We expect the road for the iron ore miners to be bumpy ahead given the huge steel inventory build-up in China over the past two months.
The inventory build-up is leading to large production cuts as real demand for steel remains weak.
We believe current stabilization in iron ore spot prices is an indicator of the levels at which contract prices will be agreed upon. We expect a decline of 40% in Australian iron ore fines contract price for FY10 supply.
We are concerned about the state of the iron ore market in the near term, given the additional supply available. In FY11, we expect iron ore contract price to remain at FY10 levels.
Sesa Goa management expects iron ore sales to grow at 20-30% pa over the next two years, and volumes to touch 25mn by FY12.
However, with no respite expected in the prevailing downcast conditions, we expect demand for iron ore to decline from China.
We expect the company to witness a flattish volume growth of 3.3% y-o-y (16.2mn tons v/s 15.7mn tons) in FY10 and 13% y-o-y (18.3mn tons v/s 16.2mn tons) in FY11, significantly lower than company’s expectations.
Sesa Goa’s average iron ore realizations are expected to fall 30% y-o-y in FY10E. The estimated decline is lower than 40% y-o-y fall anticipated in contract prices due to the depreciation of the rupee against the dollar.
Further, the increase in the share of Karnataka and Orissa mines would lead to an increase in the transportations costs thereby adding pressure on OPM.
As a result, we expect OPM to shrink 15.5ppts y-o-y to 33.4% in FY10 and 3.9ppts y-o-y to 29.5% in FY11.
At Rs88.6, Sesa Goa is trading at FY10E P/E and EV/EBIDTA of 6.9x and 3.9x respectively. Based on 1-year forward P/E, company is trading at a discount to its global peers. Huge cash balance forms a significant portion of Sesa Goa’s value.
We believe that low valuations are justified given the rising concerns over global economy and falling iron ore prices.
Hence, we believe that upside for the stock could be limited and therefore assign a MARKET PERFORMER rating with a target price of Rs93.5.