ending in March, while the export contracts are due for revision in April 2011. Given the changing business environment globally, the company has appointed a consultant to evaluate various options for pricing of its iron ore contracts. In our view, any change in the pricing mechanism would help capture short-term fluctuation in prices, which is likely to benefit the company in fetching higher realizations.

NMDC intends to diversify its operations by moving downstream through the establishment of steel plants and pellet plants. Accordingly, the company has lined up capital expenditure of Rs26,500 crore for the next five years. In addition, the management has indicated that it plans to acquire mines in Australia, Brazil and South Africa.

In FY09, the company’s Ebitda margins of NMDC stood at 77.2%. We expect margins to remain at 77% in FY10, but expand to 81.5% in FY11 due to revision in contract pricing. Thereafter, we expect margins to stabilize.

We believe that the company is well placed to fund its expansion plans through internal accruals, without resorting to external debt. Despite the company’s huge expansion plans, its net debt to equity is expected to remain comfortable. The company had cash and cash equivalents of Rs12,000 crore at the end of December, which is expected to increase to Rs14,189 crore by FY15.

Graphics by Ahmed Raza Khan/Mint

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